Sunday, September 13, 2009

Core Argument of “Worry-Free Investing”

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

The core argument of the book Worry-Free Investing, by Zvi Bodie and Michael J. Clowes is that stocks are too risky for most investors and they should invest in inflation-protected bonds (called I Bonds in the US and Real Return Bonds in Canada). The justification for this claim is in Chapter 6 where they show the results of some simulations.

Monte Carlo simulations can be a good way to get a feel for the various possible outcomes of investing over a period of time. The authors use historical returns on US stocks from 1926 to 2000 to simulate a one-time investment of $100 in US stocks over 30 years to show what could happen.

To make the numbers more meaningful, I’ll multiply them by 100 so that the initial investment is $10,000. In the three simulations the authors show, here is how much the stocks are worth after 30 years (adjusted for inflation):

Simulation 1: $75,000
Simulation 2: $5200
Simulation 3: $200,000

For comparison, an I Bond with a 3% return above inflation would give $24,300 after 30 years. The authors then point to simulation 2 saying “we see that very bad outcomes can occur for long-time horizons.”

The outcome of Simulation 2 seemed very unlikely to me. I decided to run my own simulations based on choosing each year’s return randomly from the historical returns in Figure 6.2. Instead of only doing 3 runs, I let my PC go for a few hours, and it completed a billion runs. This is more than we need, but it gives a good picture of the possible outcomes.

One thing I learnt was that 25-year olds are about 10 times more likely to die before the end of the 30 years than they are to get stock returns as bad as in Simulation 2. In only one out of every 140 simulation runs the stocks were worth less than $5200. In 87% of runs, stocks beat I Bonds. Half the time stocks were above $86,000 compared to I Bonds at only $24,300.

If we accept Simulation 2 as a meaningful result even though it happens only once out of 140 times, what about the high end of stock return possibilities? In one out of 140 runs, stocks returned more than $1,060,000!

The main result here is that the authors’ three simulations do not give an accurate picture of what is likely to happen. If that result of $5200 were just one out of a list of 100 simulation runs, it wouldn’t seem nearly so scary.

2 comments:

  1. Seems like a lot of people prefer guaranteed, but low-return investments over investments with slight long-term risk of inferior returns. I think this attitude is fine as long as someone saves a significant portion from an excellent income and looks forward to working a long time.

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  2. Gene: I suspect that what people mostly fear is a sudden drop in stock prices. Perhaps among those who think long term, many fear underperforming guaranteed investments. I think you're right that someone with take-home pay of $100k and living on only $70k could save enough for retirement with guaranteed investments, but the thundering herd making much less would have great trouble.

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