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Investing  | March 18, 2019

About 25 years ago, I was a fresh-faced graduate trainee at a leading investment bank in London. One day, my parents dragged me along to a garden party organised by some friends.

Once there, I was introduced to the global head of the bank's stock trading business, who must have been a mutual friend of the hosts. He was someone I knew by reputation, but not that I'd actually met before. He made a surprising revelation during our conversation.

He was a nice guy. Old school. Mostly we exchanged the usual chit chat that you get at these events. But one thing that surprised me has always stuck in my mind.

You see, he admitted that he never invested in stocks for his personal account. That was a big deal, given that he was the guy running one of the biggest traders and brokers of stocks in the world.

His reasoning was simple. Since his entire career (translation: annual bonus) was linked to the fortunes of the stock market, he didn't think it wise to also keep his fortune in stocks.

(He did actually have a big position in the bank's own stock, since he was a board director. But that was also heavily linked to the fortunes of the stock market - giving him even more reason to look elsewhere with the rest of his money.)

That was an extreme case. Very few private investors have their careers tied to financial markets (or enjoy the lucrative bonuses of professional stock traders). Which means almost all private investors should have substantial investments in stocks, given the profits they offer over time.

Last time, I looked at how the performance of stocks smashes that of bank deposits. Cash is suitable for the short term. Stocks are the best place to be over the long run. But let's dig further, to see how to make the most out of stock markets.

Stocks for the ultra-long run: US stocks since 1928

(Log scale, nominal, dividends excluded)

The key here is to understand the difference between a stock's current market price and its true value. The price is merely the point at which the last trade happened. It's where marginal buyers and sellers meet.

Most investors, most of the time, are sitting on the sidelines. They're waiting for a better chance to buy at a lower price, or a better chance to sell at a higher price. Or they're just happy to sit on what they've got, and wait for a very long time.

Stock prices are often wildly optimistic, meaning everything has to go right for a good outcome. They're also often wildly pessimistic, meaning you can pick up the stocks of solid companies for peanuts. Put another way, sometimes they're way above a reasonable assessment of underlying value, and sometimes they're deeply below it.

In my view, for multiple reasons, there's one single way for private investors to get the best results from stocks. That's to always aim to buy stocks when the price is cheap, relative to value. Then wait.

All other things being equal, this increases the dividend yield, if nothing else. That's because dividend payments are usually based on underlying company profits, not on the stock price.

The dividend per share (DPS) is the total money allocated to dividend payments by the company, divided by the number of shares. If DPS is $1 and the stock price is $20, then the dividend yield is 5%. If DPS is still $1 but the stock price has dropped to $10 for some macro reason, such as a general market collapse, then the dividend yield increases to 10%.

We can't know the precise future prospects of the company, either before or after that stock price fall. But we do know that the dividend yield has doubled after the price fall (assuming the company can still afford the payments, which can be assessed by looking at its cash flows and current cash position). The higher yield improves the prospects of strong future profits, all other things being equal.

Buying at that lower price also adds a substantial chance that you'll enjoy much bigger price gains in the coming years. That's as short-term market pessimism passes, and the stock price rises back up to (or above) the real value.

Even during a recession, when company profits may fall, in most cases they'll recover later. Since most of the value of any stock derives from profits that will be generated way out into the future, smart investors can exploit market short-termism to their great advantage.

Of course, not every single stock investment works out, even when you buy them cheaply. Even long-established companies can sometimes get into trouble. That can be either of their own making (mismanagement, strategic missteps, fraud, etc.) or due to factors outside their control (such as new competitors or government regulations).

But if you apply the approach consistently - of buying well across many stocks, or stock indices - you're sure to do well on average. Buying stocks when they're cheap reduces risk, and increases likely future profits.

It's just a question of having the patience and conviction to see it through. That means ignoring short-term price falls, other than seeing them as an opportunity to buy something even more cheaply.

In my last article, I made this statement: "Cash is low risk in the short run, but high risk in the long run. A portfolio of stocks is precisely the opposite. It's riskier in the short run, but low risk in the long run."

I then explained my reasoning. But now I'd like to back it up with more evidence. I'll do that by looking at the outcome for an investor that bought US stocks at one of the worst possible times - at the market peak just before the global financial crisis. How would that investor have done, up until today?

In October 2007 the S&P 500 index traded at 1,867. By March 2009, the index was briefly down 57%. That would be enough to scare practically any investor.

But, by March 2013 it had made back all the losses…less than 6 years after the previous peak. That's despite the huge banking sector still being in trouble, and having diluted the hell out of existing shareholders with massive capital raises to shore up balance sheets.

By October 2017, a decade after the 2007 peak, the index reached 2,575. That's a total gain of 38%, equivalent to 3.3% a year. On top of that, there would have been dividends of around 2% a year, for 5.3% total average annual return.

Let's assume the index investment was then sold. After taxes on capital gains and income, the net return would be around 4% a year. That's equivalent to a total return of 48% over a decade, with compounding (i.e. assuming the net dividends were reinvested).

