Stocks always go up, in the long run. At least that’s what every financial adviser seems to say. Because stocks always go up in the long run, many advisers tell us we should sit tight and never worry about a market decline. Patience will be rewarded.
There are at least two problems with this line of reasoning.
First is the fact that, as the economist John Maynard Keynes pithily noted, “in the long run, we are all dead.” Many will ignore Keynes wisdom here because it seems to be a hyperbole. But, it’s important.
What Keynes was saying is that the long run should not concern us as much as what comes before the long run. If you have forty years before retirement, sure, maybe you can afford to ignore the short run. But, if you don’t have decades to recover, you cannot have blind faith in the long run.
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That is because of the second problem with the assumption that stocks always go up in the long run. Sometimes, they don’t, as the chart below shows.
Markets Really Don’t Always Recover
This is a chart of Japan’s stock market. Investors enjoyed a bubble in the 1980s and the prices have never recovered to their 1989 peak. A focus on the long term has not been rewarded.
Japan, skeptics will argue, is a special case. Its demographics changed, and, besides, the global economy changed. But, these factors really aren’t very special.
Populations are aging around the world.
And, of course, the global economy is constantly changing. Japan is not unique. Many other global stock markets have suffered long term declines. The next chart shows the risks investors must consider when investing in stocks, the risk that markets do not always go up in the long run.
This chart is from a paper published by the National Bureau of Economic Research (NBER) called “A Century Of Global Stock Markets”. It’s written by William Goetzmann Philippe Jorion. The author’s found the U.S. stock market is something of an anomaly. According to the NBER, the authors:
“…construct a series on real capital appreciation for equity markets in 39 countries covering most of the 20th century. Their “financial archeology” shows that the United States is the exception in a global capital market frequently wracked by financial crisis, political upheaval, expropriation, and war.
The United States has had by far the highest uninterrupted real rate of return at 4.73 percent a year. In sharp contrast, the median real appreciation rate for the other countries is only 1.5 percent annually.”
Could the United States revert to the global mean and deliver long run returns that are lower than what individual investors and financial professionals expect? Absolutely. And, this is important because, as the NBER notes, small differences in long term returns makes a large difference in dollar terms:
“Compounded at a 5 percent rate of interest, for example, the approximately $24 dollars Peter Minuit, the Governor of the West India Company, paid for Manhattan Island would have grown into about $1.6 billion in current dollars by 1995. But compounded at a 3 percent rate, the financial outcome is a mere $1.3 million.”
How to Minimize the Risk of Large Losses
By now, you may be worried that stock markets don’t always come back and that small differences in wealth accumulation are important. Fortunately, research shows that large losses can be minimized.
The 10 month moving average (MA) can help. This was demonstrated by Mebane Faber in his paper, A Quantitative Approach to Tactical Asset Allocation.”
He tested the 10 month MA from 1901 to 2012, a period of time that included the Great Depression, the financial crisis of 2008, the Internet bubble, a time of runaway inflation and times of deflation. It is a broad sample of economic and global changes.
His research shows that using the 10 month MA can reduce risk. He also found that this simple strategy beat the market over that time period. But, most importantly, it reduced risk.
Over that time, the S&P 500 delivered an average annual return of 9.3% to buy and hold investors. The worst year saw a loss of 44%. Selling when the price fell below the 10 month MA and buying back when the index crossed above the average led to an average gain of 10.2% a year and a worst year of 27%.
This simple strategy actually shows a gain in 1931 when the S&P 500 lost 43.9%. It gained 1.4%. The same pattern was seen in 2008 when the S&P 500 lost 36.8% and the strategy gained 1.3%.
The chart below shows the S&P 500 over the past 15 years.
The sell signal in 2007 was timely. It avoided the entire bear market. However, the entry signal came after the index rallied more than 30%. Now, that would have not mattered.
A buy and hold investor lost more than half their capital. An investor using this MA had most of their peak capital intact. They invested a large amount on the buy signal and accumulated greater wealth in the long run.
Let’s assume an investor has $100 when the sell signal was given in 2007. That investor would now have about $200.
The MA trader would have suffered some short term losses and been out of the market 38% of the time. That $100 however, would have grown to more than $595.
That’s right – avoiding losses is the most important factor to accumulating wealth. And, the 10 month MA could help you do that with just a few trades every decade.
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