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Thursday, May 1st, 2008 Subscribe To Our Feed
By Selwyn Gerber:
“Rip Van Winkle would be the ideal stock market investor. Rip could invest in the market before his nap and when he woke up 20 years later, he’d be happy. He would have been asleep through all the ups and downs in between.”
- Richard Thaler, a University of Chicago economist
Bulls, Bears and other Hairy Creatures
The theoretical formula for stock market success is quite simple and universally known: buy low, sell high. The devil, so to speak, is in the details. How do we know when prices are low and when prices are high. Anybody who has ever bought a stock knows that no matter how high prices go, they can always go higher. Alternatively, unless a stock price is zero, it could always go lower. In fact, the typical investor does the exact opposite of what they should do. They buy when stocks are high and they sell when they are low. Why this is so will be discussed in later chapters.
If blessed with perfect prescience, an investor will always know when to get in and when to get out. He will be fully invested when prices are rising, in a “bull” market, and will hold cash when prices are falling, in a “bear” market. The problem is that in the short term, we can watch the bulls wrestle the bears but we can rarely see definitively who is winning. As soon as it seems certain that the bears are in control, the market can violently turn in the other direction. The confirmation of as trend often comes too late, just as market forces are about to spiral in the other direction.
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On the other hand, the long term picture is quite different. Simply put, growth of the market represents the underlying growth of the economy. As economies expand, so too do the earnings of those companies that make up the lion’s share of the economic activity. While at any given time economic expectations will cause markets to price stocks differently relative to earnings, earnings growth is the truest indicator of value creation. The conclusion is obvious. Over the short term there will always be bear markets from time to time, so long as the future resembles the past and humanity continues to march forward with economic development, but history is always ultimately on the side of the bulls.
Morningstar reveals that $1 invested in the stock market in 1925 would have grown to over $3,000 by 2007. This stunning performance is in line with the historical average. In Figure 1-1, we see that this long-term performance is typical behavior for U. S. stocks. Dr. Jeremy Siegel reported in Stocks for the Long Run that $1 invested in 1801 would have grown to $13,431,814. This represents appreciation in both cases of more than 10% annually and forms the basis for long-term fortunes. But it wasn’t clear sailing - there were severe headwinds along the way. Therein lays one of the keys to success: always invest for the long term. In fact if you divide the market into 10 year periods, the market has posted positive returns more than 90% of the time - and there was not a single 15 year period where it didn’t appreciate!
“If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.”
- Benjamin Graham, author, Security Analysis, 1943, and Warren Buffett’s mentor
The stock market has risen steadily over time. Although gains, and losses appear to be greater on the left side of the chart, that is only because the value of this widely followed average has gotten higher over time. The decline which occurred in 1929 was much worse, on a percentage basis, than the recent bear market that began in 2000. Viewed from a long-term perspective, neither was as bad as investors feared at the time.
As can be seen by this chart, even short term bear markets, eventually come back and take out their previous highs. As such, an investor who invested in the index immediately before the crash of 1929 would still end up a winner, so long as he resisted the temptation to adjust his portfolio in response to the crash. A twenty year nap might have been just the trick to save him from ruinous investment moves.
“I studied a lot of academic research and I was startled to discover that stock picking, market timing and other popular investment activities usually hurt investors rather than help them. Until you understand why indexing works you’ll always be wasting time and money searching in vain for the next great stock market guru. I used to pick winners - until I picked some losers and blew myself up.”
- Henry Blodget, former Merrill Lynch Analyst
Most people, however do not invest all at once. For example, many contribute small piece of their earnings each year to their Individualized Retirement Account (IRA) to build a nest egg for the future. Fortunately the picture is even better for those investors who invest their earnings on a staged basis, over time.
As can be seen by Figure 1-1, staged investing, known as “Dollar Cost Averaging,” leads to those long-term gains and helps to smooth out the violent zigs and zags that come hand in hand with lump some investing. While this method may not be right for all investors, the above graph shows the tremendous power of a long term buy-and-hold strategy that ignores short term fluctuations in market prices
Unfortunately investors rarely see the forest through the trees and short term market volatility scares many investors out of the stock market, usually when things look their worst, and right before the long term, upward trend reasserts itself. Rip Van Winkle investors, however, won’t even notice these swings as they will be sleeping well and enjoying their lives confident of the long term outcome rather than anxiously watching every market tick.
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