Taking The Gloves Off On The Discussion of Rational Investment Analysis (Part 3)

• IRON100
• July 18th, 2010

Because of other business items, a semi-vacation trip I am taking this week, and other interruptions, I am going to continue to provide some additional shades of meaning to the dilemma of how returns in the stock market are generational in nature (that is, they go through cycles that can last a generation). I will also discuss, via the works of Ed Easterling of Crestmark Holdings, LLC, how volatility can skew compounded returns (the only way to measure real growth in equities) to numbers far lower than are reported, and how those volatility cycles can be exacerbated by, of all things, life happening to investors (college, home, expenses, etc). 

At least in the current lifespans of Americans, most individuals will have about 40 years, or two generations as defined by Mr. Easterling, to do most of their investing in their lifetime. What generally happens over the history of the U.S. stock market is that one will face one bull market (averaging about 15 years) and a secular bear market of about 17 years. (This data provided by Ibbotson Research via John Mauldin in Bulls Eye Investing (2004 edition page 29-30.) While this is not a shock to many people who have more than a passing interest in equity markets, investing, or trading. the next piece of data might.Through the last eight bull and bear markets, the returns were not really correlated to GDP during the fastest century of growth in the U.S. Through eight bull and bear markets, the average compounded return for the Dow Jones Industrial Average was -4.2%, while GDP averaged 6.9% compounded during those same bear market periods. During bull market periods, returns averaged 14.6% while GDP grew at a compounded rate of 6.3% In other words there is very little correlation of equity returns to GDP growth from 1901-2000. (This data taken from page 87 of the 2005 Edition of Unexpected Returns: Understanding Secular Stock Market Cycles, by Ed Easterling). 

The fact that markets do cycle between secular bull and bear markets also brings into the "return" equation the whole concept of volatility in returns and the dispersion of those returns annually over time. On page 39 of the 2005 Edition of Unexpected Returns: Understanding Secular Stock Market Cycles, by Ed Easterling,   one will see that returns will roll between -9% in 1919 to nearly 7% in 1928, only to roll back to -9% in 1949 with a smattering of positive and negative returns that culminated in the precursor of the greatest bull market of all time that began in 1982 and ended in 2000.What is even more disturbing is the dispersion of those returns over time. In the 103 years shown in Easterling's work (shown on page 40-41 of Unexpected Returns: Understanding Secular Stock Market Cycles, by Ed Easterling) one would find out that the Dow Jones Industrial Average would have a 50% frequency of annual returns ranging from -16% to 16% and a 35% chance of greater than 16%. In that same study, the chances of returns being less than -16% happened 16% of the time. The bottom line is that it is basically a coin flip each year of Dow Jones Industrial Average history from one year to the next as to whether one year one gets a mid teens annualized percentage return or a negative mid-teens annualized percentage return. That dispersion remains the same in the 103 year period or any 20 or 50 year period.  In other words, from one year to the next, it is a crap shoot as to whether one will have a good or bad year in the Dow Jones Industrial Average. 

Now let’s talk about the "life happens" part of the long-run investing equation. To summarize, life happens in ways that destroy overall compounded return. Why?1) Naturally, as emotional creatures we run out of the markets in times of high volatility, particularly in those times when recovery happens. That is why equity markets tend to fall two to three times as fast as they rise. (That one was and is obvious to anyone who has invested in equities). 

2) Compounding returns has nothing to do with an average return (which is the simple arithmetic average of a string of annual returns put together, which most pundits (including some rather famous radio financial show hosts) use to define what true stock market returns are historically. When one includes transaction costs (which are real and occur with even ETFs) and exclude dividends (which are normally paid out as cash anyway), instead of getting the 7.4% average return on the S&P 500 index over the 103 years from 1901-2003, one would only have received about 5.4% compounded return. If that is true, then instead of investing $1000 in 1901 and receiving $1,676,661 on December 31, 2003, one would only have received 159,841 at 5.4% return. One would have lost out on about 90% of that "stated average" return, because that return DID NOT REALLY EXIST.

3) Let’s see, what other "life happens" events occur? Well, one knows what they are. A new home, college, Christmas or Hanukkah gifts, a new car, unknown medical expenses, drawing down of savings during unemployment periods ( at least 1 in 6 of you reading this likely have experienced that one lately)  are all just the tip of the iceberg of reasons to draw down savings. Now, how much of that $159K is left after we forgot to invest it? Oh yeah, I forgot that we only had 40 years and not 103 years to invest! If one is on the verge of depression or ready to step out into Interstate highway traffic over the depression associated with the inability to invest for retirement with all of this bad news I have just delivered, hold on just a minute. What I will do over the next few sessions is to describe how one can best avoid the investment traps that can shaft every individual investor who thinks he or she even has a ghost of a chance at retirement. There are ways to avoid the destruction that "buy and hold" style strategies tend to create over time.I will eventually get into the points I was going to make about 1987 and 2000 and how one taught me a huge lesson about the other and probably protected me from ruin, but that will be blended into this discussion.

More good information is coming. Stick with this series (which will have many parts). It will be worth your while I think. 

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Tickers: average returns versus compounded returns, dispersion of returns, life happens, long-term investing, secular bear markets, secular bull markets, stock market cycles, transaction costs

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