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Friday, December 11, 1998

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Enjoy Utopia, Expect Reality

What a wonderful period the past fifteen years have been for equity investors. A couple of days ago, somebody asked me about the long-term average returns on stocks. I said it had been about 11%. No, this friend didn't want to know about returns since the beginning of tracked history (at least according to Ibbotson Associates, the data source I've used for this article). He wanted to know about the return in the '80s and '90s (I guess that should be 1980s and 1990s to avoid a Y2K problem). I knew it would be significantly higher, but wasn't sure what the number would be.

After a little digging, I found out that the S&P 500's compound annual return over the past fifteen years was 17.5%. That may not sound impressive to you folks who earned over 30% between 1994 and 1997, so let's look at the numbers another way. A $10,000 investment in the S&P 500 at the end of 1982 would have been worth over $112,300 at the end of last year. The powers of compounding at work for you.

This high level of return is far above those historically returned by equity markets. The S&P 500 has averaged a 13.2% compound annual return between 1950 to 1987. Going all the way back to 1926, we find that investors have made 11% annually (my guess was right!). Of course these figures are the compound average returns. As we all know, if you put one leg in cold water and the other one in hot water, "on average" you would be comfortable. Not too reassuring.

Over the past few years, however, there hasn't been too much cold water thrown on the S&P 500 stocks. In fact, only one of the past 15 years, 1990, has shown a negative total return. Even then, the negative return was a very modest -3.2%. The other 14 years have not just had positive returns, they've had stellar results. Five of the years (1985, 1989, 1991, 1995, and 1997) have yielded investors total returns over 30%! The rest have ranged anywhere from a somewhat miserly 1.3% in 1994 to a plump and joyful 23.1% in 1996.

Having been fortunate enough to participate in the phenomenal recent returns from the stock markets, it is easy to forget a fundamental aspect of finance. Over time, equity returns are higher than those of bonds and money market funds because stocks are "riskier," i.e., more volatile, investments. Stocks prices are going to jump around much more than those of "lower risk" investments. We have all seen over the past few months how volatile stocks can be in the short term. Industry leaders such as Chase Manhattan Bank (NYSE: CMB) fell 54% from a July high of $77 9/16 to $35 9/16 in just over two months before rebounding to the low-$60's. While recent market movements have been nerve-wracking, the quick rebound has added to many people's sense of complacency in putting short-term investments in the market.

If you've been watching the stock market over the past few years, it's very hard to accept the 5%-7% you might get in various bond funds, not to mention the 4%-5% most money market funds and certificates of deposits are paying. I speak from experience. I hope to buy a home sometime in the next three years, yet some of the money I expect to use in this purchase is invested in the stock market. Why? Look at how much the stock market has performed. Not only have the short-term returns for the market been spectacular, but I think that I can pick stocks that will do even better. Even making the assumption that my stock-picking ability is stellar, I'm skating on dangerously thin ice.

The stock market goes up over time. It has happened over the last seventy years and will most likely be true over the next seventy. In addition, over the long term, equities will likely earn more than bonds, which will probably earn more than money market funds. It has happened that way in the past and should continue to do so in the future. The key part of that assertion, however, is over the long term. The likelihood of this statement holding true over the short term is much more tenuous.

There are numerous years where stock performance has been horrible. In 1973, the S&P 500 fell 14.7%. That drop was followed by a 26.5% plunge in 1974. What does that mean to investors? A $10,000 investment at the end of 1972 was worth $6,275 at the end of 1974. If excellent stock picks resulted in this investor outperforming the market by 5 percentage points per year, the investor would still have only $7,094. If he had been saving that investment to buy a home, his "great" stock picking wouldn't have prevented him from being a renter for a few years more than he expected.

We should not become so complacent that we casually invest money in the stock market that needed in the short term. Before doing so, recognize that you are essentially hopping on a plane, flying out to Vegas, and throwing your money down on a poker table. Skill and knowledge will help you avoid some losses, but luck is the overriding force. While stocks rise most years, the 9% loss of 1962, the 12% loss of 1941, or the 43% loss of 1931 will occasionally pop up. It doesn't happen because of anything you do, it occurs because of unexpected changes in the marketplace. These occasional losses aren't an unusual happenstance. They are a certainty that justifies the higher returns equity investors make over the long term.

I'm not trying to insinuate that equity investing is bad. It is an extraordinary opportunity for people who have decades to invest. Taking higher returns and compounding them over long periods of time is an amazing way to create wealth. When investing in stocks for the short-term, however, remember that much greater risks are being taken. Market drops and plunges do not always correct themselves within a few months. The S&P 500 investor at the end of 1972 broke even four years later in 1976. Then, he went underwater again in 1977. While it's not pleasant to experience, it is part of owning stocks. I feel pretty confident stating that S&P 500 investors will experience negative returns over a three-year period sometime in the next 50 years. At the same time, I am even more confident that an S&P 500 investor today will be well rewarded for his investment 50 years from now.


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