The Hitchhiker’s Guide to the Market

The Market; specifically, the stock market. Everyone’s heard of yet, however so few realise what it actually is or indeed what it does. The only time the stock market ever really seems to be in the news or mainstream media, is during a ‘correction’ or a crash.

What is it?

A collection of the great companies of the world. It is measured by people and companies investing in stocks and shares of other companies, in the hope that those companies are successful, their profits increase and their share price goes up. These stocks and shares are then traded on Stock Exchanges around the world, where the supply and demand for shares dictates the price at which traders will buy and sell them. Some will believe the price of a particular share will increase in the future, whereas others will believe it will go down. This is why the stock market fluctuates in value and is highly volatile in the short-term.

What is a market correction?

A stock market correction is something which happens during a sustained period of growth. The market essentially ‘overheats’ and needs to cool down a little. This happens due to a sustained upward trend of stock prices, which leads to more investors ‘buying-in’ to try to capture this upward trend before the downward trend begins.

However, as more and more investors buy into the market, stocks eventually become ‘overbought’ and those who had already owned those stocks, begin to believe they are reaching their ‘peak’ in terms of price. They then begin to sell their shares and the price is driven down. It really is as simple as ‘supply and demand’.

A decline in the stock market is described as a correction when it falls by at least 10% from the previous peak. It is important to understand however, that these corrections are as inevitable as they are temporary.

On average, since the turn of the 20th century, there has been a stock market correction every single year. To break this down further, in the 38 years from 1980 – 2018, the S&P 500 (comfortably the world’s largest stock market index) averaged an intra-year decline of 13.8%. Additionally, the FTSE All-Share Index (consisting of roughly 600 of the 2,000 companies traded on the London Stock Exchange) experienced average intra-year declines of 15.3% from 1986 – 2018.

The salient point from this is that the market has inherently dropped by more than 10% every single year, something which is incredibly important for those investing for the long-term (which should be all investors). It has always done this and will continue to do it in the future – nobody will know when it will happen (anyone who tells you they do is lying) but the one thing we can say for sure is that it will. The evidence must not be ignored.

The mainstream media will forget to mention that a market correction happens as often as the earth orbits the sun. The next time this happens, they will try to create a sense of fear and panic in order to shock you and sell their news. However, the enlightened among you will now see these headlines and think “Oh look, the market is correcting itself again” before going about your day, safe in the knowledge that the sun will rise again tomorrow and that his has no impact on your long-term investment strategy. Only those who panic will lose.

Does it go up as well?

Now, despite these inevitable declines, the stock market continues its infinite upward trajectory. Taking the example from the S&P 500, despite average intra-year declines of 13.8% in the 38 years since 1980, the index provided positive returns in 29 of those 38 years. That’s a positive annual return 76.3% of the time over the last 38 years! If you’ve had money invested in an S&P 500 index tracker since 1980, you will have received an average annual return on your investment of 8.8% compound, and can consider yourself to be extremely fortunate indeed.

The power of compounding

Compounding is essentially growth upon growth. As an example, let’s say you invest £10,000, which experiences growth of 5% over the following 12 months; you will begin the next year with £10,500 – a return of £500. Over the next 12 months, again, your investment grows by 5%. This year you started with £10,500, which has now increased by 5% to £11,025. Your return of 5% on the original £10,000 yielded £500, yet the following year the same 5% return yields £525. Same return in terms of percentage, but the compounding effect has added an additional 5% of your 5% return (£25 = 5% of £500). This happening every year since you originally invested your £10,000, and I think you get the idea of the impact this will have over the long-term.

Compounding can have a staggering effect on the long-term return of investments. Take, for instance, the following example:

Jenny is aged 25, and has made the conscious decision to start saving. She has no particular use for this money, other than to simply invest for her unknown future. She sets a target to save £5,000 each year, which she deems affordable, and invests this money in the FTSE All-Share Index. She does this throughout her working life every year without fail. She is now 65 years old and the FTSE All-Share Index has grown by 5% each year on average over this 40 year period. Her investments of £5,000 per annum (totalling £200,000 over 40 years), have now grown to a total of £639,199. That’s a 319.6% return over 40 years, or a median annual return of 7.99%. 40 years of compounding has transformed the average annual return of 5%, into what is essentially 8% per annum, just by investing regularly over a long period of time.

