The Best Year in History to Invest

The year 1948 was the best time to invest in modern history. If you had invested some cash once a year since 1871 and held it for 10 years, 1948 would have been the single best starting point, delivering a 10-year annualized real return of 18.1%.

This insight came from an analysis provided by Mebane Faber on the website World Beta. He measured the results if you invested just once per year in the market since 1871, and then held each investment for 10 years. He also calculated the cyclically adjusted price-to-earnings (CAPE) ratio -- a measure of the market's current price against average earnings over the past 10 years -- for each of the years as well, and found that the average CAPE for the 10 best years was 10.92 compared with 23.31 for the 10 worst years. At first glance, it might make sense to invest in years with relatively low market valuations.

Here's a look at the three best years from the study:

Complete table is at http://www.mebanefaber.com/2012/07/23/the-10-best-and-worst-times-in-history-to-invest/.

And here are the three worst years:

Complete table is at http://www.mebanefaber.com/2012/07/23/the-10-best-and-worst-times-in-history-to-invest/.

This is fascinating data for long-term investors to consider, and I think there are at least three meaningful takeaways:

1. Based on current events, picking the best years isn't intuitive. It's unlikely that anyone living in 1948 would have envisioned the next decade as a great time to invest. The world had just fought one of the most destructive wars of all time, and the two emerging superpowers viewed each other suspiciously. Europe was in such a state of devastation that it required massive economic assistance via the Marshall Plan that was begun that year.
   
   Domestically, there were many who feared a return of economic stagnation after the war. Who would have guessed that General Motors (NYSE: GM), General Electric (NYSE: GE), and other great American businesses would have been able to successfully pivot from wartime production to benefit from an expanding and increasingly prosperous domestic economy in the decade after 1948?
   
   Similarly, who would have envisioned that the decade after 1998 would have delivered such relatively paltry returns? In 1998 alone, the Nasdaq rose approximately 39%, driven by the performance of Yahoo! (Nasdaq: YHOO), Amazon.com (Nasdaq: AMZN), and Netscape. Indeed, that year, Nasdaq had its third best performance since it was begun in 1971. Both the Dow and the S&P 500 delivered solid returns that year as well. Perhaps one helpful thing about studying history is that it makes you more humble about predicting the future. Choosing the best year to invest based on current events seems like an impossible task.
   
2. Variability in returns is considerable: The annualized return for 1948 is almost 23 percentage points higher than the return for 1910, which would result in a gigantic difference in total returns for the average portfolio. This is something that Vanguard founder John Bogle also found when he looked at investing returns from one decade to the next.
   
   The lesson here is clear, I think. Investors should always be putting money to work year in and year out, in order to smooth out the returns over time. Investing all of it in the market at one point in time seems like a very risky proposition. History suggests that we're unlikely to predict the future accurately, and that any given year may be considerably above or below the average historical total return. Given all that, it's definitely wise to gradually put your money to work in equity markets.
   
3. Years with lower cyclically adjusted P/Es appear more attractive: The data from Faber's study seems to indicate that the years with relatively lower valuations tend to perform better over time. This hypothesis probably makes perfect sense to value investors.
   
   It's funny, but points 1 and 2 appear to contradict point 3. A look at history shows that individuals shouldn't attempt to time the market based on current events or analyst forecasts, though the valuation data suggests that a strategy based on investing in years with relatively low market valuations might possibly result in outperformance.
   
   I have two responses to this dilemma. First, I still believe that putting your money to work gradually over time will smooth out your returns, and is preferable to moving your cash in and out of the market. Waiting to invest in a market that appears "cheap" still seems like a somewhat risky gamble, especially since there is considerable disagreement among experts on which valuation metric one should use to measure the "price" of the market. For the record, the CAPE for 2012 is currently 22.25. So today's market would appear relatively expensive by historical standards.
   
   Second, I don't think investors should focus solely on investing in the "market." Yes, passive index funds are ideal for the vast majority of portfolios. But I also believe that everyone would benefit from investing in great businesses that can grow considerably over long periods of time. Apple (Nasdaq: AAPL) is a great example of what such a strategy can deliver. During the decade after 1998, a year that delivered the third worst 10-year returns on record, Apple grew eightfold. Investing a small portion of your portfolio in that one stock would have surely taken off some of the sting of the substandard market return over that time. Of course, choosing which stocks will outperform isn't easy. Another wonderful business, Amazon.com, actually lost money for investors in the 10 years after 1998.

When in doubt, ask Buffett
Writing to his shareholders, Warren Buffett weighed in on this dilemma back in 1962, according to a fine article by Jonathan Burton for Marketwatch:

"I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few when it is minus on the same order, and a majority when it is in between," Buffett wrote. "I haven't any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor."

Buffett wisely indicates that he can't predict the future and that he won't bother trying. I think his view supports the idea of putting money to work gradually and consistently over the years. And, of course, we know he did quite well by investing in individual stocks. Most portfolios would be improved by including a few of those in addition to index funds.

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