Les then Two months of 2024 have passed, but the year has already been a pleasant one for stock market investors. The S&P The 500 index of major US companies rose 6% to cross the 5,000 mark for the first time ever, driven by a wave of enthusiasm for tech giants like Meta and Nvidia. Japan’s Nikkei 225 is tantalizingly close to surpassing its own record set in 1989. The vibrant start to the year has revived an old debate: should investors go all-in on stocks?
There are some pieces of research being discussed in financial circles. One was published in October by Aizhan Anarkulova, Scott Cederburg and Michael O’Doherty, a trio of academics. They advocate a 100% stock portfolio, an approach that runs counter to long-standing mainstream advice that suggests a mix of stocks and bonds is best for most investors. An all-stock portfolio (although half American and half global) is likely to beat a diversified approach, the authors say – a finding based on data going back to 1890.
Why stop there? While the idea may sound absurd, the idea of ordinary investors putting their money towards buying assets in the housing market is considered normal. Some advocate a similar approach in the stock market. Ian Ayres and Barry Nalebuff, both at Yale University, have previously noted that young people will benefit most from the long-term impact of capital growth but have the least to invest. The duo have argued that young people should borrow to buy shares before reducing debt and diversifying later in life.
The other side of the argument is led by Cliff Asness, founder of AQR Capital Management, a quantitative hedge fund. He agrees that a stock portfolio has a higher expected return than a portfolio of stocks and bonds. But he argues that it may not yield a higher return based on the risk taken. For investors who can use leverage, Mr Asness says it is better to choose a portfolio with the best balance of risk and return, and then borrow to invest more of it. He has previously argued that this strategy can deliver higher returns than an all-stock portfolio, with the same volatility. Even for those who can’t borrow easily, a 100% stock allocation may not provide the best returns based on how much risk investors are willing to take on.
The problem with choosing between an equity allocation of 60%, 100% or even 200% is that the history of the financial markets is too short. Arguments on both sides rest – explicitly or otherwise – on a judgment about how stocks and other assets perform over the very long term. And most of the research showing that stocks outperform other options focuses on their track record since the late 19th century (as is the case in the work of Ms. Anarkulova and Messrs. Cederburg and O’Doherty) or even the early 20th century.
While that may sound like a long time, it’s an unsatisfactorily small amount of data for a young investor thinking about how to invest for the rest of his working life, perhaps half a century. To address this problem, most studies use rolling periods that overlap to create hundreds or thousands of data points. But because they overlap, the data is not statistically independent, which reduces their value when used for prediction.
Moreover, the picture may look different if researchers look at the longer term. An analysis published in November by Edward McQuarrie of Santa Clara University looks at data on stocks and bonds going back to the late 1700s. It finds that stocks did not consistently outperform bonds between 1792 and 1941. There were decades when bonds outperformed stocks.
The idea of using data from such a distant past to make investment decisions may seem somewhat ridiculous. After all, the financial world has changed immeasurably since 1941, not to mention since 1792. Yet the financial sector in 2074 will almost certainly look very different from the recent era of rampant stock market outperformance. In addition to measurable risks, investors also face unknowable uncertainty.
Diversification advocates struggle when stocks are in the middle of a rally because a cautious approach can seem timid. But financial history—both the lack of recent evidence on relative returns and glimpses of what happened in earlier periods—provides ample reason to hold firm. At the very least, proponents of a 100% equity allocation cannot rely on an appeal to what happens in the long term: it simply doesn’t last long enough. ■