Why You Should Stick With Stocks

Nov. 24, 2009 — -- After the beating we took in 2008 and early 2009, many investors opted for more conservative portfolios.

That meant less emphasis on stocks, more on cash and bonds. The evidence of this trend can be seen in the money that has poured into bond mutual funds this year compared to a trickle into stock funds.

This is a predictable response when the stock prices fall close to 50 percent in the span of a year.

But some recent reading I've done reminds me why stocks must play a central role in most investors' portfolio, particularly when it comes to retirement planning.

First, there is a recent study from T. Rowe Price, the Baltimore-based mutual fund outfit. This study reviewed what would have been the best kind of portfolio for investors to adopt just prior to the brutal 1973-1974 bear market. During this period, the Standard & Poor's 500 Index fell more than 40 percent.

T. Rowe Price chose the 1973-1974 bear market because it is the most recent that provides 30 years of subsequent investing history to study.

The two hypothetical investors considered in the T. Rowe Price study were a 65-year-old new retiree and a 45-year-old still 20 years away from retirement.

Had these investors had the benefit of foresight, what would have been the best portfolio type to own over the long haul?

Would they have been better off shifting to much more conservative portfolios just prior to the bear market? Or should they have stuck with a significant stock allocation that they reduced gradually over the years?

The T. Rowe Price conclusion is that for both investors, portfolios holding large amounts of stocks outdid either an all-cash or an all-bonds portfolio over the course of the next 30 years.

The all-cash or all-bond portfolios looked like the better choice in the early years after the bear market ended in 1974, but then investors in these portfolios would have missed out on gains that piled up in later bull markets.

"Investors who stick with a very conservative strategy to avoid all bear markets may fall behind because they don't participate in bull markets – which historically have tended to be more frequent and have a longer duration than bear markets," says the T. Rowe Price study.

Stuart Ritter, a T. Rowe Price financial planner, summarizes the findings this way: "Participating in bulls over the long run beats avoiding bears."

Winning with stocks, however, requires patience and fortitude to avoid rash moves during steep stock market declines. Many investors simply do not have the psychological makeup to sit still as they watch their portfolios plummet with no end in sight.

To strengthen your own stock-investing fortitude, take a look at the latest edition of "Winning the Loser's Game," one of the classics on individual investing by Charles D. Ellis. The recently published fifth edition takes into account last year's brutal experience with the addition of a chapter called "Disaster – Again."

Reviewing the 2008-2009 bear market, Ellis writes, "For long-term investors, as always, the worst action would be getting out of stocks. But, as always, that's what many investors would do: Lock the barn door after the animals had run off."

For individuals who doubt the wisdom of investing in stocks, a reading of Chapter 18 alone is worthwhile. In this chapter, "Planning Your Play," Ellis explains the substantial risk posed by inflation and how it makes an all-cash or all-bond portfolio less secure than many investors realize.

"The corrosive power of inflation is the investor's worst enemy," Ellis writes.

A telling chart in the book shows that after taking inflation into account, a portfolio invested entirely in U.S. Treasury bills posted a negative return in 35 percent of the years from 1926 to 2006, the same as an all-stock portfolio.

But the all-stock portfolio posted an after-inflation, average annual return of 7.2 percent during that 80-year period, compared to just .8 percent for the "super safe" Treasury bills portfolio.

Any time the stock market makes you nervous, study these numbers presented by Ellis. Maybe they will be enough to help you maintain the focus and patience needed to succeed as a long-term investor.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.