A Simple Way to Explain Successful Investing

You've probably heard of Nate Silver by now. He's the statistics blogger whose forecasting model has correctly predicted 99 of 100 state races in the last two presidential elections. His work is a triumph of math and statistics over punditry and guesswork.

Silver's recent book, The Signal and the Noise, includes a group of charts showing average annual S&P 500 (INDEX: ^GSPC  ) returns plotted against the index's starting P/E ratio. I've recreated them here, because I think they are an excellent and simple way to explain successful investing (a different context from what Silver used).

First up, these are average annual S&P 500 returns since 1871:

Source: Robert Shiller; author's calculations.

Notice how random it is? Valuations, measured by P/E ratios, don't tell you all that much about what stocks will do over the coming year. Sometimes stocks are cheap, only to become cheaper over the course of a year as markets fall. Sometimes stocks are really expensive, and they get even more expensive over the course of a year as bull markets roar.

Over one-year periods, it's a crapshoot. You really have no idea what the market will do.

What happens if we look at average annual returns over five-year periods? Things get a little more orderly:

Buy stocks when valuations are low, and you'll probably do all right over the coming five years. Buy at high valuations, and you'll probably regret it over the next five years. There's a chance something else will happen, but investors tend to get what they deserve over five-year periods. Compared with one-year periods, it's less of a gamble.

Now look at what happens over 10-year periods:

It's even more orderly: Those who buy stocks at low valuations will very likely do well over 10-year periods, while those who buy expensive stocks very likely won't. Forget the crapshoot; we can now put the odds firmly in (or against) our favor.

The lesson here is simple, but it's probably the most important in all of investing. To reasonably assure success:

  • You have to buy stocks when they're cheap.
  • You have to hold them for a long time.

Otherwise, you are, at best, playing a game of dice.

If this is so simple, why do so many investors do poorly? Silver interviewed former tech analyst Henry Blodget, who had this to say:

If you talk to a lot of investment managers, the practical reality is they're thinking about the next week, possibly the next month or quarter. There isn't a time horizon; it's how are you doing now, relative to your competitors. You really only have ninety days to be right, and if you're wrong within ninety days, your clients begin to fire you. You get shamed in the media, and your performance goes to hell. Fundamentals do not help you with that.

In other words, their world resembles the first chart -- the crapshoot.

Meanwhile, investors added $660 billion to stock funds between 1997 and 2000, when stocks were at record-high valuations. If they were patient enough to stick with their investments for 10 years or more, they still occupy the far right of these charts, locking in low returns.

Warren Buffett once gushed to PBS about Ben Graham's classic book The Intelligent Investor. "I really learned all I needed to know about investing from that book, and particular chapters 8 and 20," he said.

What did chapters 8 and 20 discuss? How to buy cheap stocks and how to hold them for a long time.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 


Read/Post Comments (25) | Recommend This Article (134)

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  • Report this Comment On November 13, 2012, at 5:43 PM, hskerns wrote:

    why would anyone quote Blodget?

    Henry Blodget (born 1966) is an American former equity research analyst, currently banned from the securities industry for lying in his stock analyses, who was senior Internet analyst for CIBC Oppenheimer during the dot-com bubble and the head of the global Internet research team at Merrill Lynch. Blodget is now the editor and CEO of The Business Insider, a business news and analysis site, and a host of Yahoo Daily Ticker, a finance show on Yahoo

  • Report this Comment On November 13, 2012, at 5:50 PM, moneymaster7 wrote:

    Good stuff

  • Report this Comment On November 13, 2012, at 5:57 PM, xetn wrote:

    So, how do you know stocks are "cheap" as in buy low and sell high?

    Since no one knows what a stock price will be in the future, you can never be sure you are buying cheap.

    Or, or you basing your decision on historical prices? Then you are confronted with the old warning: prior performance is no guarantee of future performance.

  • Report this Comment On November 13, 2012, at 6:25 PM, ShyOptimist wrote:

    The charts used refer to the entire S&P so the conclusions are more related to the entire market than any individual stock. Over time numbers like index PE ratios tend toward the mean so you would want to buy below the mean. Kind of a statistician’s version of buy low.

  • Report this Comment On November 13, 2012, at 6:40 PM, Seanickson wrote:

    Thanks, this is a great article. Buying stocks is a zero sum game, a fairly arrogant action. Its important to try to imagine what your advantage is over the person that thinks theyre better off selling. Having a long term outlook in a short term world could certainly be that advantage.

  • Report this Comment On November 13, 2012, at 7:39 PM, colleran wrote:

    So I buy an S&P Index Fund and hold on. Way too simple, but almost certainly correct.

