Peter Lynch, probably the best known and most influential investor in America, is leading millions of small investors astray. In the September issue of Worth magazine the legendary former manager of Magellan fund says that a stock portfolio is THE answer and a sure long term gain, even if you make withdrawals of 7 percent a year. That strategy, in fact, has about a 50 percent chance of losing principal for the retirees who follow it.
The article, titled "Fear of Crashing", argues that stock prices may suffer small and large corrections but they still offer superior returns to bonds. Long term, he says, stocks offer a total return of 11 percent.
"This brings me", he writes, "to an investment strategy I described in my second book, Beating the Street. If I convince you of its merits, you will never again buy a bond or a bond fund, and you'll stay fully invested in stocks forever."
To prove his point, he then shows that you could invest $100,000 in stocks and withdraw $7,000 a year, selling shares as necessary since the initial dividend yield would be only $3,000. What he bets on are stocks with regular increases in their dividends--- growth stocks. In spite of constant withdrawals of principal, his figures show that if stocks provide a total return of 11 percent a year ( 3 percent dividends, 8 percent appreciation) you would have $349,140 at the end of 20 years.
To prove his point, he asked Bob Beckwitt, manager of Fidelity Asset Manager fund, to "crash test" the idea and assume the market loses 25 percent of its value the day after you invest your $100,000. The result, Mr. Beckwitt concludes, is that you would have $185,350 at the end of 20 years.
"That's not as good as $349,140, but it puts you $85,350 ahead of the $100,000 bond.", Mr. Lynch writes.
Curious, I called Ken Bingham, a Paine Webber broker in Dallas who tends to be cautious with his clients money. "That sounds like a high withdrawal rate to me. When my clients want that much, I ask them if they are willing to run out of money. If they aren't, I advise them to live on the income.", he said.
Mr. Bingham wasn't alone in his skepticism. Steven Penner, a principal with LCG Associates, an investment consulting firm in Dallas, expressed his doubts. So did James Floyd, an investment strategist and researcher with the Leuthold Group in Minneapolis.
Skepticism from others, however, isn't proof. The true test is how such a program would have performed in the past.
I asked Mr. Bingham if he had "Hypo", a program from Tower Data Systems in Bethesda, Maryland. Hypo is used by many mutual fund companies to demonstrate the historic results of investment programs. A version of the program used by the American Funds group in Los Angeles allows you to quickly calculate the results of systematic withdrawal programs over multiple time periods in their mutual funds, dozens of major indexes, and over 30 major individual stocks. Instead of drawing conclusions from a single abstract model, we could see how an ACTUAL investment program that took 7 percent annual withdrawals would have worked out in multiple investment periods of 20 years.
Mr. Bingham didn't have the program but could get it. We arranged to meet in his office the next afternoon.
"Look at this!", he said the next day, tapping his computer screen. "Just a year or two makes a big difference."
"If you retired in 1969 your $100,000 would have turned to $52,700 in 15 years... but if you retired in 1971 it would be $143,800... and if you had retired in 1975 it would be $594,100. I'd say that's quite a bit of difference.", he said.
Mr. Bingham had asked what would have happened over every 15 year investment period starting in 1960 if you had invested in the Standard and Poor's 500 Index and withdrawn $7,000 a year in monthly payments of $583.33.
To get "real world" results on the same measures that Peter Lynch used, we then examined five major indexes--- the Standard and Poors 500 Index, the Dow Jones Industrial Average, and three Lipper fund indices--- and how they would have performed in every 20 year period since 1960 or 1965.
The results are stunning.
While Peter Lynch projects a future value of $349,000 and a worst "crash" case of $185,000, real investors could have experienced a much greater range of results.
Try having $829,215 if you had the good fortune to invest in the Lipper Growth and Income Index in January, 1975.
Unfortunately, while few people would protest having MORE money than Peter Lynch projects, most people would have much less.
Some would be stone broke. That would have happened if you had invested in the Lipper Growth Fund index in 1968, 1969, or 1973.
In a total of 65 time periods with the five major indices, an investor would have LOST PRINCIPAL in 32 periods--- NEARLY HALF THE PERIODS--- and would have had less than Mr. Lynch's "worst case" in 44 time periods. (The results are summarized in table one.)
Crash Testing The 1995 Peter Lynch Strategy
|S&P 500||1960||857,075||152,722||49,856||(6 of 16)|
|Dow Jones||1960||812,212||97,037||0||(9 of 16)|
|Lipper Growth||1965||737,297||19092||0||(9 of 11)|
|Lipper G&I||1965||829,215||195,228||53,074||(3 of 11)|
|Lipper Balanced||1965||484,215||106,225||0||(5 of 11)|
Is the comparison reasonable?
I think so. While history shows that Peter Lynch could, and did, pick stocks that would have allowed an investor to follow this strategy, these results are what would have happened in recent market history if average investors had tried to follow Peter Lynchs' All-Stocks-Forever strategy into retirement using the average professionally managed fund or a major index. Without taking the burden of selling commissions or capital gains taxes into consideration, it would have been a disaster for HALF the people who followed the strategy.
What's the problem?
It isn't that stocks are bad or that Peter Lynch is wrong about stocks being a superior long term investment. Stocks are a great way to ACCUMULATE a nest egg. The problem comes from making large and withdrawals of principal.
Mr. Lynch couldn't be reached for comment.
Next: Taking a Closer Look
Scott Burns is the retired Chief Investment Officer of AssetBuilder, the creator of Couch Potato investing, and a personal finance columnist with decades of experience.