Friday, April 18, 2014

How To Win At A Winning Game

IN our last article, we showed that the rewards of staying invested in equities for the long term are tremendous. But the fact is a lot of investors in equities ended up losing money.
Consider the track record of Peter Lynch who managed Fidelity’s Magellan Fund from 1977 to 1990. He beat the S&P 500 Index in all but two of those years and averaged returns of 29% a year.
That’s mind-blowing. It means that US$1 grew to more than US$27. Had you invested as little as US$37,000 with him in 1977, you would have been a millionaire in 1990.
You would imagine that most of the investors who put money in the fund had made money. But guess what? Lynch himself once said he believed more than half the unit-holders in his fund had lost money. It depended on when they had bought and sold Magellan.
Morningstar, a mutual fund research organisation, conducted a study to track the cash flows in and out of the United States’ leading growth funds in the 90s.
The contrast between the returns of the funds themselves and the returns of the investors was absolutely breathtaking: The 219 growth funds averaged an annual compounded return of 12.5% for the five years ended June 1994.
But the investors did much worse. They apparently didn’t make any money at all; instead, they lost 2.2% a year with the same group of growth funds.
Both of these findings point to the same conclusion, that is – as a group, investors do a rather poor job of deciding when to buy or sell their investment funds.
Chart 1 shows the movement of the Dow Jones Industrial Index in the US in the last ten years. A typical inexperienced investor will probably behave as below:
July 2005: The market has been quite steady and trending up for the past 2½ years. All the market experts are saying that prices will continue to go up. Ok, I’ll invest US$10,000 to test the water first.
April 2006: The US$10,000 I invested is now worth US$10,682. That’s a return of close to 7% in one year. Not bad. Market looks firm. I think I’ll invest another US$50,000.
May 2007: My capital of US$60,000 invested so far is worth US$72,750. Wow, this definitely beats leaving my cash in the bank. Ok, I’ll transfer US$100,000 more from my fixed deposit and invest in the market.
January 2008: What’s all this news about the sub-prime market? Market is choppy. But it’s ok, these investments are for the long term.
January 2009: Oh no! There doesn’t seem to be a bottom to the market. Now people are talking about the possibility of another Great Depression. During the Great Depression, the Dow Jones fell from a high of 386.17 on Sept 3, 1929 to a low of 40.56 on July 8, 1932. That’s a plunge of some 90%. The market did not recover to the 1929 levels until 1954, some 25 years later! Now my portfolio is down by 37% only. I better take out what I have left.
So the investor exited the market in January 2009, and got back US$101,422 of the original US$160,000 invested. As it turned out, the investor withdrew his or her money near the bottom of the market. Two months later, in March 2009, the market rebounded sharply.
The thing is, if the investor had stayed invested and held on to his or her shares, their US$160,000 would have been worth close to US$200,000 by now (early 2014). All the numbers above exclude transaction costs and dividends.
Because of this emotional tug of war between greed and fear, many investors effectively manage to lose at a winning game.
So how exactly do we ensure that we win at this winning game?
First, understand that when you invest in a diversified basket of stocks, you are investing in a slice of the economy. As long as we need to buy and sell things – there is no question about this here because we can’t possibly produce all the things we need ourselves – then there will always be a value to productive companies.
Second, don’t exit the market when everyone is rushing for the exit at the same time. Then, you will not get a fair value for the businesses that you own.
Third, all the more, you should buy when you see businesses going on sale at a cheap price.
Now let’s see how someone would have done if he or she had kept investing in the stock market through the Great Depression. We know that the Dow did not recover to the levels reached in 1929 until some 25 years later. The Great Depression was the worst period the stock markets had ever gone through – it was way worse than the Asian Financial Crisis and the more recent Global Financial Crisis. So did an investor who put money into the market during the most adverse of market conditions see zero or even negative return?
The chart below shows an investor, let’s call her Mary, who started investing in the US market in early 1926. She put US$100 into the market every year. Her investment did well in the first four years. Then the crash of October 1929 happened, to be followed by the Great Depression. From a high of 381.17 points on Sept 3, 1929, the Dow fell to a low of 40.56 on July 8, 1932. That was a plunge of some 90%! But Mary kept faith. She believed in the continued functioning of the modern economy, that is, as long as companies are allowed to produce what people want and need, they will make money. So she kept investing US$100 into the market every year.
By the end of 1950, Mary would have put US$2,500 into the market. Her portfolio value as at December 1950 was at US$4,342. This despite the Dow Jones Index still being 38% below its peak in September 1929.
Mary managed to grow her capital by 4% a year by consistently putting money into the stock market even through the worst of times. She managed to beat the inflation rate of 1.3% during that 25-year period. In other words, she generated for herself a real return of 2.7% a year in the most adverse of situations! This excluded the dividends she would have received from her portfolio over the years.
So to recap, the secret to winning in a winning game is:
One, consistently invest in a diversified basket of stocks that represents the real economy over the long term;
Two, don’t bail out at the worst of times. All the more, if you can afford it, put in more money at the most depressed of market conditions.
Keeping to these two golden rules will ensure that your savings will grow faster than inflation, and that you will tremendously increase your odds of meeting your financial goals.
Source: The Star