Total inflation was 18% over those 10 years, which works out at about 1.7% a year (compound). That means the net (post-tax), real (after-inflation) return would have been 2.3% a year. It works out as an increase in purchasing power of 26% over a decade.

Remember: that was from buying stocks at the worst possible moment, just ahead of the biggest financial crisis since the 1930s. And you'd still have increased the purchasing power of the invested funds by 26% over a decade. This illustrates how stocks are great sources of profit over the long run, whatever happens in between.

Of course, few people would have been fully invested in stocks for that whole time. By October 2007, it was already clear that all was not well in the financial system. At that time, it didn't make sense to have a 100% allocation to stocks.

Instead, hedging the risks with an allocation to long-dated US treasuries made sense, given you could get yields around 5%. Or simply having bank deposits, since they paid decent interest too.

Either way, a big position in cash or treasuries protected an investor from the stock market collapse. Once the dust had settled, say in early 2010, the bonds and cash could have been switched into cheap stocks. Then the investor could have ridden the recovery right up to today. That way, they'd have done much better than owning only stocks right through the turmoil.

Nowadays, bond yields are pretty low. Especially for long-dated bonds, this makes them highly exposed to any increase in inflation and interest rates. So cash makes the better stock hedge at the present time, even though interest rates are low.

Put another way, if you have 40% in stocks today and the market keeps going up you'll still get at least some stock profits. But if there's a major drop in stocks - for example if a recession finally bites - a big allocation to cash will allow you to pick up more stocks later, at lower prices - thus riding the likely recovery.

This is why I currently recommend a relatively light allocation to stocks of just 40%. This bull market is long in the tooth. But even current stock investments are still likely to do well eventually, especially if bought at undemanding valuations today.

A major market crash (say -40%) or sudden drop (say -20%) may not actually happen in the near future. So it still pays to own at least some stocks, especially if bought well.

Look at it this way. The trailing price-to-earnings ratio of the S&P 500 was 21.73 in September 1991, which is about the same as today's level. If you'd bought the index back then, and just held on until today, you'd have made 9.6% a year (with dividends reinvested and before taxes). That's 7.2% a year above inflation, over almost 28 years.

Even after taxes, that would probably have worked out close to 6% net, real return a year. At that rate, an investment doubles its purchasing power every 12 years.

Even Stocks Aren't Always a Good Idea

Of course, there have been some extreme episodes when owning stocks was a bad idea. Investors that bought at the very peak of the 1929 bubble, just ahead of Wall St. Crash and Great Depression, had to wait until about 1944 to break even.

But even then, the real (pre-tax) return was 5.9% a year for anyone that stuck with it until 1959, meaning three decades. And that was after enduring by far the biggest ever crash in US stocks, in percentage terms (around -90% between September 1929 and June 1932).

Things were also tough for anyone that bought US stocks in late 1968. After inflation, it took until 1984 to break even, including dividends. That's because inflation took off, and valuation multiples such as the market P/E collapsed by the late 1970s. But after 30 years - up to late 1998 - the average real return was up at 6.5% a year (before taxes).

The case for stocks is strong, especially if you own a diversified bunch of them. Even for those in the past that bought into stock indices at market peaks, they've always resulted in strong returns over 30 years or so. Which is about the time frame that most private investors should be thinking about.

Even over 10 years, the range of outcomes for every starting year since 1950 is between -3% and +21%. It's clear that the odds are stacked in the favour of stock investors that take a long-term approach.

The following chart shows how the range of historical outcomes narrows as holding periods become longer, using data for US stocks since 1950. No single 20-year period made less than 4% nominal return. Bonds did well too, in the past. But I can't see how that will be repeated in future, given still-low bond yields today. (Unless we're about to experience deep and prolonged deflation, which seems highly unlikely given how central bankers behave these days.)

Putting this together, if someone told me I had to pick one single investment, and could not touch it for at least a decade, it would definitely be a stock index. But which one?

I'd probably choose to invest in the MSCI All-Countries World Index of stocks (ACWI). Over half of it's made up of US stocks, with the rest split between other countries, both developed and emerging markets.

At the end of February, the MSCI ACWI had a trailing price-to-earnings ratio of 16.9. It also had a dividend yield of 2.6%. Since US companies make big cash distributions in the form of stock buybacks, and there are lower levels in other places too, I estimate the total distribution yield is about 4%.

Corporate profits should roughly grow in line with nominal GDP growth in the countries where they operate. Let's say nominal GDP growth across the world averages about 4-5% in future, measured in US dollars (being 2% inflation and 2-3% real growth on top).

Add that to the distribution yield and this stock index looks good for about 8-9% a year, over the long run and in US dollars.

Now let's see… 8-9% a year on highly diversified stocks… or 2.6% on US treasury bonds… or even less on cash? It's clear which is preferable.

For a one-stop shop of stock investing, you can buy the iShares MSCI ACWI ETF (NASDAQ:ACWI). With a more targeted approach - especially one that's focused on deep value stocks - you're likely to do even better.

A revolutionary initiative is helping average Americans find quick and lasting stock market success.

275% in one week on XLF - an index fund for the financial sector. Even 583%, in 7 days on XHB… an ETF of homebuilding companies in the S&P 500. 

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