The Risk Behind Buffett's Advice

Warren Buffett's investment advice echoes the long-term stock investors' refrain: "Buy and hold." Further, adopting academics' (and Jack Bogle's) beliefs, he advises holding an inexpensive S&P 500 index fund. That sounds easy. And, coming from the master, undoubtedly profitable. We only need to look at a long-term stock index chart to prove the wisdom and ease of following it. But wait…

About that long-term graph – it's flawed. It lacks the two key adjustments needed to provide an accurate, historical picture. Without it, returns are overstated and risks, understated. Once done, the adjustments show a more complicated picture, one that raises doubts not only about Buffett's advice, but also about any long-term strategy involving the stock market.

Starting point – The simple graph

Let's go way back, 100 years to 1915, prior to the Great War (World War I). (Note: All the graphs are of the Dow Jones Industrial Average, excluding dividends.) This simple graph is the one happily shown to investors. Looking back 100 years reveals its weakness: The numerical scale turns the Roaring 20s and Great Depression stock market into a ho-hum, flat line.

Chart courtesy of the Federal Reserve Bank of St. Louis (FRED)

Adjustment #1 – Use log scale

Investors know they're going for percentage return, but many graphs still use simple, numerical plotting. Thus, a series of equal percentage moves shows up as a dramatically rising line (e.g., 100% moves from $25 to $50, $50 to $100 and $100 to $200). The solution is to use a logarithmic scale that allows us to see percentage changes. Here is that long-term graph with a log scale:

Chart courtesy of the Federal Reserve Bank of St. Louis (FRED)

Now the earlier market moves can be compared to later ones. But, looking at the now obvious late 1970s and early 1980s, investors might wonder about whether that flattish pattern doesn't paint too rosy a picture during those high inflation years. That takes us to the next adjustment.

Adjustment #2 – Remove inflation (and deflation) effect

Financial data measured in currency units (e.g., U.S. dollars) need to be made "real" by adjusting for changes in the currency's purchasing power. Only then can the data be compared and analyzed over time. The importance of doing so is visible in a graph of the U.S. dollars it takes to buy the same amount of goods over time. Plotted on a log scale, we can see the increasing inflation rate during the 1970s and early 1980s.

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Chart courtesy of the Federal Reserve Bank of St. Louis (FRED)

While inflation adjusting is common for economic indicators (e.g., real GDP), it is infrequently used for investment returns. (An exception is pension actuarial work, where inflation affects salaries – hence future pension payments – thereby requiring inflation + real return assumptions for the fund assets). Here is the long-term graph with both the log scale and inflation adjustments:

Chart courtesy of the Federal Reserve Bank of St. Louis (FRED)

Now, reality hits. Return withers as risk blossoms. Yes, stocks have risen over the long run, but the road travelled looks more treacherous and, therefore, a path less easily adhered to.

The bottom line