  • Report this Comment On November 13, 2012, at 10:32 PM, wowiraptor wrote:

    I use 4 metrics for considering stock purchases

    1. P/E ratios less than 10

    2. B/V less than 1

    3. Div >3.5%

    4. catalysts such as this weeks pull back, or a bastard child of the market, or one that lost market favorability. Admittedly this is not as easy to determine as the first three.

    additional metrics::

    1. Mid cap or Large cap... staying away from Small Cap stocks

    2. Traded on exchanges NYSE and AMEX equities traded on these exchanges have lower tendency toward financial statement massaging and management fraud which screws over long term holders of stocks

    Stock screeners at most company's like TD ameritrade are quite common now and makes the research much easier on the first three Items

    Using the top 4 metrics I have been able to isolate between 10-40 companies in any given quarter I can narrow my focus on. Some are always in the screen and are crap.. usually I can find 1-2 in any given quarter that are nice.

    then I wait for fear to enter the market...and pull the trigger..:D woo hoo

  • Report this Comment On November 14, 2012, at 4:00 AM, SPARTANBURG wrote:

    After 20 or so years of investing and actually believing that I am a value investor, I finally understood that for someone to profit from the stock market is to purchase stocks when they are cheap vis a vis valuation. Time of course plays a major role, but when you have the guts to purchase when others are unwilling or scared seems to be the best course of option.

    I presently started doing exactly this i.e. purchasing shares at cheap prices, forgetting timing as much as possible and closing my ears at the sirenes that are around me. Hopefully, my gains from this venture will be at a level that I will prove to myself that this idea REALLY works.

  • Report this Comment On November 14, 2012, at 9:23 AM, Gideon17 wrote:

    It's ironic that you espouse the virtue of long term data in the stock market yet declare Nate Silver's work as "a triumph of math and statistics over punditry and guesswork" after only two elections, both of which were won by the same man/party.

  • Report this Comment On November 14, 2012, at 9:26 AM, TMFMorgan wrote:

    ^ 99 out of 100 is enough data to know his results are more than random.

  • Report this Comment On November 14, 2012, at 10:52 AM, jgneuw wrote:

    Very instructive charts. If one first throws out the outliers then the centroid of all the charts lies within the same zone ------ p/e around 15 and the returns somewhere around 10-15 %. And, this kind of performance is probably exactly what we look and hope for in stock picking. My point is that the short term data is about as valuable as the longer term ones. What we don't get is trend direction for the data point populations. ---- JN

  • Report this Comment On November 14, 2012, at 10:59 AM, fool3090 wrote:

    And watch fees. Don't pay too much on price and don't pay too much on commissions, annual management fees, etc. My strategy: broad-basket of diversified Vanguard ETFs on dollar-cost average in tax-protected accounts with dividends reinvested for free, then buy dividend-paying good companies on market swoons.

  • Report this Comment On November 14, 2012, at 6:08 PM, mtprx wrote:

    @TMFMorgan

    What if there was a way to influence the holding period for stocks in a really positive way. I'm in favor of a proposal that simply say's that if you buy a US company and hold it for 5 years the capital gain would be untaxed ie., 0%. No short cuts, no early breaks just a 5 year holding period. Let the short term traders pay all the taxes and fees they like but give the serious investor a better chance at decent returns.

  • Report this Comment On November 14, 2012, at 6:17 PM, TMFMorgan wrote:

    ^ Many have proposed this. I'm generally in favor.

  • Report this Comment On November 16, 2012, at 12:39 PM, BxBruce007 wrote:

    "^ Many have proposed this. I'm generally in favor. "

    Would someone please get that message to the guys in Washington?

  • Report this Comment On November 16, 2012, at 1:16 PM, hearshoping wrote:

    Interesting Editor's picks. This article illustrates Graham's buy (a good company) low and hold. Another pick suggest buying Apple high (after it's 10 yr. run-up). All bases covered.

  • Report this Comment On November 16, 2012, at 1:41 PM, wolfmansbrother wrote:

    Great article, Morgan. The only piece of advice I would add, having learned it the hard way, is to also keep an eye on financial performance via ROE, and/or analysis of the statement of cash flow.

    When I started investing, I just bought the cheapest stocks I could find using ratios like P/E and P/B. I ended up investing in some "value traps" that were cheap when I bought them, but got a lot cheaper. Nowadays, in addition to cheapness, I'm also screening for companies that are generating a decent return on equity.

    This has the effect of weeding out companies that are burning through cash and/or generating actual losses, while still returning a set that are undervalued with respect to their competitors and the market in general.

  • Report this Comment On November 16, 2012, at 3:02 PM, WineHouse wrote:

    All of this is predicated on the assumption that all financial benefit from stock ownership is due to capital gains (profit due to share price appreciation).

    I have learned the hard way (i.e., through experience) that there is a less risky way. Combine the notion of stock price appreciation with the notion of dividend growth, and voila! you have income! Income that grows in dollars per share as the company grows (regardless of the market price which varies according to the mentality of the herd). Over time, while the "current yield" per share may not vary much (because over time share prices of growing companies usually go up by roughly the same proportion as the dividend dollars paid out), the yield based on original share price grows and grows and grows. The growth in payout generally exeeds the rate of inflation. Hold those shares long enough (say 20 or 25 years), and you've got annual dividend payouts that approach the original share price. AND whatever that "paper capital gain" might be, it's still there as gravy.

