3 Things Every Investor Should Know About the Stock Market

What's interesting about these three quotes?

"The market remained almost entirely professional [today], as the investing public continued to leave stocks severely alone."

"At least 7 million shareholders have defected from the stock market … leaving equities more than ever the province of giant institutional investors."

"Across the country, investors are fleeing the stock market for the safety of cash."

The first is from 1932. The second is from 1979. And the last is from 2011.

For as long as there has been a stock market, there have been raging bull markets and crushing bear markets. After the latter, investors silently come together and agree that stocks are rigged against them -- an Ivy League gambling machine for suckers. They become frustrated and move on.

Yet the verdict of history is clear. Of the major assets most investors can own, stocks have performed the best on average over the long term -- by a long shot. Deutsche Bank recently published its annual Long-Term Asset Return Study, which tells the story:

Asset

Average Annual Real Return, 1838-2012

Stocks 6.49%
Treasuries 2.77%
Corporate Bonds 2.72%*
Gold 0.35%

Source: Deutsche Bank. *1913-2012; longest available period.

So, if history is so clear, why do investors write off stocks time and time again? I think it's a misunderstanding of three basic things.

1. If you want stocks to work in your favor, you have to hold them a really, really long time
The average stock these days is held for about seven months. That's pathetic, and it goes a long way to explain why so many investors -- professional or otherwise -- grow frustrated with poor returns.

There's just no way you can expect to earn a decent market return if your time horizon is measured in months. In the short run, stocks are bucked around by fear, greed, rumor, and drivel. Only when stocks are held for years -- many years -- can you be reasonably assured that accumulated business value will be reflected in market returns. The longer you hold them, the more likely it is that solid average annual returns will materialize, and vice versa.

There's a neat way to show this. Going all the way back to 1871, here's how much the maximum and minimum real (inflation-adjusted) annual market returns have been after holding the S&P 500 (INDEX: ^GSPC  ) for different amounts of time:

Source: Yale, author's calculations.

Hold stocks for a year, and you're at the mercy of the market's madness -- maybe a huge up year, or maybe a devastating loss. Five years, and you're doing better. Ten years, and there's a good chance you'll be sitting on positive annual returns. Hold them for 20, 30, or 50 years, and there has never once been a period in history when stocks have produced an average annual loss.

The same can't be said for bonds. Wharton professor Jeremy Siegel once compiled data similar to the chart above using Treasury bonds. Going back to 1802, Treasury bonds have suffered bouts of negative real annual returns over 20- and 30-year periods. As Siegel noted at a conference I attended last year:

Even when looking at periods that ended in the bottom of the Great Depression, stocks had a positive real return if held for 20 years. You have never lost money in stocks over any 20-year period, but you have wiped out half your portfolio in bonds. So which is the riskier asset? And nothing that's happened over the past ten years negates this data.

To me, this is a razor-sharp argument on why you should prefer stocks if you have a long time frame. But it's also really telling. Do most investors know you may need to hold stocks for 20 years before seeing positive average annual returns? I doubt it. And that's why so many get frustrated and leave, robbing themselves of long-term opportunity.

2. Starting valuation determines future returns  
The Dow Jones (INDEX: ^DJI  ) traded at a lower level in August 2011 than it did in August 2000 -- before dividends, that's 11 years of negative returns!

This shouldn't be surprising given the chart above. But it should make you ask: Why do long stretches of negative returns happen?

Almost invariably, the answer is simple: Starting valuations were too high.

Over the long haul, stocks return an average of about 7% a year, and trade at an average of about 18 times earnings. But averages are… averages. What happens in between is a wild mix of annual returns well above or below the 7% average.

When stocks go through a period of above-average returns and valuations jump to above-average levels, they will be followed by a period of below-average returns to balance it out. This is simple reversion to the mean. And you can count on it like clockwork.

So, back to the year 2000 example. Yes, stocks declined from 2000 to 2011. But what happened before that? We had several years of preposterously good returns that created nosebleed valuations -- the dot-com bubble! What followed (the last decade) was reversion to the mean.

Taken all together -- the bubble boom and its aftermath reversion to the mean --  the Dow produced returns almost exactly equal to historic averages from 1995-2011:

Source: S&P Capital IQ, author's calculations.

Just what you should expect.

Buy stocks when they're cheap, and future returns will likely be high. Buy when they're reasonably valued, and you'll do just fine. Buy when valuations are high, and you'll suffer for years. You get what you don't pay for. This is the single most important (and ignored) lesson of investing.

