Profit From Playing the Odds

"The stock market rises 10.5% in value per year."

Among the many truisms in investing, there's perhaps none more universally accepted than this one. Ask any stock market investor, and he'll nod his head in agreement almost automatically. "Yep, 10.5% -- that sounds just about right."

Oh, sure, you'll get quibbling from some corners. Dividend lovers are quick to point out that capital gains account for just 6% or 7% of those historical stock market gains and that dividends make up the rest. Economists will pull reams of data from their briefcases to support their arguments that the actual performance is 10%, or 11.2%, or whatever other number they used in their doctoral theses. But by and large, most people agree that 10.5% is "close enough for government work," as the saying goes.

Double your money, double the fun
But what does it actually mean to say that the market rises 10.5% per year? Let's take an example. Put $100 in an S&P 500 index fund and increase it by 10.5% every year for seven years:

Which shows the source of another truism: Put your money in the market, and it will double in seven years.

Factoids versus facts
Of course, if you've invested in the market for any length of time, you probably know how very misleading these numbers can be. I can't recall a single year in which my portfolio increased precisely 10.5%.

The fact of the matter is that, on average, the market doesn't rise in value in such a "beautiful line." Touch a stock chart ,and you'll come away with a bloody finger -- the things are awfully jagged. Lots of sharp ups. Lots of sharp downs (those are the ones that really cut).

But more ups than downs, right?
Precisely. That's the point I'm getting to. Historically, the market doesn't rise 10.5% per year, every year. It does rise by roughly that amount over long periods of time, but those rises come in fits and starts. On average, investors will see two "good" years for every one "bad" year.

One day, while idly punching away at my calculator, I got to wondering: If the market doesn't go up 10.5% per year, every year, then perhaps there's a more realistic way to depict its movements -- something along the lines of "two steps forward, one step back." Starting with the truism that the market has two good years for every one bad year, here's what I came up with:

Scenario 1: The beautiful line

Scenario 2: The real world

Mind you, I'm not angling for any Nobel Prizes in Economics with this -- just looking to build a slightly better mousetrap. But in this Fool's experience, Scenario 2 looks a lot more realistic than Scenario 1. The market has up years (in which it rises 20% on average) and down years (in which it falls 6.3% on average).

For the record, you can get similar results by pegging the average at 17% for up years and -1.4% for downers; or 25% and -13.7%, respectively. But the point appears clear under any of these scenarios: Assuming the stock market adheres to its historical trend, any "bad" year must be counterbalanced by two "good" years -- and not just any old good years, but years significantly better than the market's bad ones.

You can do better
If investing is a game of chance, it seems the odds are stacked against the house -- and in your favor. You win twice as often as you lose, and your winners tend to outperform your losers by significant margins. Can't beat that with a stick.

But beat it you can.

Consider, for example, the market's performance from Jan. 2, 1998, through Dec. 29, 2000 -- not cherry-picking here, those are just the days the market was open. It was an atypical three-year period in some respects, but a very typical period in one: The market performed almost precisely as well as historical trends would predict. It was up 34.7% from start to finish, closely approximating the 34.9% rise you'd expect to receive from a market that rose 10.5% per annum, year in and year out.

Yet some stocks did better than others. Some stocks utterly trounced the market's puny 34.7% gain. Take a look at a few of them -- I think you'll recognize the names.

What do these companies have in common? No, they're not all "techs." What's more, no, they're not all "Bubble" stocks, or at least not in the ordinary sense of the word. For while these companies certainly benefited from the market's fit of millennial temporary insanity, each trades higher today than it did at the Bubble's peak. (Which is more than you can say for the S&P 500 itself.)

What these companies truly have in common is this: they're great businesses. They're businesses with defensible "moats" that protect them from competitors. They're determined to grow their profits and benefit their shareholders. The Bubble may explain part of their performance from 1998 to 2000, but the reason they're still succeeding today is because they are great companies.

No time like the present
So to summarize:

1. Investing in stocks generates average returns of 10.5% per year over long periods of time.
2. In general, every weak (or "down") year is counterbalanced by two years of stellar returns for the market at large.
3. Superior businesses outperform even the outsized gains that the market achieves during those "up" years.

So far, 2005 has been a pretty disappointing year for most investors, with the market rising only 4.9%. Last year wasn't much better -- the market rose just 9% in 2004. As we approach 2006, investors are naturally wondering whether it will be a good or a bad one for stocks. We never know for certain, but with two weak years at our back, the odds favor 2006 being good to us.

If you're ready to take advantage of the odds, ready to profit from the next bull market, there's no time like the present to begin investing. And I mean that literally: This Friday at noon, we released the first edition of Motley Fool Stock Advisor for 2006, containing our top two recommendations for the new year. We're happy to let you see what we've picked, and we won't charge a dime for the privilege, but there is one catch -- you must sign up for a free trial of the service.

Fool contributor Rich Smith has no position in any of the companies mentioned in this article. If he did, The Motley Fool would require him to tell you so . We're sticklers about things like that. Oh, and on that note: Amazon.com is a past Motley Fool Stock Advisor pick.