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The following is a guest post by Rob Bennett, who writes at A Rich Life.

Most people think of stocks as being “risky.” But not too risky.

Most people think it is prudent to go with a stock allocation of 60 percent, 70 percent, or even 80 percent. They cannot think of stocks as being too risky if they are willing to invest so much of their life savings in this asset class.

I think the best way to describe investor attitudes today is that we think of stocks as being both risky and non-risky at the same time. We say that stocks are risky because we know that prices can suddenly drop hard — stock prices are volatile. But we also believe that stocks are not really all that risky for those committed to holding them for the long term. However, it is easy to look at real time stock charts and quotes and panic about falling prices. In the long term, stocks always provide good returns. By following a Buy-and-Hold strategy, we can overcome the riskiness of stocks.

I don’t think it is so. I view this as dangerous thinking.

It really is almost so. The long-term average return for U.S. stocks is 6.5 percent real. If you hold stocks long enough, you are in all likelihood going to obtain a return in that neighborhood. Buy-and-Holders are very much on the right track, in my assessment. Focusing on the long-term really is the key to becoming a successful investor.

However, my strong sense is that most investors have not thought through carefully what it means to stick with stocks for the long run. To try to stick with stocks for the long run and fail to do so is the worst of all possible worlds. The possibility of becoming a failed Buy-and-Hold investor is the biggest unknown risk of stock investing.

To stick with stocks for the long run not only in your aspirations but in the real world, you need to know before you buy stocks precisely what it is you are signing up for. I have had conversations with thousands of middle-class investors that tell me that most of us have little idea how rocky a road it is that we are traveling by going with high stock allocations today.

Investors have told me that they choose their stock allocations according to an assumption that it is possible they will see a 50 percent portfolio loss. In other words, they won’t put $200,000 into stocks unless they feel comfortable with the thought of for a time seeing that portfolio balance reduced to $100,000.

The thinking here is sound. You need to be prepared for a worst-case scenario. But where in the world did we get the idea that a 50 percent loss is a worst-case scenario?

Following their 1929 highs, stock prices fell 89 percent in nominal terms, 80 percent in real terms. And the valuation levels that brought on the 1929 crash were far lower than the valuation levels that brought on today’s bear market. If stocks continue to perform in the future anything at all as they always have in the past, we should be looking at the prospect of a 50 percent loss as a best-case scenario, not a worst-case scenario.

Another big problem is that most Buy-and-Holders have never stopped to define clearly what constitutes the “long term.”

How long is it that you will have to hold stocks to see your portfolio balance return to levels that don’t cause you to lose sleep at night? A year? Three years? Five years?

Try 25 years.

I’ve performed a regression analysis on the historical return data to determine how long it may take for an investor who bought stocks in 2000 to see a positive return, presuming that stocks perform in the future at least somewhat as they have always performed in the past. The numbers show that eventually a Buy-and-Hold strategy really will pay off. But given the prices at which stocks were selling in 2000, it may take a long, long, long time. In a worst-case scenario, investors who purchased stocks in 2000 will still be in the hole in 2025.

Buy-and-Hold really is a fantastic strategy for those who buy stocks at reasonable prices. It’s a virtual impossibility for stocks purchased at fair-value prices to pay a negative return for 10 years. So those able to wait that long can buy stocks when they are selling at fair-value prices without worry as to how things are going to turn out. But it’s a huge mistake to think that the rules that apply when stocks are selling at fair prices also apply when the sorts of prices that have applied from 1996 forward are in effect.

There have been four times in U.S. history when the P/E10 value rose to 25. The 20 year real return (including dividends) for the first three occasions was: (1) -0.2 percent; (2); 0.4 percent; and (3) 1.9 percent. We are today halfway through the fourth of these 20-year post-bull time-periods. The P/E10 value we reached in the bull market that ended in 2000 was 44. The P/E10 value that launched the Great Depression was 33.

Those who sell early in a bear market suffer losses. But the losses of those who sell early end up being small compared to the losses suffered by those who hold and hold and hold and then finally sell because the pain becomes just too great to bear. I believe that all investors need to become intimately familiar with the numbers cited in this article before adopting a Buy-and-Hold strategy.

The greatest unknown risk of stock investing is the possibility that you will try to follow a Buy-and-Hold strategy but come up short because you did not educate yourself up front as to just how bad things might get before the bear market comes to an end.

Rob Bennett views Treasury Inflation-Protected Securities (TIPS) as a greatly underrated asset class. His bio is here.

[Kevin] I find Rob Bennett’s views on buy & hold to be quite fascinating, and I thank him for a great guest post and for sharing his views here. Dear reader, what are your thoughts on the stock market? Is it too expensive? None of us can predict for sure, but after a decade of sideways growth, what are your thoughts on where things are going to go in the future?

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52 Comments Guest on Sep 21st 2011

52 Responses to “The Biggest Unknown Risk of Stock Investing”

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