3. Volatility. It's real!
This one ties the first two together.

Investors likely become frustrated with stocks because they once heard that stocks return 7% to 9% a year, and they've been lulled into thinking it's true.

But it's really not. While the long-term average return has been about 7% a year, stocks rarely return that much in any given year. Instead, they spend the majority of years returning either far more, or far less, than the 7% average:

Source: Yale, author's calculations.

In the 141 years since 1871, the S&P 500 has spent 75% of the time outside of the range most investors would likely consider "normal." Stocks have spent far more years up or down more than 20% than they have in the neat 1%-10% range they're sometimes marketed as producing.

What that shows is so important: If you want to earn historically average returns over the long haul, you have to put up with a maddening amount of volatility. You have to take the ups with the downs. It's part of the game.

It's perfectly normal for stocks to fall 20% in a year. It doesn't mean the economy is broken, the game is rigged, or that you should give up. It's just what they do. They've always done it, and they'll do it again in the future.

As investor Frank Holmes once put it, "Don't let [volatility] scare you. It's normal. Use the volatility to your advantage. Don't become bitter. Become better."

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.

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Comments from our Foolish Readers

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  • Report this Comment On September 24, 2012, at 5:52 PM, nberube wrote:

    Great read.

    The people who are saying the market "went nowhere" for the past 10 years need to change their investing strategies.

    A lazy investor who would've simply bought low cost ETFs every month for the past 10 years would be doing great today.

    Be lazy, my friends.

  • Report this Comment On September 24, 2012, at 6:45 PM, TMFCrocoStimpy wrote:

    From pt #1, it would be really interesting to see what these returns would be like if a equal amount (inflation adjusted) where invested each year during the time periods. At first blush you might think that it would cause the returns bands to narrow faster as time goes on, but since you would be continually loading the funds the impact of your endpoint in time will carry much greater influence than the starting time, making the "down" periods as end points much more painful. Kind of like the impact on retirees who had to start drawing on their portfolios during the recession.

    -Xander

  • Report this Comment On September 24, 2012, at 7:10 PM, tkell31 wrote:

    Relying on past returns is kind of, sorry, stupid. The law of large numbers applies equally to the stock market as it does to most companies. At this stage of the game it is critical to pick good individual companies to invest in since the market cant continue to increase in value by an avg of 7% forever. For reference think of our country as it is now and what it was like 140 years ago when this comparison begins. The cities, roads, and primary energy distribution systems are built. The impact of that on the market was profound and will never come back at close to what it once was.

    Some nitwit probably laid out the same chart 5 years ago and it would have shown the DOW at 16 or 17K by now.

    Or maybe in 30 years we'll be looking at DOW 108,000, but I sincerely doubt it.

  • Report this Comment On September 24, 2012, at 7:45 PM, PositiveMojo wrote:

    I was a momentum trader for a few years and had really great returns - well over 50%. But... when Europe hit the skids volatility spiked and I was spending a lot of time analyzing stock and making trades, just to break even. It was pretty frustrating.

    So, I decided to cash out and leave the market for a while, until things became more stable. Now, I am wondering if that was just a stroke of luck or whether or not it can be repeated? Should I now buy and hold, and forget the long hours of analysis? Or even, whether or not things will ever be stable again?

    I hate sitting on cash and need to decide on what strategy I'll be taking next. Thanks for some food for thought.

  • Report this Comment On September 24, 2012, at 7:47 PM, nberube wrote:

    tkell31 :

    There will likely be 438 million of us in 2050.

    http://www.pewsocialtrends.org/2008/02/11/us-population-proj...

    If you don't think this means more cities, more roads, more primary distribution systems, then I don't know what to tell you.

    The Dow will grow because the GDP will grow. That's not wishful thinking, just basic math.

  • Report this Comment On September 24, 2012, at 8:05 PM, nberube wrote:

    ... and if you think the US has reached it's economic zenith and can only decline from here, don't worry, you're in good company :

    “Everything that can be invented has been invented".

    -- Charles H. Duell, Commissioner, U.S. Office of Patents, 1899.

  • Report this Comment On September 24, 2012, at 8:42 PM, mountain8 wrote:

    This assumes that we aren't invaded while all our forces are somewhere overseas.

    Sorry, I'm a bitter vet. And I'm worried.

  • Report this Comment On September 24, 2012, at 9:39 PM, cashforever wrote:

    This article is like the holy grail of investment knowledge and logic. Thank you.

