By Scott Lummer
Chief Investment Officer, mPower

It's true: The older I get, the better I was. In addition to the high school festivities, I got together with about 20 of my 8th grade classmates. As I was driving home, I started thinking about how things have changed over the past 30 years. No, not in terms of waistlines and crow's-feet but concerning perceptions of investing and the stock market.

Back to the Future

To demonstrate the differences, we're going to go back to those wonderful days of yesteryear, circa 1970, to interview little Scott — who we will refer to as Mini Chief Investment Officer (MCIO). He has all the statistical tools and conceptual knowledge that I have now but not the specific data on what has transpired between 1970 and 2000. He also has the maturity of an 8th grader, which of course is no different than now.

mPower: Good morning, Scott!

MCIO: What's happenin'?

mPower: Excuse me, Scott, could you turn down the music?

MCIO: Oh, sorry. I was just listening to Chicago. I know this idea of mixing brass and rock music will be the wave of the future.

mPower: OK, let's get to our subject matter. How do you think stocks will perform over the next 30 years?

MCIO: Of course the future is kind of hard to predict. But, based on historical performance, the market should return about 9.5 percent per year.

mPower: How stable will that return be?

MCIO: It depends on the economic environment. The only time stocks have really been volatile is during a depression. Since the end of World War II, the worst two-year decline in stocks has been 13 percent. Unless we were seeing a depression, you could probably count on not having a bigger loss than that over two years.

mPower: How reliable is your forecast?

MCIO: I'm as sure about this forecast as I am sure that bell-bottoms will always be in fashion. We have 45 years of historic data available, which should give us a high degree of confidence about the numbers.

mPower: What about bonds?

MCIO: Bonds are badddddd.

mPower: So, you wouldn't recommend bonds?

MCIO: No man, this is the '70s, baddddddd is good. The great thing about bonds is they offer a certain return.

mPower: Should investors buy short-term or long-term bonds?

MCIO: Long-term. Bonds have never lost more than 8 percent in any two-year period, so you can be virtually assured that your investment is safe, regardless of your time horizon.

mPower: So, you think investors would be wise to invest a lot in long-term bonds?

MCIO: Definitely. Not only are bonds very safe, but bonds have no correlation with stocks. So, in the unlikely event that bonds decline, there is a chance that stocks may increase in value.

mPower: Should investors diversify internationally?

MCIO: That would not be groovy. Although going to places like Amsterdam is cool, investing overseas is risky. I think that international stocks have, like, double the risk of domestic stocks.

mPower: One last question, do investors have to worry about inflation?

MCIO: Nah. There is no way the government would allow inflation to get above 4 percent.

The More We Know, the More We Know We Don't Know

Let's see where little Scott was wrong:

• He thought stock returns would be 9.5 percent annually — they were actually 11.5 percent. Not too bad.
• He thought stocks wouldn't experience steep declines except in a depression. Within a decade of the interview, stocks suffered a two-year loss of 38 percent.
• He thought long-term bonds were very safe. Yet, in the early '80s they lost 19 percent over a two-year period.
• He thought bond and stock returns would show no correlation. Yet, since the 1970s, the correlation between stocks and bonds has been very high (0.4).
• He thought that international stocks would be much more volatile than domestic stocks. Yet, the difference in risk has been trivial.
• Finally, he thought inflation would be predictably low. Yet, inflation has been very volatile in the past 30 years, at times reaching the double digits.

Oops

If little Scott had relied solely on past data in formulating his strategy, he would have invested heavily in long-term bonds and eschewed international diversification. He also would have had an unrealistic sense of confidence that he would meet his investment objectives because he underestimated risk and inflation.

My point is this: Predicting the future is very difficult, regardless of how much historical data we have to back us up. Times change, paradigms shift, and we can never forecast the unforecastable. The only thing that is predictable is the arrogance of those of us in the investment profession who believe we can predict the future.

So, What Does This Mean?

Be humble, grasshopper. You really can't be sure about what markets will do over the long term. Put a lot of cushion in your financial plan. Diversify broadly. And ... what's that? ... MCIO has something to say ... "Never trust anyone over 30" (or under 14).