08/26/2007 08:54 pm ET Updated May 25, 2011

The Market Volatility Myth: Part 2

My column last week stirred up a firestorm of controversy. I stated that, over the long term, markets were about as predictable as the sun coming up in the morning: They go up.

Many readers took issue with my views. Let's revisit the issues you raised and look at the data:

1. Do I concede that there is short term market volatility?

Of course, but it is much hyped and of no consequence to Smart Investors who are properly allocated. These investors do not have sell their stocks in a down market and can wait for the recovery which 80 years of data tells us is likely to occur over a relatively short period of time.

2. But what about the admonition that "past performance is no guarantee of future results?"

Neither short nor long term data is a guarantee of future results. In fact, you could make the argument that short term success as a fund manager is predictive...of poor performance the following year. One study examined the performance of 100 fund managers over an 11 year period. It found that only 14% of them were able to repeat their stellar performance the following year.

Long term data is obviously more reliable than short term data, but it is still not predictive of future results. Nevertheless, long term market data is our most reliable source of risk and returns. It does not eliminate risk, but Smart Investors are guided by this data in making their investment decisions.

And this data tells us that markets go up over the long term. With only one exception, the domestic stock market has not declined for three consecutive years in the past 50 years. That is a pretty impressive record.

3. What about inflation? Doesn't that distort this rosy picture?

Not really, although that is a common misperception. In the past 50 years, investors in a globally diversified portfolio of two easily obtainable index funds would have earned an annualized return in excess of 11%. When you adjust for inflation, the return is still in excess of 7%.

4. But what if you don't have 50 years to wait for these returns?

Returns (before and after adjusting for inflation) for shorter periods of time were also impressive: For the past ten years, the returns for this portfolio were 8.5%/5.9%; for the past 5 years they were 10.0%/7.1%; for the past 3 years, they were 14.2%/10.8%.

And keep in mind, these returns were yours for the taking. All these hypothetical investors did was buy the global stock market. No market timing. No stock picking. No studying. No research.

5. Should you invest today in such a portfolio?

For the vast majority of investors, an all stock portfolio is too risky. For example, in 1973 and 1974, this portfolio lost about 40% of its nominal value and 51% of its purchasing power after inflation. But the historical data tells us that far more conservative portfolios still have yielded superior returns.

Let's assume you had invested in a portfolio consisting of 60% stocks and 40% bonds. You followed the same, simple strategy for the stock portion of this portfolio that I described above for the all stock portfolio. For the bond portion of your portfolio, you simply replicated the Lehman Bros Aggregate Bond Index, using a low cost index fund.

These would have been your approximate returns, before and after adjusting for inflation:

50 years: 10%/6%
10 Years: 8%/5%
5 years: 8%/5%
3 years: 10%/7%

So what's the bottom line?

Investors with an appropriate asset allocation can wait out short term volatility, without incurring any losses. These investors were rewarded with superior, inflation busting returns.

It is not risk free strategy, but that is the point. It is only by participating in the stock market -- and taking appropriate risks -- that you will be able to outpace the ravaging effects of inflation.

If anyone has a better idea -- and the data to back it up -- I would like to hear it.

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