Fran Kinniry, who runs the investment strategy group at the Vanguard Group, is worried that the market crash of 2008 is about to be compounded by a huge collective mistake on the part of investors in 2009.

What's happened is that the strong positive returns of the fourth quarter of 1998 are rolling out of the ten-year performance numbers and being replaced by the staggering losses of the fourth quarter of 2008. If that weren't bad enough, the outsized bull market returns of 1999 will also be winding out of the decade performance numbers in 2009, to be replaced by the bear market numbers of 2000, 2001 and 2002.

As a result, stocks are likely to show losses for ten-year rolling periods in the quarters and years that lie ahead. Kinniry thus fears investors will conclude that stocks in the long run do not pay off, unless advisors convince them otherwise. At this point, bonds look like better investments if you're looking in the rearview mirror, even though the great case for bonds is really only a great case right now. In actuality, if we are indeed near the bottom of the recession, we are likely looking at rising interest rates, which would make them less attractive.

As baby boomer clients approach retirement, advisors must face a difficult task of communicating clearly about the need to own equities over the long run.
Fortunately, Kinniry has anticipated the problem and has gathered data that you can use to persuade clients that stocks, despite recent history, should still be at the heart of most portfolios. Two recent studies by his group remind us why equities are so important in a long-term portfolio. For the next ten years, he says, there will be a bonus for accepting the extra risk inherent in stocks-the equity risk premium-and he pegs it at 7 percentage points. That translates to an expected nominal annual return of 9.5%. Here's what he is thinking.

Gluck: The 2008 stock market shocked most investors and advisors. But was it really that shocking?

Kinniry: People who were caught by surprise weren't looking at the market's history. Our expectation is that stocks have a one-year standard deviation of 20 with a mean return of 10%. Two standard deviations from the mean should cover 95% of your experience-and that gives you annual returns ranging from minus 30% to plus 50%. So 2008 wasn't typical but it also wasn't unprecedented.

Gluck: In some of your research, you seem to say that, having enjoyed such a long period without volatility, what we're getting now should almost be expected.

Kinniry: From 1982 through '99, there was only one down year in the stock market. But in the market's longer-term history, negative returns are experienced once every four years. During that unusual period, people may have believed that stocks were a one-way ticket to wealth. That ignores the idea of an equity risk premium. You shouldn't expect a return for stocks that's 7 percentage points above inflation or 4.5 points above the prime rate if there's no volatility.

Gluck: So that's where you put the equity risk premium?

Kinniry: Yes. We feel it's about seven. With inflation averaging about 2%, that gives you an expectation for stock market returns that average 9.5%.

Gluck: That's not what we've seen during the past decade.

Kinniry: No. The past ten years, the stock market has had a 0% annual return. For ten-year periods, the standard deviation is five, and that means ten-year returns should range from 0% to 20%. So here, too, what we've seen isn't out of the expected range.

Gluck: But in previous years, were you also forecasting the same kind of equity risk premium?

Kinniry: No. In the late 1990s, we absolutely believed the equity risk premium would be smaller. We do tactical asset allocation and we use our group's research in our Vanguard Asset Allocation Fund. Normally, it has a target of 60% stocks and 40% fixed income. But in the late '90s, we were very, very defensive, and the fund was 100% in fixed income. Then, price-to-earnings ratios were at unprecedented levels. Today, in contrast, I would call the P/E ratio normal to slightly below average. That makes us think the equity risk premium should be about where it has been historically, if not slightly higher than that. That's how we get to 7%.

Gluck: Just to be clear, that's 7 percentage points above the risk-free rate of return for a three-month Treasury bill. Right?

Kinniry: Yes. We're saying 7% in real terms. Our ten-year forecast for inflation is 2.5% annually, so that gives you a 9.5% nominal return.

Gluck: Many advisors are getting horrifying calls from clients. "My college savings is decimated. My retirement money has declined dramatically." And very many client portfolios have losses of 25%, 35% or more. How can advisors put those losses in perspective for their clients?

