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Six Thought Experiments based on the US Stock Market Historical Performance

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Following the last article on InvestorTrend.net about the world history real returns on stocks, bonds and Treasury Bills for the most relevant countries, it became clear that equities are the best vehicle for building long-term wealth, despite all the downward and weaker periods throughout history. I thought it was also useful to include 6 thought experiments based on an article made by Davis Advisors, named “The Wisdom of Great Investors – Wealth Building Wisdom from Some of History’s Greatest Investment Minds”. In fact, the one thought experiment which will not be included here was presented in the last mentioned InvestorTrend article regarding the long-term performance of US stocks, bonds and treasury bills. 

  1. Four Hypothetical Reactions to a Bear Market

The chart below shows how four different hypothetical reactions (using only the long side) to a market correction affect the outcome of their investments. Four hypothetical investors each invested $10,000 in the S&P500 from January 1, 1972–December 31, 2013. During this 42 year period, however, each hypothetical investor reacted differently to the brutal bear market of 1973–1974, when the market lost more than 40% of its value.

  • The “Blocked/Nervous Investor”: Following the ’73–’74 bear market, he sold out of stocks and went to cash on January 1, 1975 for the remainder of the investment period. His ending value on December 31, 2013 was $19,554.
  • The “Market Timer”: He also went to cash on January 1 1975, but was prescient enough to move back into stocks on January 1 1983, at the beginning of an historic bull market (conveniently). His ending account value was $260,892.
  • The “Buy and Hold Investor”: He maintained his original position in stocks during the entire 42 year journey. His ending account value was $654,413.
  • The “Opportunistic Investor”: Recognizing that the ’73–’74 bear market had created opportunities for the patient, long-term investor, he contributed an additional $10,000 to his original investment on January 1, 1975. His ending account value was $1,531,092. Notice that the “Opportunistic Investor” invested twice as much money as the other investor types and was able to successfully time the market.

hypothetical-reactions-to-bear-market

These hypothetical scenarios have some convenient characteristics, as for example having more capital available at the same time that a successful timing of the market is employed. However, what stands out is the magnitude of the difference between each of these scenarios. And these are still possible scenarios nonetheless.

  1. The percentage of Periods with Positive and Negative Market Returns

Below are presented the percentage of monthly, yearly, 5 year and 10 year positive and negative return periods for the market from 1928 to 2013. The market is represented by the Dow Jones Industrial Average for the period 1928 through 1957 and by the S&P 500 for the period from 1958 through 2013.

percentage-of-periods-with-positive-and-negative-market-returns

As you can see, over short monthly periods only 62% of periods were positive while 38% were negative. However, as an investor’s holding period increased, the percentage of positive periods for stocks increased, culminating in 94% of 10 year periods delivering positive returns versus only 6% delivering negative returns. Note that in this study we can’t see the order of magnitude of the positive and negative returns, which should be taken into account.

  1. Recognize That Periods of Low Returns for Stocks Have Been Followed by Periods of Higher Returns 

History has shown that investors should feel optimistic about the long-term potential for stocks after a disappointing period.

Illustrated below are 10 year returns for the market from 1928 to 2013. The golden bars represent 10 year periods where the market returned less than 5%. The green bars represent the 10 year periods that followed these difficult periods. The market is represented by the Dow Jones Industrial Average for the period from 1928 through 1957 and by the S&P 500 for the period from 1958 through 2013.

In every case, the 10 year period following each disappointing period produced satisfactory returns. For example, the 1.2% average annual return for the 10 year period ending in 1974 was followed by a 14.8% average annual return for the 10 year period ending in 1984. Furthermore, these periods of recovery averaged 13% per year.

poor-market-periods-are-followed-by-stronger-market-periods

  1. Don’t miss the best days

The graphic below compares the 20 year returns of an investor who stayed in the course from 1994 to 2013 to those who missed just the best 10, 30, 60, or 90 trading days. The results underscore the danger of trying to time the market:

  • Staying the course over the entire 20 year period resulted in the highest return of 9.2% per year.
  • Missing just the best 10 days during this 20 year period reduced the return to just 5.5% per year.
  • The investor who missed the best 30 trading days over this 20 year period experienced an investment that remained flat.
  • An investor needed to miss the best 60 days for his return to plummet.

danger-of-timing-the-market

The market is represented by the S&P 500.

  1. Understand That Short-Term Underperformance is Almost Inevitable

This is not exactly a thought experiment, but it makes an important point. When evaluating managers, short-term performance is not a strong indicator of long-term success.

The chart below illustrates the percentage of top-performing large cap investment managers from January 1, 2004 to December 31, 2013 who suffered through a three year period of underperformance. The results are staggering!

  • 95% of the top managers’ rankings fell to the bottom half of their peers for at least one three year period, and
  • A full 73% ranked among the bottom quarter of their peers for at least one three year period.

Though each of the managers in the study delivered excellent long-term returns over the entire 10 year period, almost all experienced a difficult stretch along the way.

percentage-of-top-quartile-large-cap-equity-managers-whose-performance-fell-into-bottom-half-or-quarter-for-at-least-one-three-year-period

The data was taken from the performance of 197 managers from eVestment Alliance’s large cap universe whose 10 year gross of fees average annualized performance ranked in the top quartile from January 1, 2004 to December 31, 2013.

  1. The Power of a Systematic, Disciplined Investment Approach

Systematic investing involves investing money in equal amounts at regular intervals, regardless of the market environment. For example, an investor with $10,000 to invest in stocks may opt to invest $2,500 every three months during the year.

The chart below shows how a hypotheti­cal systematic investment plan would have fared during a very challenging period for investors—the brutal bear market from 1929–1954. The good news is that despite the market not breaking new highs for 25 years, the market still returned 5.4% per year. Still, a systematic investor who committed money each year did even better, receiving 11.7% per year.

dow-jones-systematic-investing

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