Fortune favours the brave, history favours the investor

“Money can beget money and its offspring can beget more,” said US political leader and intellectual Benjamin Franklin. But only if you invest your money, we hasten to add.

STOCKS VERSUS CASH – THE FEAR OF LOSS VERSUS THE GUARANTEE OF (INFLATION ADJUSTED) LOSS

Over the long-term, stocks are usually the best performing asset class – by a huge margin. But “stocks are risky” is the most common objection. Yes, they are – in the sense that stock prices can move up or down, depending on the performance of the company and market sentiment.

So, what is “safe”? Cash? Well, yes, over the very short-term – in the sense that a dollar in a bank today will still be a dollar next week. But be wary of the illusion of money. US$1-m from 1926, held literally in cash – the metaphorical “money under the mattress” – will today have lost 93% of its spending power. Put simply, the US$1-m will be able to buy only around 7% of what it would have been able to buy 92 years ago. So, similarly, the savings you have now will almost certainly be worth a lot less in real spending power in 20 years. You know how your parents say: “A hundred dollars was a lot of money when we were young”? Now you know why.

THE RISKS OF BUYING STOCKS

When you buy a stock you are buying a “share” (hence the term) in a business. So, it’s no different from buying a ‘share’ in a friend’s café. If the café is popular – it has good food/service, is well located and efficiently managed – it should make profits. And as a shareholder, you should enjoy the benefits of those profits. It’s the same as a shareholder in any company. You share the profits of the company through “dividends” paid out from those profits. But if your friend’s café does badly, the business could go broke and your share in it could end up worthless. At an extreme, a publicly-listed company could also go broke. More likely though, companies can suffer business downturns and this is then reflected in the price of its shares. That’s “business risk”.

Unlike your friend’s café, selling your shares in a publicly-listed company is a lot easier. Shares are bought and sold, with buy and sell prices and volumes publicly displayed, on trading days. But some small stocks trade on relatively low volumes. So, if you hold a large block of those shares, selling may be more difficult than for large stocks which trade on large volumes daily. That’s “liquidity risk”. But mind you, even a low liquidity public stock is a lot better than the situation in your friend’s café, where finding a buyer for your share is likely to be vastly more difficult .

Apart from business risk, share prices can go down purely on market sentiment. Markets go through cycles, driven by economic conditions, valuations and sentiment. And during down cycles, share prices can fall – and sometimes quite significantly – without any change in the company’s business. That’s “market sentiment or market cycle risk”.

BUT THIS IS WHY INVESTORS BUY STOCKS, NOT WITHSTANDING THE RISKS

The long-term history of stocks is about mean reversion on rising trend lines. That is, stock markets go through cycles – up and down. But in sound economies, stock prices generally go up and down against a rising trend line. Over the period 1926 to 2016, US stocks registered compound annual returns of between 10% (for large companies) and 12% (for small companies). Treasury bills earned only 3.4% per year. Inflation, on the other hand, eroded the real spending power of money by 2.9% a year.

Taking a shorter period of time, between 1998 and 2017, US$1 invested in US stocks would have registered compound annual returns of between 7% (for large companies) and 10% (small companies). That safe haven asset, Treasury bills, returned only 1.9% a year. It fell behind the inflation rate of 2.1% a year. As for cash – that metaphorical “money under the mattress” – it lost one-third of its spending power/real value.

Of course, there may be periods of deflation when cash can see a rise in its purchasing power. During these periods, stocks will typically suffer falls in market prices. But the modern history of the global economy has been overwhelmingly inflationary, not deflationary.

The US, the world’s largest economy, saw, between 1945 and 2017, almost 6 months of economic expansion for every month of economic contraction.

As a result, over the period 1926 to 2018, the average bull market (periods when stock prices rise more than 20%) in the US lasted 9 years, with average cumulative total returns of 474%. The reverse – US bear markets (periods when prices fall more than 20%) – last only 1.4 years, with an average cumulative loss of 41%.

MANAGING MARKET CYCLE RISKS

As we can see from the above economic and market statistics on the US, the historical averages favour the long-term stock investor. We all know the saying “time is money”. The reverse is even more profound – “money is time”.

Market timing is for highly skilled, active traders – people with expertise, access to sophisticated financial information systems, and the ability to closely monitor and analyse market moves. For the ordinary investor, staying invested has historically worked a lot better.

For example, international investment firm Morningstar’s estimate of 1-year returns for US stocks in the period 1926 to 2017 puts the periods of gains at 74% versus 26% for periods of losses. But as the period of returns lengthens, the odds of making money rises dramatically. For 5-year annualised returns, the periods of losses reduce to only 14%. By the time Morningstar got to 15-year annualised returns, the periods of gains were 100%. No periods of losses.

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