Kinniry: This has of course been a very tough environment. But it's important to remember that the returns we've seen would rank in the bottom 5% to 10% of returns looking back through all of time. They're certainly once-in-a-generation returns. During the 2000 to 2002 bear market, stocks lost 45% but bonds were up 30%. You really have to go back to the 1970s or even the 1920s to find this kind of environment. So this has happened three times in the past 80 years.

Gluck: Another topic your group recently published research about is time diversification. This is another area that advisors would do well to understand.

Kinniry: Time diversification is the idea that investments in stocks are less risky over longer periods than over shorter periods. This has been the subject of heated debate in the academic community for a long time. Whether it's true really depends on your measure of risk. If you look at standard deviation, risk shrinks with time. And if you consider the worst ten-year returns for stocks, there are only two periods-the decade that ended in 1938 and the one ending now-with negative returns. Whereas, again, you get negative annual returns 25% of the time. So if those are your measures of risk, then time does reduce risk. However, if you consider the growth of a dollar, and analyze potential paths that dollar could take, the risk of holding equities actually increases over time. In terms of your potential terminal wealth, equities actually become more risky over time, not less risky.

Gluck: That's contrary to what almost everybody believes.

Kinniry: That's because most people are looking at things in terms of standard deviation.

Gluck: You've pointed out that for an investor to benefit from a 30-year holding period, he has to experience 30 one-year periods.

Kinniry: Exactly. You want to have enough equity risk to accomplish your goal but not so much that, if you have a bad year or a bad three years, your losses are going to make you more conservative. That's the worst time to become more conservative. If everyone had a 30-year horizon, 100% stocks would be the optimal portfolio. We can't find any 30-year period during which stocks underperformed bonds. But that leaves aside the question of your decision horizon. When do you bail out of stocks or fire your advisor? That's the more important question. How much downside risk can you take before you change your policy?

Gluck: What should an advisor tell retirees or people about to retire who have just lost 30% of their portfolios? What do they tell the 60-year-olds who are five years away from retirement? They had $900,000, with a $1 million target for retirement. Now, that $900,000 is $600,000.

Kinniry: Even if that retiree gets normal returns now on a portfolio that is 60/40 stocks and bonds-meaning a 10% annual return on stocks and 5% on bonds, for a combined return of 8%-in five years, they'll be back to $900,000. An 8% return for five years gets you 50%. The worst thing to do today is abandon your strategy. It's prudent to rethink it. If you were overweight in equities and didn't understand the risks, you may need to make adjustments. But don't go totally to Treasury bonds. You can't change the results you already have, but you can affect what's going to happen during the next five to ten years. And today, the equity markets look as favorable as they have in 20 years.

Gluck: But in the near term, it looks like earnings could really be hurt. How does that jibe with your positive scenario for the next ten years?

Kinniry: Even if earnings for the Standard & Poor's 500 falls to $60, which would be an unprecedented decline from $100, where it had been, to below levels in 1996 and '97, we'd still be at prices that are 15 times earnings. Could the P/E go lower? That's a wild card.

Gluck: Is $60 earnings really what you're thinking at this point?

Kinniry: The most bearish analysts are somewhere north of $60. Wall Street analysts are predicting $90. That's the basis for the P/Es of 10 that people are talking about. We're not looking for the economy to rebound quickly. We see the economy and capital markets not being correlated very closely. Look at what happened in China. It had the strongest economy ever for ten years ending in 2002, and there was a negative ten-year return on stocks. When the economy was actually slowing is when China had a 300% return in the stock market. Over the very, very long run, the economy has to be linked to the capital markets, but in the intermediate term, there's really not a lot of linkage.

Gluck: In a recent study you co-authored with Chris Phillips, you observe that ten-year performance numbers for stocks are about to change a lot. Could you explain?

