Should Long-Term Investors Be 100% in Equities?

An interesting new paper, “Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice,” challenges the conventional wisdom that investors should diversify across stocks and bonds and the young should hold more stocks than the old. The authors, Aizhan Anarkulova, Scott Cederburg, and Michael O’Doherty, assessed the performance of several strategies that provide long-term appreciation and capital preservation through a mix of equity and fixed-income exposures based on the participant’s age—such as target-date funds. They also evaluated balanced strategies (such as 60/40) that remained constant regardless of age.

Their 1 million bootstrapped simulations used a dataset of returns on domestic stocks, international stocks, bonds, and bills covering 38 developed countries. The data covered the period from 1890 to 2019, but the sample periods for individual countries varied based on data availability and when the country achieved developed market status. Five countries—Denmark, France, Germany, the UK, and the US—were included in the full sample.

The authors evaluated strategies based on four retiree outcomes: wealth at retirement, retirement income, conservation of savings, and bequest at death. At age 65, retirees begin to receive Social Security income and draw down on savings with constant real withdrawals using the popular 4% rule. They concluded that a simple all-equity portfolio (either all domestic or 50% international) outperformed across all retirement outcomes. For example, they found that a strategy of investing 50% in domestic stocks and 50% in international stocks throughout one’s lifetime generated more wealth at retirement, provided higher initial retirement consumption, was less likely to exhaust savings, and was more likely to leave a large inheritance. The outperformance was a result of “capitalizing on the high average return of stocks.”

What About Diversification?

Before jumping to conclusions, there are significant problems with the paper. To begin, it’s no surprise that riskier stocks produced higher net worth and greater bequests because riskier stocks have higher expected—but not guaranteed—returns. However, if achieving the highest expected return were the only consideration, investors should own only the riskiest stock(s), ignoring the benefits of stock diversification. Clearly, investors care about more than just earning the highest expected return—they care about risk-adjusted returns, as well as other issues we will discuss. And diversified portfolios tend to produce higher risk-adjusted returns. As one example, over the 37-year period from 1987 to 2023, a 100% equity allocation using Vanguard Total Stock Market Index VTSMX returned 10.62%; a portfolio that was 60% VTSMX and 40% Vanguard Total Bond Market Index VBMFX returned 8.74%. Despite the higher return, the balanced portfolio produced a higher Sharpe ratio (0.61 versus 0.54) and a much lower worst-case drawdown (negative 31% versus negative 51%).

Let’s examine some other problems with the paper. The first is that, while the authors noted that the all-stock portfolio produced worse drawdowns—the average drawdown of 68% for the domestic stock portfolio was the highest (higher than the 57% average drawdown for the 50% domestic/50% international portfolio)—and worse left-tail results, they failed to note that investors are highly risk-averse on average, weighing the pain of losses more heavily than the benefits of gains. Second, they failed to address the question of whether investors could stand the pain of the larger losses, stay the course, and realize the long-term benefits. Third, they failed to consider the question of the marginal utility of wealth. At some level, the benefits of potential incremental wealth gained from investing in riskier equities (versus safer bonds or Treasury bills) are not worth the downside risk, as the marginal utility of wealth declines as wealth increases and eventually approaches zero.

Given these issues, it is interesting that they noted, “Minimizing intermediate drawdowns appears to be a priority for regulators regardless of retirement outcomes. An important policy issue is the extent to which regulation should focus on minimizing the psychological pain of intermediate drawdowns versus maximizing the economic outcomes of retirement savers given the vast performance disparities across strategies.” Perhaps regulators understand these issues far more than the authors, who appear to focus only on maximizing return without considering risk, the behavioral issues related to investing in risky assets, investor loss aversion, and the marginal utility of wealth.

Stocks for the Long Run?

However, we are not done yet. We have not addressed perhaps the biggest problem with the paper: Is it really “stocks for the long run” as Jeremy Siegel wrote in his book of the same name?

Drawing on new data sources that have become available since Siegel published his book, Edward McQuarrie, author of the study “Stocks for the Long Run? Sometimes Yes, Sometimes No” (Financial Analysts Journal, Vol. 80, No. 1) produced new findings that “substantially diverge from the record available to Siegel.” McQuarrie’s data series for both stocks and bonds began in January 1793. Among his key findings were:

• Over the 150 years from 1792 to 1941, the performance of stocks and bonds produced about the same wealth accumulation by 1942.
• Over the next 40 years (1942-81), stocks far outperformed, providing the basis for Siegel’s claim.
• From 1982 through 2019 (prepandemic), while stocks outperformed, the results were much closer to the first 150 years than to the following 40.
• Results for the entire 227 years were weakly supportive of Stocks for the Long Run: The odds that stocks outperformed bonds increased as the holding period lengthened from one to 50 years. However, the odds never got much higher than two in three and increased only slowly as the holding period stretched from five years (62%) to 50 years (68%).
• However, the subperiod results did not support Stocks for the Long Run, as before the Civil War, the pattern was the reverse: The longer the holding period, the greater the odds that stocks would underperform bonds—for holding periods of 30 and 50 years. In that era, stocks always underperformed bonds.

McQuarrie’s findings led him to conclude that Stocks for the Long Run was “built on a faulty premise: that the strong returns on stocks seen after World War II, combined with the poor returns on bonds through 1981, reflected a stationary process. The old historical record appeared to show that stocks had always returned 6% to 7% in real and there had always been a substantial equity premium. The new data show that the 19th century, particularly the antebellum era, saw quite different returns than the 20th century, with repeated equity deficits.”

McQuarrie then went on to show that Stocks for the Long Run also fails out of sample, as the favorable experience of US stock investors in the 20th century does not hold internationally. He noted that “the 2020 Credit Suisse Yearbook calls out returns over the trailing 50 years. For the world ex US, 1970 through 2019, the authors now report parity performance for equities versus government bonds, at 5.1% and 5.0% annualized. Outside the US, the equity premium has been just that small in recent decades.”

Perhaps the most interesting conclusion of Anarkulova, Cederburg, and O’Doherty was that “Americans could realize trillions of dollars in welfare gains by adopting the all-equity strategy.” In his article “Why Not 100% Equities” in which he discussed several problems with the paper, AQR’s Cliff Asness noted: “Equities are already 100% owned. If some investors read this ‘new’ paper and decide to buy more equities, they have to buy those equities from other investors. This can force the price up, and the expected future return down, but everyone can’t suddenly have double the normal amount of equity dollar return out of thin air. Claiming there are trillions being left on the table is really just noneconomic hype.”

Investor Takeaways

There are several key takeaways for investors. First, they must accept that stocks will not always beat bonds, no matter the investment horizon. That is only logical because stocks are riskier, and while that risk should result in an ex-ante premium, if stocks always outperformed, there would be no risk and no risk premium! Said another way, there can be no equity risk premium if stocks are not risky, regardless of the horizon. Second, diversification of risk across unique assets is always a prudent strategy. Third, an investment policy statement should be tailored to an individual’s unique ability, willingness, and need to take risk, taking into account their capacity (both from a financial and psychological standpoint) to withstand the risks of severe equity drawdowns.

I would add that investors should not be limited by diversifying to only stocks and bonds. Other assets have logical risk premiums and can help diversify portfolios, reducing tail risks. Among those investors could consider are real estate; senior, secured loans sponsored by private equity floating-rate debt; reinsurance; and long-short factor funds.

The views expressed here are the author’s. Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.

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