Market Myths Exposed

Wall Street has told another ½ truth.

It is common knowledge that the stock market averages around an 8% annual return over time. Well, that may be true but the institutions and media reinforcing this ½ truth may have a different definition of “over time” than your definition.

From 1870 through today the stock market has averaged close to an 8% return but as we can see from this chart, there are extended periods of up markets and extended periods of down markets.

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The S&P 500 is a market capitalization – weighted index of 500 widely held stocks often used as a proxy for the broader stock market, and includes the common stocks of industrial, financial, utility, and transportation companies.  Standard & Poors chooses the member companies for the S&P 500 based on market size, liquidity, and industry group representation.

From 1982 through 2000 the stock market went up over 600%. For that 18 year period investors annualized a 15.3% return. That is fantastic!

But then from the year 2000 to 2009, a period of 8.5 years, 59% of those gains were wiped out. Investors lost 8% annualized over those 8.5 years.

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The S&P 500 is a market capitalization – weighted index of 500 widely held stocks often used as a proxy for the broader stock market, and includes the common stocks of industrial, financial, utility, and transportation companies. Standard & Poors chooses the member companies for the S&P 500 based on market size, liquidity, and industry group representation.

There are extended periods of time when an investor may average gains of 10%, 13%, 15% and higher but then there are extended periods of time when investors lose 2%, 3%, 8% and more annualized over long stretches of time.

Investors retiring in the late 1990s were feeling comfortable only for many of them to loose close to 50% in the following bear market. This shows the randomness of investing in the stock market. Success and failure was determined by the time period and sequence of returns of the overall stock market.

The number one fear of Americans is not dying. It is living too long and running out of money during retirement. So how do you know how much you need to have saved and invested over time to ensure a safe and comfortable retirement?

Let’s look at an example of two investors who both saved 10% of their income and invested it as was recommended by the institutions. They each invested 60% in Equities and 40% in Bonds over a 30 year period. That means they both began to invest 10% of their salary beginning at age 35 and retired at age 65. Both of these investors were disciplined, surely sacrificed at times and were responsible.

They did what was recommended by the experts.

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The S&P 500 is a market capitalization – weighted index of 500 widely held stocks often used as a proxy for the broader stock market, and includes the common stocks of industrial, financial, utility, and transportation companies. Standard & Poors chooses the member companies for the S&P 500 based on market size, liquidity, and industry group representation.

Both of these investors did the same thing. The only difference is the year they were born and the period of time they invested.

The above illustration shows two hypothetical investors who lived and worked at different times in U.S. history. These two individuals each earned a constant real salary over 30 years, and each contributed 10 percent of their salary at the end of each year to an annually rebalanced 60/40 allocated portfolio. They invested 60% in equities and 40% in bonds.
One individual retired in 1921 and the other in 2000. The above illustration recreates the paths of their wealth accumulations over their respective 30 years of work. The 1921 and 2000 retirees are chosen for having accumulated the least and the most wealth of anyone in US history after a 30 year work period utilizing this scenario.

Both saved the same percentage of their income and they had roughly similar amounts saved until about 5 years prior to retirement. Neither could have been aware of their future record breaking status even 5 years before their respective retirement. It was in the last 5 years prior to retirement that events either went very well or very poorly for these individuals.

The last 5 years matter so much because it is only after working and saving for a long period of time will there be a large sized portfolio. With a large sized portfolio, much can be lost or gained quickly, depending purel on the direction of the stock market those last 5 years.

In Blue, the markets did not fare well prior to retirement and the gentleman retiring in 1921 ended up with less than 4x his salary beginning in retirement.

The gentleman retiring in 2000 was able to take advantage of the bull market in the late 1990s and he benefited greatly because he had been investing for 25 years prior. He ended up with over 10X his salary to begin retirement.
Both did the same thing, both sacrificed to invest in a disciplined manner as they had been told yet they came out with vastly different outcomes.

This shows the randomness of investing in the stock market. Success and failure was determined by the time period and sequence of returns of the stock market during their working years.

According to financial planning theory a person should have a combination of risky assets and safe investments in their portfolio. Over the last hundred years or so this has meant to have a certain percentage of your assets in stocks and mutual funds and a certain percentage in bonds. It theorizes that over the long haul equities will outperform bonds and bonds will dampen the downside volatility of the stock market. It is very common to use a 60/40 Equity/ Bond split.

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The S&P 500 is a market capitalization – weighted index of 500 widely held stocks often used as a proxy for the broader stock market, and includes the common stocks of industrial, financial, utility, and transportation companies. Standard & Poors chooses the member companies for the S&P 500 based on market size, liquidity, and industry group representation.

This chart shows a 5 year annualized rate of return going back to 1870. This clearly demonstrates that the traditional recommended allocation historically has very wild swings in both positive and negative directions. Although these wild and unpredictable swings have occurred historically, this is considered to be a conservative portfolio by the institutions recommending them.

An allocation of 60% of investments in equities also called stocks and mutual funds and a 40% in bonds invested in the mid-1990s would have annualized a return between 10 and 15%.

An Investment in 2000 would have given negative annualized returns.

This shows the randomness of returns based more on the time frame invested. The sequence of stock market returns actually determined the outcome simply from the period of years of investment. Utilizing what is recognized as the traditionally conservative allocation model can still result in many 5 year periods of low to negative returns.

You know the future of the stock market and can say it with certainty!
The stock market will continue to go up and the stock market will continue to go down. There will continuously be periods of over performance and periods of underperformance.

One way to judge the underperformance or over performance of the market is to look at how far above or below the S&P 500 is from its historical trend. This is known as Regression to Trend.

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The S&P 500 is a market capitalization – weighted index of 500 widely held stocks often used as a proxy for the broader stock market, and includes the common stocks of industrial, financial, utility, and transportation companies. Standard & Poors chooses the member companies for the S&P 500 based on market size, liquidity, and industry group representation.

The red line is the trend of the market and we can see that it has trended up since 1870. We can also see how far above or below the Regression to Trend the market was at critical times.

For instance, in 1901 the S&P was 86% above the trend. That was followed by a horrible bear market that ended up 59% below trend.

In 1929, the market was 80% above trend followed by the horrible bear markets that did not end until the S&P 500 was 67% below trend. This was known as The Great Depression.

We can see historically that every time the market has been extended it has fallen 50% below trend. We are currently approximately 70% above trend after being 92% above trend just months ago. We know the market will go up and the market will go down. We also know that every major high has been followed by major bear markets. It is simply the way cycles work.

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The S&P 500 is a market capitalization – weighted index of 500 widely held stocks often used as a proxy for the broader stock market, and includes the common stocks of industrial, financial, utility, and transportation companies. Standard & Poors chooses the member companies for the S&P 500 based on market size, liquidity, and industry group representation.

In 2000 the market was an astounding 143% above trend, nearly double 1929 levels. The S&P 500 has been above trend for two decades with the exception of the low in March of 2009. But we have been between 70% and 90% above trend since late 2014.

The major troughs of the past saw declines in excess of 50% below trend.

Just falling to trend would put the S&P 500 around 1100. We are currently around 2000. That would be close to a 45% drop in the S&P 500 and that is just getting back to Regression to Trend.

What would happen with another 50% fall from the Regression to Trend as we saw in the 1920s, 1930s and 1980s after previous overextended Bull Markets? That would cut the 1100 number on the S&P 500 in half.