Kinniry: Many investors look at trailing returns to make decisions about where to invest, and as the ten-year trailing returns for stocks lose the performance of the late 1990s-a 230% return from '95 through '99, with average gains of 20% a year-the ten-year return is going to go off a cliff. In August 2008, the ten-year return for stocks was about 6%. Four months later, it was zero. The bear market is part of the explanation, but what's more important is what happened ten years ago. And things are going to look even worse in January when this article is published. We'll have lost the fourth quarter of 1998, when the market had gains in the high teens. And after 2009, we'll lose 1999. So in January 2010-unless returns for 2009 match the 25% gain we had in 1999-the ten-year return will continue to drop. We could have a good 2009 and still have the worst ten-year return ever. I worry how that is going to affect people's choices. Long-term returns are going to look bad for quite a while, and the idea that stocks always beat bonds over the long run is going to be very hard to see. We could be faced with a 15- or 20-year period through 2020 during which bonds have outperformed stocks.

Gluck: So as the spectacular returns of the late '90s fall off the rolling ten-year number, and as these terrible bear market returns are added into the calculation, at both ends of the period, there's a sort of magnification. That's what's causing the ten-year number to drop so quickly.

Kinniry: It's also the volatility. People may think ten-year returns are slow moving, but nothing could be further from the truth. When the numbers at both ends are outliers, ten-year returns are going to look very, very volatile.

Gluck: Are you fearful that today's numbers could feed into bearish sentiment? Strategists could look at this and say, "Maybe we've had this all wrong and shouldn't be investing so much in equities."

Kinniry: That's exactly why we wrote that piece. If people know what is going to happen in the numbers and they understand why, maybe they'll be less likely to react in the wrong way.

Gluck: You also say that even if the market returns 9.5% a year for ten years, its trailing-20-year return will still be below the 20-year return on bonds. That seems astounding.

Kinniry: It's astounding, but it also doesn't really matter. We can't change what has already happened. For people investing today, what's important is what will happen during the next ten years. Trailing returns for one, three, five and ten years are going to look negative for quite a while. But if you get a 9.5% annual return on money you put in today, that's what you get, regardless of what happened in the past.

Gluck: What is your outlook for bonds?

Kinniry: We expect returns of about 4.5%. So our equity risk premium of stocks to bonds is five. That's wider than it has been historically. That's why we are bullish on the equity risk premium.

Gluck: You're looking for 4.5% on a ten-year government bond? And inflation of 2.5% a year for ten years?

Kinniry: That's right. So bonds would give you a 2% real return.

Gluck: That's your long-term inflation forecast, but what about the short term? Do you see inflation or deflation being more of a problem?

Kinniry: I think there's a tug-of-war. In the short run, you have commodities, wages, housing and China all slowing. Those all point to what I would call near-term disinflation, meaning lower inflation year over year, or possibly actual deflation. Longer term, though, the pressure will be upward.

Gluck: How concerned are you about the government bailouts and the enormous growth in the federal deficit?

Kinniry: I think it's a matter of prioritizing concerns. We certainly wouldn't choose to have the federal balance sheet double in six months. At the same time, the risk of not doing anything could have been much more severe. That's what would give you a 1929 event or 1989 in Japan.

Gluck: But right now we have Treasury bills at zero yield and the dollar strengthening. Isn't that kind of Alice in Wonderland?

Kinniry: It just shows that despite everything that's happening in this country, people may feel we're a little bit ahead of the financial crisis relative to the rest of the world, and that the actions being taken here are a little bolder and more aggressive. So there's both a flight to quality in Treasury bills and a flight to the dollar.

Gluck: But at some point, does the world look at the risks of those actions and say, "Wow, this got way out of hand." Will people think the dollar is way overvalued?

Kinniry: This is a global situation, affecting everyone, and if you look at which country may be best positioned to come out of this first, we could be the one. We got into this mess through housing, and the only way to get out of it is to clear up housing. People don't buy houses on the price of the house, they buy on debt-service ratios, and the only way to get mortgage rates lower was to take Treasurys lower. And now you can walk in and get a mortgage at a reasonable rate. I think everything they're doing makes a ton of sense.

Gluck: Still, considering all we have to get through, Vanguard's forecast seems pretty bullish for stocks.

Kinniry: We're actually more bearish than some. I've seen a lot of forecasts for equity returns of 10% to 15%. And if you looked only at valuations, you could make a case for being even more bullish. We tend to be a little cautious.