Arguably however, the amount of time spent investing has a greater impact on the eventual growth than the actual amount invested. Sticking with the above example, let’s assume Jenny had waited until she was 35 before deciding to begin her long-term investment strategy:

Investing £5,000 each year at a return of 5% per annum compound, but this time over 30 years instead of 40, Jenny would have accumulated a total of £353,803 by the time she reaches age 65. This still represents a very decent return of 235.8% on her investment (totalling £150,000 over 30 years), but means that Jenny has missed out on a vast amount of growth to her money, simply by waiting another 10 years to start investing in the market. That 10 years would have provided an additional 83.8% growth on her total investment, without needing to pay any more in each year, or requiring any higher average annual returns.

It’s about time in the market, not timing the market

Many economists, traders and investment bankers will try to tell you that they add value to your long-term investment strategy by buying individual stocks and shares at the right time, in order to provide the greatest return on each individual investment. They will attempt to predict what is going to happen in the future, whether that be in the market as a whole, within individual asset classes or even within separate sectors within different asset classes.

The simple truth however, as evidenced by decades of research, is that nobody… NOBODY, can consistently time the buying and selling of individual stocks and shares and outperform the market itself over the long-term. This is particularly pertinent when you consider the astronomical fees and charges they will apply to your investments to pay for the “expertise” of Active Investment Managers and Hedge Funds. 

Sure, there will be some people who are able to sustain out-performance over a particular period of time.However, trying to find those who can, within a snap-shot in time, out of thousands of investment houses and fund managers around the world, all selling the same nonsense that they will “beat the market”, is frankly a nigh on impossible task. It simply isn’t achievable by anyone over the long-term, which is what investing in the market is for. Do not be fooled by snazzy sales people and expensive marketing equipment that your fees will ultimately be paying for.

Do not try to predict what is going to happen and do not worry about where the market is now. If you’re thinking “well, the market is at an all-time high right now, so I should wait for it to fall before buying in”, don’t. All that time you spend waiting for the next market correction to buy-in at a better value, everyone else is busy making money. Get in now, invest, and forget.

Don’t get smart

Here’s an example of why you should buy into the market, and just hold your investment there for long-term rewards. If you had invested £10,000 in the FTSE All-Share in 1997, and simply left it all in there, without adding anything or taking anything away, up until 2017, your investment would have grown by an average annualised return of 6.26%. Given what we already know about the power of compounding, that’s a pretty good return over 20 years.

However, if with that same £10,000, you had tried to be smart and invest when you thought the time was right and, as a result, had missed the 10 best days of trading over that period – i.e. 10 days out of 20 years, those annual returns would have fallen from 6.26%, to just 2.81%. Just by missing 10 days of trading, you may have lost out on growth of 3.45% per year. To go one further on this, if in those 20 years you had been out of the market on the 30 best days of trading, you would have made a loss of -1.05% per annum on average. Missing the 50 best days would have resulted in a loss of -4.06% each year.

This then is evidence that you cannot outsmart or out-time the market, and that the best strategy for long-term investment returns is simply to get in and stay in. Invest and Forget.

Bull and Bear markets

Bear – A ‘Bear Market’ occurs when the stock market suffers a decline of more than 20% from its previous high and tends to occur during economic crashes or recessions. Since the Wall Street Crash in 1929 and subsequent Great Depression, there have been 10 ‘Bear’ markets.

