A tortoise’s path to wealth: Ignore ups and downs
Many investors check the performance of their investment accounts online every day. Some log into their accounts even more frequently. With such constant account viewing, they end up witnessing every twitch and turn of the stock market. Every market victory that adds to their portfolio is met with jubilation, fast replaced with abject downheartedness when stock prices plummet.
Unfortunately, much of that market action is simply noise — swings in stock prices that cannot be explained by changes in economic fundamentals. Behavioural finance experts have labelled this phenomenon the “excess volatility puzzle.” Investors’ shifting attitudes toward risk and emotionally driven trading behaviour make stock prices much more volatile than expected future corporate profits and dividends would dictate.
In fact, when you peer through the volatile swings, daily stock prices, on average, move almost imperceptibly. From January 1950 through July 2014, the S&P 500 price index increased an average of 0.03% per day. Your eyes aren’t tricking you; that is a microscopic 300th of 1% average daily gain in stock prices. Winning days barely outnumber losing days — stock prices increased on just 53.4% of days. On nearly onehalf of the days, stock prices are dropping; so much for the utility of daily account monitoring.
However, with approximately 250 trading days in a year, a minuscule 0.03% average daily gain added up inch by inch. Over the course of an average year, U.S. stock prices rose 7.6% per annum since 1950. An expanding economy that fuelled corporate earnings growth was the real driver of stock prices. U.S. GDP and corporate earnings per share over the same period grew at annual rates of 6.6% and 6.1% respectively, right in line with stock price growth. (Valuation differences and stock dilution primarily account for the modest variations.)
Unfortunately, many investors can’t hear the signal of long-term economic growth through the noise of market volatility, particularly the inevitable cycles and infrequent crashes. Nowhere is this more evident in the corrosive impact of the “buy high and sell low” timing of many mutual fund investors. A recent study by the Federal Reserve Bank of St. Louis found that the returns of the average fund investor in U.S. equities from 2000 to 2012 lagged a “buy and hold” investor by 2% a year. Patient, far-sighted investors confident in the long-term growth prospects for the economy amassed nearly 30% more wealth at the end of the 13-year period than reactive investors focused on short-term market exigencies.
Like the proverbial hare, some investors believe they can win the race for market beating returns through fastpaced, active trading. One U.S. study of 66,465 households with accounts at a large discount broker found that the more frequently investors traded, the worse their performance results. Those investors who traded the most underperformed the overall stock market by a stunning -6.5% a year. The slow and steady “buy and hold” approach far outpaces the fast and furious when it comes to investing.
Many investors can’t hear the signal of longterm ... growth
The long-term economic signal that investors need to heed today is not the anemic growth outlook for Europe or Japan or the subpar growth prospects for Canada and the United States. Given the rapid expansion and growing impact of the emerging and developing countries, it is the total world economy that matters. In this regard, the International Monetary Fund recently forecast the global economy (in U.S. dollars) will grow at an annual rate of 5.6% over the next five years. Despite the drag of the aftermath of the global credit crisis, this growth rate is not far off the 5.9% annual rate enjoyed by the world economy since 1980.
Some back-of-the envelope arithmetic paints a positive picture for future stock returns. Globally, stocks today have a dividend yield of 2.5%. Assuming stock prices increase on average 4% to 5% a year, which is a modest lag to projected global economic growth as corporate profit margins or valuations compress, the total expected average return for global equities is in the 7% per year range.
Of course, this expected return will be accompanied by a considerable dose of volatility as markets zig and zag. In fact, returns in any one year may lurch from minus 10% to over 20%. An unforeseen shock could even tip the world economy into a nasty recession. Like the wise tortoise, however, the patient, globally diversified investor knows that “slow and steady through thick and thin” is the best path to eventual wealth.