Many would-be investors fear the stock market. Equally, many do not adhere to the fundamental principle of identifying capital for savings and capital for investment. The irrational emotions of fear and euphoria are very real when applied to the stock market. The stock market drops far more quickly than it rises.
The stock market in its most fundamental form consists of three asset classes: stocks, bonds and cash. A common or preferred stock is essentially a participation in a business. Unlike a bond or cash, a business can grow and can transfer a return on capital via a rise in the share price to the investor through growth of earnings, payment of a dividend and an estimation at what a dollar or euro worth of earnings today will be worth at a time in the future. The first two are easily and readily quantifiable. The third, the price earnings ratio, is at best an estimate and at worst a speculative guess.
Investors in stocks must have a long-time preference. Our emphasis should be the growth of purchasing power of our investments, after being adjusted for inflation. Professor Jeremy Siegel in his classic study shows that the compound annual real return on common stocks (equities) is approximately 6.6% pa after inflation since 1994. Professor Arnott’s 200-year study in 2003 showed that from an average historical return of 7.9%, annual annualised return dividends accounted for 5%, inflation accounted for 1.4%, real dividend growth accounted for 0.8% and rising valuations accounted for 0.6%.
The stability and consistency of returns of common stocks in the US market (where most data is available) is noteworthy. 6.7% pa from 1802 through 1870, 6.6% from 1871 to 1925 and 6.4% per year through 1926 to 2012. Even during the time when the US faced the most inflation for 200 years, the average return on stocks was 6.4% pa.
The increase in value of stocks has remained extraordinarily stable as US and European societies evolved from an agricultural through an industrial economy to the post-industrial technology and service-based economy we have today. However over the short term stocks are volatile. From 1982 through 1999 during the greatest bull market in US history, stocks produced an amazing after inflation return of 13.36% pa – double the historic average. During the 12 years from the bull market peak of 2000, returns on stocks fell to 0.3% pa.
Regression to the mean (prices returning to historic averages) is a market truth and almost eternal. Investors are advantaged by holding stocks over the long term. Owning a participation in publicly traded businesses is a marriage not a dating experience and to echo Warren Buffet “should be held forever”. Or in other words staying the course and “keeping your head when all those around you are losing theirs”. This will not happen unless investors value what they hold and have separated their savings from investments.
Jeremy Blatch TEP
This article was also published in the online and print editions of the Sur in English