History Stole Your Market Returns

While reading Josh Brown's book Backstage Wall Street this weekend, I came across this quote from current New York Times columnist Joe Nocera. It's from 1995, when the Dow Jones (INDEX: ^DJI  ) traded at around 4,000. Back then, Nocera couldn't believe the optimism sweeping investors away:

The pessimists -- PESSIMISTS! -- say that the Dow will go to 5000 by the turn of the century, and that the fund industry will grow by an additional trillion dollars. The most optimistic -- Jessica Bibliowicz of Smith Barney, as it happens -- predicts a 6500 Dow.

Funny: By 2000, the Dow traded above 11,000. How many times in history have the most optimistic investors been off by 70% on the upside? As far as I know, never.

I won't ramble on about how big the dot-com bubble was or how dumb investors were back then. That got old years ago.                

But there's a related point that's still worth talking about. What's interesting about the 1995 forecasts Nocera cites is how rational they were. Since the 1950s, the Dow has increased by an average of 6.8% a year (before dividends). With the Dow trading at 4,000 in 1995, the analysts polled in Nocera's article were forecasting annual returns of 5% to 9% -- normal, average returns, basically.

In other words, assuming valuations were reasonable in 1995 (and they were, for the most part), the Dow should have traded somewhere between 5,000 and 6,500 in 2000. That's where you should have expected it to have been had there been no dot-com bubble.

Now, if the Dow had traded at 5,000-6,500 in 2000, think about what that would mean for investors today. Instead of the "lost decade" investors endured from 2000-2010, they would have earned an average annual return of 6% to 8.5% a year -- almost exactly average, historically.

Here's another way to think about this. The light line below is a hypothetical Dow increasing 6.8% a year (the historic average) starting in 1995. The dark line is the actual Dow:

Sources: S&P Capital IQ and author's calculations.

Did you notice? The two lines end in the exact same spot. Returns from 1995 through today have been almost exactly average, historically.

And yet think of all the frustration over lousy market returns lately -- disgruntled investors sullen over the fact that most money invested over the last decade has lost value after inflation. Without question, the last 10 or 12 years have been an awful time for most investors.

The takeaway from that is really important:

  • From 1995 through today, the Dow produced average returns of about 7% a year. That's good.
  • But nearly all of those returns happened from 1995 to 2000. The market literally took 17 years' worth of returns and squeezed them into five, which sent valuations in 2000 through the roof.
  • Valuations in 2000 practically guaranteed that returns over the last decade would be poor.

I know. You might think it's Monday morning quarterbacking for me to say, "Look, if you invested in 1995 instead of 2000, you'd be rich today!"

But that's exactly what I'm saying, and I think it needs to be repeated over and over again. For the literally tens of millions of pages of market analysis and financial advice out there, smart investing really boils down to just three points:

  • Buy stocks when they're cheap, or at least reasonably valued. That doesn't mean market timing; it means focusing on valuations above all else.
  • Hold them for a long time. That could mean a decade or more.
  • Ignore what happens in between. If you choose to watch, be assured: It will be ugly at times.

Anyone who bought from 1997-2000 or 2006-2007 when valuations were high and felt cheated two or three years later as returns sank broke all three rules. Many more will do so in the future. And just like over the last decade, they'll sit in shocked disbelief, wondering what happened, when the honest answer is, "Nothing unusual."

As Ben Graham, Warren Buffett's early mentor, used to say, "In the short term, stocks are a voting machine, and in the long term, stocks are a weighing machine."

During no time has that been more evident than 1995 through today.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (25) | Recommend This Article (70)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 03, 2012, at 3:40 PM, portefeuille wrote:

    The current rally appears to follow this trend line ...

    from comment #13 here ->

  • Report this Comment On April 03, 2012, at 4:10 PM, portefeuille wrote:

    That trend line for the closing values of the S&P 500 index

    f(t) = f(0) * exp ( 1/15 * t^0.37),

    where t counts the trading days since March 9, 2009 (t = 0), thus f(0) = 676.53

    currently (t= 755 for April 3, 2012) increases by around f'(755) ≈ 0.5515 per trading day (there are around 252 trading days per year), so at "current trend line speed" the index rises by around 10% p.a..

  • Report this Comment On April 03, 2012, at 4:43 PM, BlazerMania wrote:

    "In the short term, stocks are a voting machine, and in the long term, stocks are a weighing machine."

    Does TMF have an editorial policy requiring the daily use of this quote?

  • Report this Comment On April 03, 2012, at 4:45 PM, TMFMorgan wrote:

    ^ We use it so frequently because the lesson is so often ignored or forgotten.

  • Report this Comment On April 03, 2012, at 5:02 PM, seattle1115 wrote:

    "Ignore what happens in between. If you choose to watch, be assured: It will be ugly at times."