• The Wall Street Crash of course caused the worst Bear market in history, where the S&P 500 fell by roughly 86% over a duration of 33 months. Other notable crashes and subsequent Bear markets are the Fed tightening in 1937, causing S&P declines of 60% over 5 years, the OPEC oil embargo in 1973 where the market fell by 48% over 21 months, the Tech bubble in 2000, where tech stocks were wildly overvalued, resulting in a crash of 49% and finally, of course, the Global Financial Crisis in 2007, where the S&P 500 fell by 57% over a year and a half.

Bull – A ‘Bull Market’ is essentially what happens when the stock market recovers from crash and Bear market. You will hear about these less often, simply because it’s what’s happening most of the time – so it’s not news. A Bull market is the opposite of a Bear market, in that it represents a rise of 20% from a previous low point. A few statistics for you on the Bulls that have followed the Bears mentioned above.

• The Bull market that followed the Wall Street Crash saw the previous fall of 86%, recover by a staggering 324% in the 58 months from June 1932.
• The 1937 Bear market, where the S&P fell by 60%, saw a Bull market recovery of 158% over 4 years from 1942.
• A relatively small crash in August 1987, caused by overheating markets and only lasting 3 months, was followed by an astonishing Bull market beginning in December 1987, producing returns of 582% over the next 150 months, so far the second longest Bull run in history.
• Finally, the one you’re all waiting for, since March 2009, the stock market has been on a Bull run for the last 106 months, with a return of 295% over that time.

What does this mean?

You may draw your own conclusions from these statistics and, by the way, I’m taking nothing away from the hardship that the various crashes over the years have caused so many people. However, when we look at this in the context of investing in the market for the long-term, we can see that; A) Bear markets are relatively rare – there have been 10 in the 89 years since and including the Great Depression and B) They are ALWAYS followed by a more aggressive and more sustained Bull market.

So, if you’re investment horizon is 30 years from now and the stock market crashes in 2020 – this is something that you must be prepared for but also something to relish for your long-term investment strategy. DO NOT sell your investments at the first sign of a market crash. If this happens, and it will, simply wait for it to recover and watch your investments soar. Do not fear the Bear, simply wait patiently for the Bull. When everyone panics and sells their investments for the safety of cash, the intelligent investor will wait to reap the rewards this will bring to the market.

I cannot tell you when there will be a crash, and I cannot say when the subsequent recovery will begin. What I can say with confidence however, is that these things have always happened and that they will continue to always happen in the future.

The evidence – a crash in the stock market has always been followed by a bigger and better recovery. There is nothing to suggest anything other than this will continue to happen in the future.

Should I invest in the market?

The simple answer to this question is yes. Historically, the stock market has always been on an upward trajectory and has always grown over the long-term, whichever way you look at it. Inflation will always erode cash over the long-term, and so the only way for your money to maintain its purchasing power 30 years from now is to have at least a decent proportion of your overall wealth invested in the stock market.

Diversification of your wealth is key to optimum returns. There is no point investing all of your money in one asset class, one geographical region or one sector. The only way to sustain consistent investment returns is within a Globally diversified portfolio of equities (stocks and shares), fixed income assets (bonds and government bonds), property and cash. These can be weighted according to how much risk you want to take.

If you have a long time horizon for your investments and consider growth your priority, then a high weighting towards equities has historically been the best way to go. However, if you value more stable yet lower long-term growth, a slightly higher weighting should be towards bonds and cash. You can simply slide the allocation along a scale depending on the amount of risk you are prepared to take for the returns you seek.

If you are not investing for the long-term and only have short-term needs in mind for your savings, I would suggest that you do not invest in the market. The consumer investor should only invest their hard-earned wealth if for a long-term goal or saving for their unknown, long-term future.

Remember, the House always wins. If you want consistent long-terms returns for your money, invest in the Global Stock Market (aka the Great Companies of the World) and leave it there to benefit from the brilliance of human ingenuity. If you ever hear anyone utter the word ‘Alpha’ when presenting a long-term investment strategy – you would be best served by getting out of your seat, walking out of the door and running for the hills!

*All stock market performance figures and statistics taken from J.P. Morgan’s brilliant ‘Guide to the Markets’ document.