  • Report this Comment On September 24, 2012, at 9:51 PM, NickD wrote:

    pick 10-15 giant companies when your 20 invest in them for your entire life you will have millions if not 10s of millions

  • Report this Comment On September 24, 2012, at 10:01 PM, NickD wrote:

    20-25 invest 100-300 a month

    25-30 300-600

    30-35 600-1k

    35-40 1-2k

    40-45 2-3k

    45-50 3--5k

    50-55 5-6k

    60-65 6-8k

    think about it when your 20 and your investment could do the investing for you

  • Report this Comment On September 24, 2012, at 10:43 PM, dtony wrote:

    Having relied on interest income investments more recently and being on a fixed income makes relying on equities a difficult choice. A conservative investment service/manager who could produce steady returns above inflation would be very welcomed.

  • Report this Comment On September 24, 2012, at 11:01 PM, johnedparry wrote:

    I think that the most relevant and interesting comparison would be between equities and real estate.

  • Report this Comment On September 24, 2012, at 11:02 PM, MarquezDLS wrote:

    This is just a beautiful article. It's making a lot of the same points as a lot of MF articles, but cleaner and purer. Bravo.

  • Report this Comment On September 24, 2012, at 11:40 PM, nberube wrote:

    mountain8 :

    1) Thank you for your service.

    2) Here's what Buffett has to say about the fear of the future.

    http://www.youtube.com/watch?v=N9Ny6pjCS-8

  • Report this Comment On September 24, 2012, at 11:42 PM, rftwpuma wrote:

    As we age we have the capacity to do many things. But if you do not invest and learn as you go you will be at a real disadvantage. Because at some point, if your lucky, all you can do is manage your money. Other opportunities will not be there due to age.

    And if you do not pass your knowledge on you will have failed.

  • Report this Comment On September 25, 2012, at 12:32 AM, NickD wrote:

    McDonalds Coke Pepsi Walmart Nikey General Mills Johnson & Jonhson Procter & Gamble you just performed better then the index and 99% off those hedge funds for the past 50years anyone wanna say otherwise?

  • Report this Comment On September 25, 2012, at 10:19 AM, Darwood11 wrote:

    Good summary, Morgan. Thanks.

  • Report this Comment On September 25, 2012, at 11:15 AM, Loppem wrote:

    Interesting points but why compare returns of stocks with those of Treasury bonds (considered as a risk- free asset class, which stocks are not)?

    Would it not make more sense to compare the returns of stocks with those of corporate bonds (which would/should include some high-yield bonds as well)?

  • Report this Comment On September 25, 2012, at 1:26 PM, MrFinance223 wrote:

    Very good article, Morgan. You explain the "lost decade" as well as anyone I've heard.

  • Report this Comment On September 25, 2012, at 3:39 PM, JadedFoolalex wrote:

    Loppem,

    Treasury bonds are not risk free. They are subject to interest and inflation risk as are all bonds! You've been warned...

  • Report this Comment On September 25, 2012, at 4:18 PM, MrFinance223 wrote:

    Bonds delivered some sharp gains the past few years as interest rates dropped. But the losses are equally as sharp when interest rates go back up - which they will at some point

    With today's interest rates, most of the capital gain potential from bonds has been realized. However, we have yet to experience the potential for capital losses that lay ahead.

  • Report this Comment On September 25, 2012, at 4:48 PM, kyleleeh wrote:

    <<This assumes that we aren't invaded while all our forces are somewhere overseas.>>

    The US Navy is larger then the next 13 largest navies combined and 9 of them belong to our allies...how is this alleged invasion force going to get to here, and remain supplied? This is the exact reason Germany was not able to Invade England in 1940 despite having a huge numerical advantage on the ground. You need a HUGE navy and merchant marine to invade overseas.

  • Report this Comment On September 25, 2012, at 5:51 PM, 48ozhalfgallons wrote:

    To experience the best fishing, photography, sex, wine, cheese, contracts and stock returns is all about knowing one's standards then exercising patience..... waiting for the world to come to one's own terms and settling for nothing less before releasing one's assets.

    You have lost once you have acquiesced to someone else's terms and turned over your assets to their charge.

  • Report this Comment On September 25, 2012, at 6:18 PM, 48ozhalfgallons wrote:

    10 giant companies to invest in for 20 or 30 years beginning 1990: Just sit back, relax and you will net millions by retirement.