    It's a matter of accentuating the positive, isn't it? I actually have a routine, a process I can employ to keep myself focused on the big picture. On those days when my investments are performing well, I think to myself "I made some decent money today." On the days when I take a bath, I think to myself "Look at all these excellent buying opportunities!"

  • Report this Comment On April 03, 2012, at 5:58 PM, somethingnew wrote:

    These are the kind of articles I like to read. Thanks Morgan. I sometimes feel like I get more out of my Fortune magazines from the '80s that I got off Ebay than my current Fortune subscription that I subscribe to. Many times the past is a good indicator of the future.

  • Report this Comment On April 03, 2012, at 6:01 PM, TerryHogan wrote:

    Actually the editorial policy requires mention of Warren Buffet, Ben Graham, Charlie Munger, Peter Lynch, or John Bogle in at least every third article. Just like ads touting the next big stock have to include something about Warren, Bill Gates, or Steve Jobs.

  • Report this Comment On April 03, 2012, at 6:06 PM, xetn wrote:

    It seems to me that the Dow run up in the mid to late 90s was in no small part do to the Fed's currency creation during the same period. Although it in no way compares to the current era (2008-present). Actually, the "current era" should include the whole 1st decade do to Fed actions following the bubble burst.

  • Report this Comment On April 03, 2012, at 6:15 PM, seattle1115 wrote:

    By the way, maybe I'm just not very bright, but what the hell does "weighing machine" mean in the context of that quote? I've never understood it.

  • Report this Comment On April 03, 2012, at 6:30 PM, MNGPHR wrote:

    seattle - it means over time the quality companies will win out as the short term erratic/irrational behavior of people will not affect these good companies

  • Report this Comment On April 03, 2012, at 6:32 PM, CaptainWidget wrote:

    Dollar cost averaging FTW

  • Report this Comment On April 03, 2012, at 6:41 PM, MNGPHR wrote:

    I really hate the term "lost decade", it wasn't lost unless you had horrible timing. I started investing in 2006, and have been increasing my 401K contribution each year, minus the time spent unemployed. That has been a real test of my patience. My returns have been crap thus far because the generation before us pillaged the market, and decided to buy houses 5 times bigger than they could afford. But I still have made money, and think that I may have a great retirement because I will be buying into a low/slow period over the next decade. Then I'll ride the next wave(s) up.

  • Report this Comment On April 03, 2012, at 7:19 PM, seattle1115 wrote:

    @MNGPHR: "it means over time the quality companies will win out as the short term erratic/irrational behavior of people will not affect these good companies."

    Hmm. Seems like a rather clumsy metaphor, but whatever. I guess the general intent was clear enough, and it's accurate (up to a point).

  • Report this Comment On April 03, 2012, at 7:33 PM, seattle1115 wrote:

    @CaptainWidget: "Dollar cost averaging FTW"

    What CaptainWidget said.

  • Report this Comment On April 03, 2012, at 7:37 PM, bossman5000 wrote:

    Hey Morgan,

    Great article. Love the graph, very interesting premise. Not sure if I buy it 100% but it is compelling.

    I am with you though on your investment strategy. Buy reasonably valued, and hold. Done. Nothing else necessary to focus on.

  • Report this Comment On April 03, 2012, at 8:05 PM, jerryguru69 wrote:

    Thank you for your perspective. One of my many pet peeves about financial writers is that they will cherry pick a historical period to prove their thesis. Shame on every writer who does this.

  • Report this Comment On April 03, 2012, at 8:19 PM, Futuroyolo wrote:

    Good article morgan. Long term value investing in my opinion is and will always be the best way to build wealth. "The Intelligant Investor" by Benjamin Graham is the single best investing book for someone who wants to follow this method. Buy companies with an established brand, have a long history (decade) of paying a dividend and when market cap to gdp is under valued.

    I read an article back in Jan 09 saying Warren Buffet made large purchases during and right after the market crash in late 08. Buffet stated when investors are scared I go a buying. It is very hard to eliminate emotion, expecially when your own money is at stake, but is prudent in the process to make money. Benjamin Graham and Warren Buffet are investing legends as Kobe Bryant and Michael Jordan are to basketball. When these guys tell you how to be successful you would be foolish not to listen.

    This investing concept works because money is not added to the market; instead it just changes hands. The market works around an equilibrium point the ups and downs of the market are just flucuations from that point, and will "always" return to its natural equilibrium. So do your homework on the markets/companies you will be investing, remove emotion from investing, never buy after a big gain/never sell after a big loss and buy entities you are willing to hold forever. Investing and basketball are my two passions and I get the same amount of enjoyment from both. So good luck investing and enjoy it otherwise it isn't worth doing.

