Hey everyone,
I want to discuss the risks of long term equity investments, specifically that risk of equity decreases over time. Here's a previous discussion that didn't fully satisfy my curiosity as it ended without a strong consensus:
http://forum.mrmoneymustache.com/investor-alley/asset-allocation-100-stocks-for-how-long/I started thinking about this when I saw this chart in Investments, 9th Ed. by Bodie, Kane and Marcus.
[1] InvestmentReturns.png
Returns are nominal. It shows that more than 5% of the time in a Monte Carlo simulation of 25 years of equity returns, equities underperformed risk free bonds around 6% of the time. You can also lose your entire investment!
Then, I read this page:
http://www.norstad.org/finance/risk-and-time.html It states the arguments for why time diversification for risky assets is a fallacy.
Here's a chart of expected total nominal return showing a range of outcomes based on the appendix from the above link. It shows how returns can be significantly lower than the median return.
[2] EquityReturnSpreads.png
For those that think this is only possible in historical simulations, here's a chart of Japanese equities in the past 30 years.
[3] JapaneseReturns.png
This doesn't include dividends so you should compare the return against 0 returns which should be roughly the risk free bond rate. The nominal capital return is only 1.7% and doesn't include inflation! Thus, in a real-world time series we can have a very small risk premium over nominal bonds.
Finally, to address the use of U.S. historical returns, I reference this paper:
http://merage.uci.edu/~jorion/papers/risk.pdf and page 19 and Table VI especially. The U.S. equity market since 1926 has experienced the most growth and lowest volatility of international stock markets. Thus to point to the last 90 years of equity performance in the U.S. as broadly representative of equity returns over the next thirty year period is highly optimistic.
I think you can still make a case for U.S. outperformance continuing into the future (most open, liquid financial markets, large internal market, no true external threats, continuing population growth, etc.) but it shouldn't depend on strict historical returns or that equity always outperforms bonds if you wait long enough.
To conclude, I think there are two parts of maintaining a 100% equity allocation. First, not having the nerve to stay the course during short term crashes (2008 - 2009 for example) and buying high and selling low. Second, the very real possibility that equities underperform bonds or even lose value over decades. No amount of time will guarantee that equities will outperform bonds.