AWM on long term stock investing

I have been asked by a number of people recently whether they should get out of the stock market now. The worries over Greece, Europe, flash crashes, global debt, oil spills. So , I have reworked a paper I emailed in the fall of 2008.

The first thing to understand is that the stock market is very volatile over short periods of time. Obviously, it is sometimes much more volatile than at other times. It moves randomly from minute to minute because it is constantly responding to news and events that effect our economy and business environment. But, over the long run, stocks follow a more rational pattern. That is because, over time, our economic system produces more good news than bad. Review the chart below. It was developed by Jeremy Siegel, Professor of finance at Wharton (note: there is debate on the accuracy of returns during the 1800's, but the trend is still relevant) :

This covers a civil war, the great depression, two world wars, the Vietnam era etc.

FYI: notice the value of gold.

For the last 400 years, since the inception of capital markets, there have been wild swings in the value of markets. There have been numerous bursting bubbles and numerous claims that this is the end of capitalism. Every time the markets rebounded and continued their upward climb.

Markets act wildly day to day, even month to month, sometimes for many years in a row. But over very long periods 10 years or more, they act very rationally. Below is a graph that shows the volatility (highest value to lowest value) of annual returns of the total US stock market between January 1926 and September 2008 over rolling 1, 3, 5, 10, 15, and 20 year periods. There has never been a period of 15 years where the markets return was negative, and only in rare cases are there periods of 10 years that have resulted in a negative return.

As you can see, that as your stock investing period of time increases, the volatility of your returns diminishes considerably.

Furthermore, this tells us that when we invest in stocks it should be for 10 or more years, otherwise we may be subject to wide swings in potential returns.

Next, look at the next chart below, similar to the chart above, it shows us that over the last 100 years the US stock market goes through stagnant periods followed by dramatic euphoric increases. The important point, with both charts, is that although we have had many bad periods, the market trends up. If you stay in long enough you will be rewarded. As long as the foundations of capitalism are secure, stocks have to return a positive amount - simply because the market will continually adjust stock prices to insure that an appropriate long term return is earned.

How does this happen? The return on a stock is the expected dividend divided by the stock price: ( Expected Dividend)/Stock Price = Return. If I own a stock worth $100 and I expect to earn $5/year in dividends then my expected return is 5%. (5/100). If I feel the dividend will go down because of bad economic news AND I demand a 5% return from this stock, then I will no longer want to hold it at $100. I will sell. When news is bad, stock investors worry about the amount of future earnings they will receive from stocks. If the market feels that dividends are going down (bad economic news), the value of stocks will go down. Likewise, if the market feels that economic news is positive the price will adjust up. For example, if I demand a 5% return on the $100 stock and good economic news leads me to believe future dividends will be $6 then I am willing to purchase my stock at $120 ($6 div/$120 stock price = 5%) and I now feel even wealthier because I own the stock at $100 and I am receiving a greater dividend return than i required from that stock.

The markets volatility is the markets way of constantly adjusting prices to changing news. Over time, there has been more positive investment news than negative. In fact it can only be that way in a Capitalist system. Otherwise the system would collapse. If we really believed that our nation and economy are collapsing then anticipated profits and dividends would be zero and therefore stock prices would be zero (see my concluding comments).

Some may look at the chart above and say “I will stay out until the market rebounds, then buy on the upswing” the problem with this idea is that one does not know when the market has bottomed. Often the market corrects itself over a few large trading days. Just read this following excerpt from:

· Charles Ellis’s WINNING THE LOSER ' S GAME. “Market timing is a "wicked" idea. Don't try it-ever. Using the S & P 500 average returns, the story is told quickly and clearly: All the total returns on stocks in the past 75 years were achieved in the best 60 months (less than 7 percent of those 800 months-over those long years). Imagine the profits if we could know which months! But we can- not and will not. What we do know is both simple and valuable: If we missed those few and fabulous 60 best months we would have missed almost all the total returns accumulated over two full generations. A recent study by T. Rowe Price shows that a $1 investment in the S & P 500 that missed the 90 best trading days in the 10 years from June 30, 1989, to June 30, 1999, would have lost money (22 cents) and would have made only 30 cents if it missed the best 60 days-but would have made $ 5.59 by staying fully invested. “

Charles D. Ellis, John J. Brennan. Winning the Loser's Game: Timeless Strategies for Successful Investing. (McGraw-Hill, 2002). Page 14.

So, what to conclude:

1. If your investing time horizon is greater than 10 years, stay the course you have decided on. If you are unsure of your course – contact me. If your investing time horizon is less than 15 years please consult with me. The answer will depend on your future plans for your investments.
2. Should you stay in the market? Yes, if you believe that our government is stable over the long period. The market may move down more or stay flat for a period of time. Again, recall the information above, As long as you have time and our nation stays strong you will be rewarded. I have also told people that if our government fails. It will not matter where your money is. It will all be worthless anyway. Our dollar, our banks, US government bonds are all dependent on our governments survival – they will all be worthless. If the US fails the consequences are too apocalyptic to imagine.
3. A decision to enter the stock market should be a long term decision with an understanding that you may, and likely will, have uncomfortable downs. The long term return of stocks of around 6.5% (after inflation) is the reward you get for accepting the wild swings.
4. Make sure that as you age, you move more of your portfolio into less risky investments. You should understand how much volatility your portfolio has, and adjust as age and life circumstances dictate.