  • Report this Comment On November 16, 2012, at 8:13 PM, Telsaar wrote:

    With the above charts as a premisis. You could make the calculation on screened companies (both positive and negative screens) i.e. company fundamental parameters. and see if there are any parameters that separate the men from the boys sorta speak. Simple test like better than average or below average on specific parameters (profit growth rate) to see if an improved correlation pops up.

    High P/E shows too much confidence in a stock. Once the interest is lost to the next hot thing. I'm sure the P/E growth stagnates. In older NAIC litature they used High P/E to deterime the stock was overvalued an to decide when to sell.

    I don't consider P/E a fundamental criterion. Since it may or may not have anything to do with the companies business practices and growth rates. (It should though). P/E just represents public demand for the stock.

  • Report this Comment On November 17, 2012, at 2:23 PM, Mathman6577 wrote:

    One way to look at "value": Compare the company (and industry or market) average P/E ratio vs. the rate of earnings growth over a 5 year or even longer period.

    For example:

    Apple has a 5-year average P/E of 16.7 vs the industry average of 17.5. It's EPS growth over the same period was 62%. I'd say it has value.

    Amazon average's over the past 5 years is a P/E of 238 (industry is 163) and EPS growth of 24%. Maybe not as cheap?

  • Report this Comment On November 19, 2012, at 1:03 PM, Darwood11 wrote:

    Good article. The charts are both a wonderful visual aid and a support for making gradual changes with specific criteria as the basis.

    I also use the old maxim that if I can't understand the business, then it isn't a buy, and it is definitely time to sell. So I look at the products, the so called "model" promoted by management and compare that to the valuations. Then I look at the competition and the industry trends.

    Here's a confession. I have great difficulty selling but when I look at the other aspects of the company, when I lose faith in the vision and direction of the company, that will usually push me to hit the "sell" button. It's worked well so far. By that, I mean that I've avoided a lot of pain. i realized on reading this that I have become a much better investor since my first Fool subscription in 2006. BTW, I've subscribed to newsletters, and studied for about 30 years, but it is difficult to separate the wheat from the chaff. Best thing I ever did was to turn off the TV and use it strictly for entertainment purposes via Netflix.

    I will admit that valuation, P/E ratio is a component in my "sell" analysis. For example, this approach saved my butt with NFLX. (I'm still an investor, but sold most before the meltdown and I do love the product).

    I've learned that the worst case in pulling the "sell" trigger prematurely is I'll miss some upside. But I've also learned there are a lot of "buy" opportunities out there and if I really make a mistake, I can always jump back in and buy back that company. To date, that has not happened.

  • Report this Comment On November 19, 2012, at 2:17 PM, SaraW946 wrote:

    I don't understand one thing: how Nate Silver's prediction of the election results is connected to his predictions of the market. I predicted the outcome of the elections in ALL 50 states without doing any statistics, just on the basis of pure political science and my expertise in political psychology and voter behavior. I am by absolutely no means in any position to predict the market and will never claim so. The two are two different things.

    I'm actually not the only one who predicted the election results, so no, I'm not bragging. There were definitely more people who did so and I hear the same holds true for the US presidential election and betting odds in the UK which, if I remember correctly, were 2.5 to 1 in favor of Obama, and I believe they also predicted correctly all 50 states. These are people who don't even live in the US.

  • Report this Comment On November 19, 2012, at 2:24 PM, TMFMorgan wrote:

    ^ I don't think Nate Silver has made any market predictions, as far as I know.

  • Report this Comment On November 19, 2012, at 3:22 PM, SaraW946 wrote:

    Yes, sorry, you are right, and I wasn't clear. I meant the way to invest successfully, but that entails predicting the market to a degree, doesn't it? :)

  • Report this Comment On November 21, 2012, at 8:15 AM, DevilzAdvoqate10 wrote:

    Fallasy of Komposition:- Re WineHouse's point, I agree it's kommon sense to not seek only Kapital Yield or only Dividend Yield but to seek the kombined, i.e. Redemption Yield, the same arithmetik as for bonds. This has nothing to do with maturity - you redeem a bond or share whenever someone buys it from you. And it's patently obvious from the fakt some bonds & shares yield only growth (or loss), some only inkome & some both.

    Low P/E is your klue to possible Growth Yield, while present Div Yield is easily gleaned from newspapers & websites. But both these data are merely historik benchmarks. While the prise may reflekt bad news on balanse-sheet, like a too big overdraft, off-radar windfalls like monster dividends may be not faktored in.

    Mega-Div:- Which is why I invest in firms like Viktoria's Sekret/Senza (LTD:NY), Mega'Bus (SGC:London) etc, they seem to do ad-hok dividends. Sometimes this is treated as rekapitalisation, & @ the latest such share-out by Stajekoach, English shareholders were given the choise to deem the payment either inkome or kapital, depending on our tax status: I suspekt Amerikan shareholders may've not benefited from that option though.

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