    Kodak

    Xerox

    GM

    Hewlet Packard

    Lehman Brothers

    Sony

    RCA

    AT&T

    American Airlines

    Pan Am

  • Report this Comment On September 25, 2012, at 6:29 PM, TMFMorgan wrote:

    ^

    HPQ is up 558% since 1990.

    AT&T is up 638% since 1990.

    Just sayin'.

  • Report this Comment On September 25, 2012, at 6:35 PM, TMFMorgan wrote:

    Also, RCA was bought and scrapped in 1986, and Pan Am only had 2 active flights a day in 1990 (it was nearly out of business already -- hardly a massive company by any stretch).

  • Report this Comment On September 26, 2012, at 1:05 PM, hbofbyu wrote:

    @ 48ozhalfgallons

    ... your point is well taken nonetheless.

    Diversifying is key because you never now what the future will bring for any specific company. But then if you diversify too much, you get the diluted returns of a mutual fund. There's a line to walk there somewhere.

  • Report this Comment On September 26, 2012, at 1:06 PM, deckdawg wrote:

    As the article points out, randomly picking some period less than 10 years may or may not produce positive annual returns. In my own experience, for the 8 year period starting in Sept 2004, my T. Rowe Price 401K produced 7% annual returns, and my self managed IRA with stocks selected almost exclusively from Motley Fool and M* produced 10.7% annual returns. I picked Sept 2004 because our company switched to TRP then, and the website calculates annual return since inception. (That time period includes a pretty typical major market correction that occurred in 2009)

    Morgan has pointed out in a previous article that the biggest thing that prevents folks from actually earning returns like this is that they keep jumping in and out of the market. I didn't do any jumping at all in my 401K, and only bought or sold individual stocks in my IRA. Don't think I ever had more than 10% of that account in cash.

    With all its flaws, the stock market remains one of the better games in town.

  • Report this Comment On September 26, 2012, at 9:01 PM, skypilot2005 wrote:

    Morgan wrote:

    "1. If you want stocks to work in your favor, you have to hold them a really, really long time

    The average stock these days is held for about seven months. That's pathetic,"

    + rec

    Sky

  • Report this Comment On September 27, 2012, at 5:24 PM, LMedico wrote:

    Mind if I ask a stupid question. Figure number one (which I really love looking at. It's so elegant and makes a good point clearly) represents the S&P 500 in general. In order to relate that information to specific positions (I imagine the overall effect is the same, merely the details would change) how does a stock's beta influence the dynamics? Will a low beta stock reach the point of no risk sooner? (Meaning that the worst returns are still positive.) Or does it just narrow the spread between worst return and best return range?Since, over very long time, voltility gets averaged out, does this mean beta and voltility don't impact the final result?

    Value, not overpaying for shares, would help a person land near the upper parts of the range. But how does dividend yield reinvested influence the dynamics? (I imagine it either shortens the time to all positive returns by shifting the range upwards or improves the top end of that range, perhaps? I also imagine, given the author, that dividends are accounted for in the returns displayed on the graph.)

    Does any other statistical element that people look at affect the trend? Such as margins, revenue, TEV, etc.? Or is it merely holding onto successful companies with a strong moat and dominant market share?

    I admit all of that is just a quibble (and mostly intellectual curiosity) as the main point should still be taken to heart: Buy, Hold, and Monitor.

  • Report this Comment On September 28, 2012, at 12:56 PM, Darwood11 wrote:

    On re-reading the article and the comments, i realized that this is exactly why I have purchased stocks in what I believe to be good companies, with some mutual funds and indexes.

    Yes, buying indexes has statistically been proven to be a good way to "sit back" while one's investment portfolio "does its thing."

    However, by purchasing stocks in good companies, I've had to expend the mental energy and take a stake in how my decision turns out. In other words, I'm neither "buying the market" nor, when I sell a stock, am I "fleeing the market." I'm looking at specific performance and the ability of a company to perform.

    I disagree with @48ozhalfgallons opinion. I think if one is going to buy stock in a company, that requires monitoring the performance of the company and deciding to sell if that firm no longer meets the original criteria. I'd never "buy and hold" an individual company with the assumption that like Rip Van Winkle I can wake up and cash in in 20 years. That may only happen on "Futurama" episodes.

  • Report this Comment On October 10, 2012, at 8:44 AM, thidmark wrote:

    "@ 48ozhalfgallons

    ... your point is well taken nonetheless."

    Yeah, something like don't let your alligator mouth get your hummingbird butt in trouble ...

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