    Disclaimer: I am only twenty-two years old so I have a lot to learn still and everything mentioned is just "my opinion". I am not commercially promoting "The Intelligent Investor" or any of the names I have mentioned in the above article. Nor am I gauranteing that a company will give you a positive return by saying "the market works around an equilibrium point and will always return to that point." Also I am a numbers guy not an english major so my grammer or spelling will not be perfect

  • Report this Comment On April 04, 2012, at 12:26 AM, BrokeInDaBurgh wrote:

    This was a very good article. Thank you.

    You know, one takeaway I have is that one wants to buy stocks when the MARKET is cheap, or at least realistically priced. This is a slightly different point than buying stocks when the STOCKS are cheap.

    Ideally I guess one tries to do both! but a diversified portfolio probably derives a large portion of its movement from market movement. At least that graph is somewhat compelling.

    Thanks again.


  • Report this Comment On April 04, 2012, at 4:58 AM, miclombardo wrote:

    Graham's quote is:

    " [...] In other words, the market is not a weighing

    machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion." Security Analysis, 2nd ed., Part I Survey and Approach, The Relationship Between Intrinsic Value and Market Price, pg. 28.

    I think he refers to the fact that on any given day (short term) companies are given a yes/no evaluation. Yes= hyped, high P/E = potentially overvalued , No= overlooked, neglected, low P/E = potentially undervalued.

    In time though (long term), as more and more people tend to understand that the factors overlooked/neglected about the company are indeed of some importance (good earning record, dividend, growth, conservative financial structure, and so on) the price of the company starts to raise, reflecting and possibly passing its intrinsic value (which, by the way, it's very rarely an exact value and must be better considered as a range of values).

    This as far as I understand. Hope it helps.


  • Report this Comment On April 04, 2012, at 7:44 AM, CMFSoloFool wrote:

    Metaphors and doublespeak of famous investors and analysts tend to confuse many people, particularly those new to investing.

    What I have observed is the Market is a short-term voting machine because it reflects investor sentiment at that time. There is no mystery here, it follows standard supply and demand equilibrium. Low supply + high demand = higher prices. High supply + low demand = lower prices. Demand is created by investors piling into a stock or into the stock market in general. The supply is always relatively static (the float of shares outstanding) so when the demand increases past the supply, investors pay more for the shares. Then you have a major panic, like the downfall of Leeman, and investors abandon stocks and drive the demand down to where prices fall.

    Timing the market is very difficult to do because most non-professional investors follow a typical herd mentality, which makes many people do irrational things. Hence, Mr. Buffett is always quoted as saying "be fearful when others are greedy and greedy when others are fearful". Simply translated, Mr. Buffett's wisdom means buy low and sell high, or buy when demand is low and sell when demand is high. However, timing is not as difficult as it seems, unless you are trying to find the exact peak or exact bottom. It can be easier if you are not too greedy and settle for close enough. If you have the long-term focus, close enough is good to beat the S&P average and pays off with patience.

  • Report this Comment On April 04, 2012, at 7:49 AM, XMFDRadovsky wrote:

    Excellent piece!

  • Report this Comment On April 04, 2012, at 9:30 AM, dtman117 wrote:

    Looks like a moving average chart. Can you use

    7% as the moving average and invest as such?

  • Report this Comment On April 05, 2012, at 1:43 AM, mrudolph72 wrote:

    Dtman: I was thinking much the same thing but when you adjust for dividends I think you might be better off just staying invested unless you're lucky and timed it perfectly.

    By the chart, let's say you thought the market was expensive in 98 and went to cash. It would take 10 years to get a chance to buy back in at a fair price

    I know i couldnt be that patient. Also after you adjust for reinvested dividends, I'd bet you would have been as well off just staying invested the whole time. Maybe even better off.

    I think this chart makes a good case for dollar cost averaging and some sort of asset allocation/ rebalancing strategy.

  • Report this Comment On April 08, 2012, at 4:07 PM, dcflipflop wrote:

    Great article as usual, Morgan.

    I find it interesting that even after the dot-com bubble burst AND the worst terrorist attack on US soil happened, we still did not get back to where the market "should have been."

  • Report this Comment On April 10, 2012, at 3:56 PM, kewlness wrote:

    Wow... I haven't seen this much praise being heaped on Morgan for one of his articles in, well, a long time.

    It was an excellent article which I enjoyed reading (like all of Morgan's articles). It must feel odd to Morgan though to not have people mad at him for some reason. However Morgan, I feel I must give this warning:

    Don't worry about the love experienced today - you'll be hated again with the next article, I'm sure. I bet the next article will be great and you will find yourself in a familiar place wearing your fire blanket.


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