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Investing fundamentals – will it be all right on the night?

Posted by: Brian Dennehy
Membership level: Free
Most clients, most of the time, have the greatest exposure to stock markets through the UK or overseas, typically a bit of both. There are times, and now feels like one of those times, when it is good to revisit why this makes sense.

Below we look at why investing makes sense at all, and the very compelling returns in the long run. More importantly, we draw out the wrinkles which occur regularly, and those much larger risks, the possibility of which you must not ignore. 
 
What’s the point?
 
If you buy shares in a company you are buying into the dynamism of that enterprise, a company which provides employment to people just like you and your family. Philosophically we could even say this is more than merely investing for your own ends, it is engaging with the world around you – not just for your good, but for the greater good.
 
Whatever your precise justification for investing, the long run returns are impressive in their own right, and equally impressive when compared with alternatives.
 
Below you can see how much money you would have made in stock markets per year since 1900, compared to the alternatives of government bonds and cash, and in particular against inflation, the scourge of long-term inflation (table 1).
 
Table 1: Long term investment returns per annum – UK, 1900-2017
 
 
 
 
 
 
Stock market
Govt. bonds
Cash
Inflation
Since 1900
9.4%
5.2%
4.6%
3.8%
Last 25 years
8.3%
7.1%
3.8%
2.8%
Last 10 years
6.3%
5.8%
1.1%
2.8%
 
If you also re-invest the income you receive (e.g. dividends in the case of the stock market) the long-term impact is very powerful. Below you can see the impact of re-investing income on an investment of £1,000 made in 1945 (table 2):
 
Table 2: Today’s value of £1,000 invested at end 1945
 
 
 
 
No income
Inc. reinvested
Stock market
£89,190
£1,816,760
Govt bonds
£630
£78,150
Cash
£1,000
£62,890
 
 
Time is a great ally
 
The argument for investing in the stock market to the exclusion of all else appears to get even better when you then take into account the likelihood of your making positive returns the longer you stay invested. 
 
For example, if over a 10-year period of investing you didn’t perform better than cash, you would feel very unlucky as the likelihood of doing better is 91% - based on 115 years of data (table 3).
 
There is no 20-year period when you would not have done better than cash – and 20 years is a typical period for lifetime investing.
 
Table 3: Probability of UK stock market investing outperforming government bonds and cash
 
 
 
 
 
2 yrs
5 yrs
10 yrs
18 yrs
Probability of stockmarket outperforming govt bonds
68%
72%
79%
86%
 
Probability of stockmarket outperforming cash
68%
75%
91%
99%
 
 
Is it really that simple? The Black Swan
 
The preceding facts represent impressive evidence on the attractions of investing. Yet they can be a mis-leading veil over the unpredictability of investment returns.
 
It was once believed there were no black swans in the world – in fact as far back as the 2nd century it was an expression used to describe that which was impossible. Then in 1697 Dutch explorers “discovered” black swans in Australia. Now it is more commonly used to describe the bias of those who believe something can never be, either through limited imagination or limited experience – and this combined with an unhealthy belief in the certainty of their world.
 
Over the years we have frequently heard the refrain that “the markets always recover”. Perhaps. Perhaps based on limited experience, albeit even over 30, 40, or 50 years. But you MUST allow for The Black Swan.
 
The sleight of hand
 
Tables 1-3 conceal periods which were very worrying for investors who lived through them, and they also hide possibilities beyond their bounds.  They take no account at all of the risks for which there might have been no precedent in our investing experience, yet which, if they occurr, would destroy your life plans. 
 
How about our grandparents’ experience? Would they have guessed that their lives would be consumed by two World Wars and The Great Depression? Sometimes fate is just going to deal you a tough hand – and you have no idea it is coming.
 
How about Japan? Their stock market has been down for nearly 30 years. It suffered falls of 80%+ at worst, and is still down nearly 50% - after 30 years! If you were living in Japan in the late 1980s you probably had most of your investments in Japan, your home market – your financial plans were devastated.
 
Ignoring those big risks for a moment, here are some statistics with regard to what has actually happened to punctuate the unruffled journey implied by tables 1-3.
  • The likelihood of the market going down in any one day is 47%...
  • …and in any one week is 45%.
  • In any one year there is a 38.6% probability of you losing money in the stock market.
  • The market has never fallen for 5 consecutive years…
  • …but has fallen for 3 consecutive years on 8 occasions since 1900.
  • The market has been up 5-10% in 15 years since 1900…
  • …but has been down 5-10% in 13 years
All of the above relates to the UK stock market, but it is very similar for the US, the pivotal world stock market.
 
What does this mean?
 
The market is brutal in confronting investors with the fact that they are often wrong. It will always probe for basic human weaknesses – greed, fear, and vanity.
 
The point is not to get complacent about stock market returns, nor your ability to decipher them in advance. They won’t be delivered to you in a nice neat package with a ribbon, which happens to coincide with the timing of your life plans.
 
Focus on (the bleeding obvious) extremes
 
This is art not science, broad strokes not fine detail.
 
The pivotal US stock market is now as overvalued as 1929, and on some measures more so. The quantity and quality of global debt has never been worse. That this has been the case for a small number of years already must not make you complacent – as said above, the market is brutal in stripping bare any weakness of yours.
 
Do let us know if you are comfortable accepting these risks head on – for example, with no higher than usual cash margin, or no wish to apply a stop-loss. Some of you might be this comfortable with these investment risks, depending on all of your circumstances. For everyone else, we continue to recommend a sizeable cash buffer. When the time to fully invest comes (it should be obvious at the time) we will all have some fun picking up bargains.
 
FURTHER READING
Topic: Market commentary


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