Understanding real market returns

Entrepreneurial Investing, Part 3

Does it pay off to be patient in the stock market? As we can see from the chart below, given to me by my colleague Ben Mackovak, the market is random in the short term, but time is ultimately your friend.

The chart represents the Standard & Poor stocks and identifies market returns vs. holding periods. If one buys a quality and value company and waits three years, the chance that a stock will earn a positive return is almost 75 percent. If one holds for five years, chances go to 80 percent. If one waits for 10 years, chances go to almost 90 percent.

TotalRealChart

So buying a quality and value company and leaving it alone or adding to it periodically allows for investing success. It’s also important to be patient and not overly emotional, especially when there is volatility or buying opportunities.

While a universe of value companies exists, only a select few are quality companies because of factors such as management effectiveness and emerging industry. Many of these indicators of quality and value are included in my investor’s checklist, which I will share at a later time. For now, in this series of articles I will share with you what I have learned from years of being an investor, from both my mistakes and successes to the mistakes and successes of others.

Michael Mauboussin writes, “Back in 1979, Nobel Prize winners Daniel Kahneman and Amos Tversky found that people exhibit significant aversion to losses when making choices between risky outcomes, no matter how small the stakes. A loss has about 2 ½ times the impact of a gain of the same size.

“Investors tend to sell their winners too early, satisfying the desire to be right; and hold their losers too long, in the hope that they won’t have to take a loss.

“The more frequently we evaluate our portfolios, the more likely we are to see losses and hence suffer from loss aversion. The less frequently we evaluate our portfolios the more likely we are to see gains.”

History shows that a declining market always comes back no matter how shocking the events that drive it down. For example, within three years of John F. Kennedy’s assassination, the Standard & Poor’s 500 index was up nearly 21 percent. Within three years of the 1993 World Trade Center bombing, it was up almost 57 percent.

The article “The Hidden Cost of Diversification as ‘Insurance’” notes that the past 75 years cover nearly every possible type of macroeconomic, technological and geopolitical event, and offers statistics to summarize the stock market’s reaction to them all. The article then asks, “Could the future introduce anything more dramatic than these and could the stock market’s behavior in the future be much different?” The answer is no.

The statistics offered in the article cover all sorts of market conditions including World War II, the Korean War, the Vietnam War, the Iraq and Afghanistan wars and the first attack on U.S. soil, as well as major geopolitical events like the fall of the Soviet Union, and even two secular bear markets (the 1970s and the 2000s) and crashes (Tech Bubble of 2000-2003 and Financial Crisis of 2007-2009).

Despite how volatile world events are, the financial markets have always recovered and eventually generate a positive rate of return.

Next month: Part 4 – Value cost averaging