The Wisdom of "Why?"

I am an unrepentant skeptic. If you want to get my attention, make a claim about a factual matter without providing any proof or data to back up your claim. Even worse, provide bad or incomplete data. The practice of skepticism has a long and shining history, starting with the Greek philosophers and running through such modern luminaries as Albert Einstein and Michael Shermer.

At its core, skepticism is the art of asking, “Why?” Someone makes a claim or observation. You ask, “Why?” They give a first answer, to which you again ask, “Why?” The process of drilling down into the issue – of peeling back the layers of the onion – can eventually lead to truth. Or, equally often, it will uncover the lack of truth.

I’d like to illustrate the concept with reference to a magazine article I read a couple of years ago. A national news weekly gave the advice that, in order to beat inflation, you should buy stocks. They used three periods of time to illustrate their point: 1926 to 2004; 1987 to 1990; and 1979 to 1981. During those selected periods, stocks paid significantly more than the rate of inflation. The investment skeptic will ask, “Why,” and look more deeply at the question.

First, we should notice the odd selection of time periods. A 78-year period, a 3-year period and a 2-year period. Hmm. What about 5, 10, or 20 year periods? I don’t have 78 years to wait, and 2-3 year periods are too short a horizon for stocks. On a hunch, I looked through the data myself. It wasn’t hard to find a few periods where stocks did not keep up with inflation. In fact, they all but leap out of the database.

For the 5 years from January 1973 to January 1978, stocks paid a total annual return of minus 4.5%, while the annual inflation rate averaged 8.0%. Stocks trailed inflation by a compounded 46%, over only 5 years! The spending power of stock portfolios was cut almost in half.
What about periods in which stocks made good money, but inflation was high enough to wipe out returns? Since you asked, the 5 years following January 1945 saw annualized stock returns of 5.2%, with annual inflation of 7.4%. I could go on and on.

The point here is that, with a sloppy or careless examination of the data, one can find select periods of time that support almost any conclusion. The question, “Why?” doesn’t lead to an answer about why stocks beat inflation, but rather to the question about why the magazine chose these time periods.

As we continue to ask, “Why,” we begin to find that stocks tend to do well not merely when inflation is high or low, but rather when inflation is moving from high to low. Paul McCulley of PIMCO has written about the difference between the journey and the destination. It is the journey of inflation from one level to another higher or lower level that triggers stock movements. Stocks move higher more often when inflation has drifted lower than when inflation is stable.

Since 1900, whenever inflation in one 5-year period changes a small amount from the previous 5-year period – what I call stable inflation – stocks beat inflation two-thirds of the time. This is true whether inflation is high or low. In times when the rate of inflation declines significantly across those sequential 5-year periods, stocks beat inflation an astounding 98% of the time.
Finally, if the rate of inflation increases significantly, stocks fail to keep up with inflation 55% of the time. In 5-year periods during which inflation rose, stocks trailed inflation by an average of 1.5% per year.

These figures provide some evidence that it is the change in the rate of inflation that matters most to stock investors, not so much the actual rate of inflation itself. The national magazine article looked only at the average rate of inflation, not the change in direction of inflation. This article also highlights the fact that even well-meaning, independent investment advice can lead us astray.

While the magazine implored investors to move into stocks as inflation moves higher, the evidence from the 20th century provides advice to the contrary. If you believe that inflation is moving higher, you need to make a decision about stocks.

Investors must be skeptical, and continually ask, “Why?” If someone advises you to buy an investment, you must ask, “Why?” If the answer is, “Well, it has paid 11% annually for the last 25 years,” you need to ask, “Why did it pay 11%?” What were the facts and circumstances that led to that 11%? Are those circumstances likely to repeat themselves? What about other time periods?

This last example should be asked of index fund promoters, who are fond of merely citing the historic average return, while giving no thought whatsoever to whether those historic returns have any hope of being repeated. Investment returns don’t just happen. They happen for reasons. An argument over index funds versus active funds misses the point. What are the reasons and conditions that led to past investment returns? Are those conditions present today? Should we rationally expect the past to repeat, or should we actually pick up our heads and look around at the real world?

The skeptic has a reputation for being a curmudgeonly naysayer that questions everything and everyone. While this behavior might not be the best way to approach all areas of your life, it is the best way to approach your investing.