Which is true?

  1. The stock market is a gamble. It is a decent investment, but it may or may not make money for you.
  2. The stock market is a reliable long term investment. It should be the core of your long term investments.

Can you be confident in the stock market?

Most investors are scared of having a major loss. They try to reduce the risk of their investments mainly with 3 methods:

3 Methods to Reduce Risk

  1. Asset allocation – Hold some bonds and cash, either separately or in balanced funds.
  2. Focus on yield – Invest for dividends or interest, or own income funds.
  3. Conservative equities – Focus on “low volatility” or stable, low growth stocks.

You should, of course, realize that any of these methods to reduce risk are likely to also reduce your returns over time. However, aren’t these conservative more reliable than the stock market?

To answer this question, the real question we need to answer is this:

Key Question

If you invested 100% in the stock market and held it long term, what are the odds that you would have strong growth over time?

Let’s assume you just broadly invest in good companies and ignore the 3 methods to reduce risk.

The stock market is a mystery to most people, so looking at actual stock market history is very insightful. The first chart is the actual stock market returns since 1871. Note that 1-year returns are:

  1. Mostly gains – 73% are gains.
  2. Lots of large gains – 31% are gains over 20%.
  3. Some large losses – 5% are losses over 20%.

In short, 1-year periods are quite unpredictable.

1-Year Returns of S&P500 - Up & Down

 

How many years would you have had to invest to be more predictable? The answer is 7 years. There have been only five 7-year periods with losses and they were small – 1% to 3% per  year. Note that 7-year returns are:

  1. Almost all gains – 96% are gains.
  2. Losses are small – The 5 negative periods were losses of 1% to 3% per year.

7-Year Returns of S&P500 - No Large Losses

 

How many years would you have had to invest to avoid losses entirely? The answer is 15 years. All 15-year periods were gains.

The worst was the 15-year period from 1929-1943, which included the 1929 crash, the Great Depression and World War II.  Even this horrible period had a gain of .7%/year.

15-Year Returns of S&P500 - All Periods Have Gains

How many years would you have had to invest to be sure of a strong gain? The answer is 25 years. All 25-year periods were strong gains between 5% and 17% per year.

25-Year Returns of S&P500 - All Periods Have Strong Gains

Very interesting to note is the fundamental change in the market around 1930. The largest companies changed from mainly agricultural to industrial. The 25-year periods ending before 1955 had gains mainly between 5%-8% per year. Since 1955, the 25-year gains have been mainly between 8%-14% per year.

The worst 25-year period was way back from 1872-1896 with a gain of 4.9%/year. In the last 80 years, the worst period was from 1957-1981 with a gain of 8.0%/year.

In short, the historical worst-case scenario was:

Worst-Case Scenario

Period

Worst Gain $1,000 Grows to

Last 145 years

4.9%/year

$3,400

Last 80 years 8.0%/year

$6,800

Bottom line: The stock market has been very reliable long term.

Why is the stock market so reliable? It is made up of many large companies that constantly look for ways to grow their profits. Over time, their profits grow, so the value of the companies grow.

Note that this does not guarantee strong gains. However, there have been a lot of major events in the last 145 years and equities performed well through all of them.

The problems with this are behavioural:

  1. Many investors will panic and sell when there is a large market crash.
  2. Most investors get far lower returns because they consistently buy investments that have performed well the last few years. This means they consistently buy high and sell low – the opposite of good investing.

Conclusions:

  1. You can be confident in the stock market long term.
  2. If you are a long term investor, the portion of your investments suitable for equities is the highest amount that you will not get scared out of in a major crash.
  3. If your time period is not long term or you would panic and sell in a crash, you should consider the 3 methods to reduce risk.
  4. If you are truly a long term investor that will stay invested through all the ups and downs:
  • A. You can ignore the 3 methods to reduce risk. They are likely to reduce your return.
  • B. 100% equities might be best for you.

 

 

Ed

 

Ed Rempel
Fee-For Service Financial Planner & Tax Accountant

10 Comments

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  3. Mike1212 on July 2, 2016 at 12:12 pm

    Very nice charts. Long term charts helped me realize that equities should be the primary investment for any long-term investor. Before that, I had always been told to be balanced, but staying in equities long-term is safer and more rewarding than any other asset class.

    In the last 40 years, the worst 15 year average return for equities, inflation adjusted, was still better than the worst 15 year average return for bonds. What is the riskier investment over 20 + years?



  4. Ed Rempel on July 9, 2016 at 10:42 pm

    Hi Mike,

    Good point and good question.

    Most people would be shocked to find that, in 20-year periods, stocks have actually been lower risk than bonds after inflation. Stocks have always gained after inflation over 20 years, but bonds sometimes lost money.

    More surprising is that the standard deviation (measure of degree of ups and downs) for 20-year periods is lower for stocks than for bonds (after inflation).

    Stocks are definitely more risky than bonds short term and medium term, but long term stocks have been more reliable than bonds.

    The reason is that stocks are companies that have managements that can adapt to whatever happens. In the last 150 years, stocks have adjusted to everything that has happened and eventually made larger profits again.

    Bonds, on the other hand, get killed by inflation. Rising inflation and rising interest rates kill bonds. They do not adapt. The most extreme example was the 30-year period from 1950-1980, when government bonds lost half their purchasing power.

    This is why most long term investors should have a high allocation to equities in their retirement portfolios.

    Ed



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