The Fed’s actions, combined with stable (but still tame) economic data, are a positive sign for long-term economic health. The stock market is also in good value territory. So, we might expect to see individual investors flooding back into the market. That is not the case right now. Not surprisingly, this is common after recessions, extended volatile markets, and following times of financial instability. We’ve had our fair share of all three over the past five years. In these markets, individual investors often feel frustration at losses, and move their money elsewhere; until the next extended bull market, when fear gives way to euphoria. This is not a winning long-term strategy.
Of the major assets most investors can own, stocks have performed the best on average over the long-term. Deutsche Bank recently published its annual Long-Term Asset Return Study, which tells the story:
Asset Average Annual Real Return, 1838-2012 Stocks 6.49% Treasuries 2.77% Corporate Bonds 2.72% Gold 0.35%
Investors often give up on the stock market, despite data that shows the long-term growth race is not close. That is due to a fundamental misunderstanding about the nature of markets: stocks only provide a consistent return if one holds them a long time.
To gain the overall average market return, about 8% for the S&P 500, one has to hold stocks for many years. The average stock these days is held for about seven months. That is nowhere near long enough, and it helps explain why so many investors, amateur and professional, grow frustrated with stocks.
There are many studies that show that investors cannot expect to earn a decent market return if their time horizon is measured in months. In the short-run, stock prices are bounced around by fear, greed, rumor, and oddities in group behavior. Only when stocks are held for more than five years can one be reasonably assured that the market return will reflect accumulated business value.
The chart below, from a Yale study, shows how much the maximum and minimum real (inflation-adjusted) annual market returns have been after holding the S&P 500 for different amounts of time:
An investor who holds an S&P 500 index for a year is at the mercy of volatility: the return is more likely to be very good or very bad. Five years, and volatility starts to even out. Ten years, and there’s a good chance the investment will be near average annual returns. Interestingly, the chart shows that there has never been a 20 year period in S&P 500 history when stocks have produced an average annual loss.
We can expect more volatility in the months to come, as Europe cleans up its debt mess and the U.S. Congress works to avoid the upcoming fiscal cliff. What that means for the markets in the short term is not clear. In the long run, we can take advantage of the stock markets consistent upward movement, and add to those returns by selecting excellent companies trading at a discount to fair value.