Monday, February 4, 2008

“Worry-Free Investing” Book Review, Part 4

This is the fourth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

In part 3 of this review I showed that the authors’ justification for disliking stocks based on simulations is misleading. Instead of doing 30-year simulations, what about looking at actual 30-year returns in the data we have from 1926 to 2000?

The worst 30-year period for stocks was from 1965 to 1994 (inclusive), where the average real compounded return was 4.3%. This means that if I Bonds had existed then, and you could get one that paid 4.3% above inflation, then it would have done just as well as stocks. But, I Bonds don’t usually pay this much. In every single 30-year period, stocks beat I Bonds.

But what about the big stock market crash after the year 2000? Even taking the 30-year period ending at the bottom of the crash, average yearly compounded real returns were above 4%, which beats I Bonds.

One of the points that the authors repeat is “the risk of owning stocks does not always decline the longer you hold them.” This depends on how you look at it. You may not know whether stocks will beat I Bonds by a little or a lot, but the odds of beating I Bonds are high over the long term.

From 1926 to 2000, yearly real stock returns ranged from roughly -40% to +60%. But, if we look at all the possible 30-year periods, the range of average yearly compounded returns was 4.3% to 10.3%. Over time, the range of average yearly stock returns declines. In this sense the risk of owning stocks does decline with time.

In part 5 of this book review, we examine the authors’ strategy based on stock options.

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