The purpose of any financial investment is to grow your money, pure and simple. But there is a bit more to what “making money” really means. Suppose you invested $10,000 ten years ago and today that investment is worth $12,000. That sounds like a good thing. But what if all the stuff you could buy for $10,000 back then now costs $14,000? No longer sounds like a good thing. Inflation is the hot sun that keeps melting away the ice-cream of your investments.
How do we know how much inflation there is? The Federal Government, helpful as always, has been publishing the inflation rate since 1947 through the Bureau of Labor Statistics (BLS). The number they provide is known as the Consumer Price Index (CPI). How they get to this figure is rather involved : they first make an educated guess as to what the average American family consumes and then measure how the price of this stuff is changing every month. If you want to know what the Government thinks your household budget looks like, take a peek at the graphic below:
The big one is housing of course, taking a 43% bite out of the family budget.
There is quite a bit of controversy about these methods. The BLS is often accused of over-estimating or under-estimating inflation by various political quarters. Obviously, one size doesn’t fit all. For example, if you are a billionaire, then you are not going to be spending 15% on food – how much can you eat after all? And if you live in New York City, probably your rent is too large to fit into that 43% box. These issues aside, I think the CPI is still a useful yardstick.
Basically, what you want to do is invest in things that are likely to beat inflation. If you look at the history of the US stock market, the results are quite impressive. In the post-war years from 1950 onwards US stocks have achieved a handsome return of about 10% per year, while inflation has only been about 4% per year. That’s a nice 6% annual return above inflation! Some researchers have also calculated stock returns over the last 200 years and they confirm a 6% or so return above inflation. By the way, these returns excess of inflation are known as real returns.
The catch is that even if history repeats itself, you can only expect this sort of performance over very long periods of time. Unfortunately, in the shorter term all sorts of bad things can happen. Take a look at the chart below which shows returns by the decade:
In two decades out of six, the stock market failed to beat inflation. Though I think the odds are actually better than that, it does seem that 10 years is not nearly long enough for a stock market buy-and-hold strategy to be considered “safe”.
It is striking how lopsided the returns are – if you have a good decade, you’d probably end up beating inflation by a very wide margin. If not, you will watch your purchasing power melt away. For example, the first decade of the new millenium (2000-2009) was quite awful with stocks losing out to inflation at the rate of 3.5% per year. That implies a decline in purchasing power of nearly 40% over the whole period! Personally I think a reasonable holding period for a stock market investor should be at least 15-20 years.
I want to warn you here about a behavioral instinct common to all human beings. I don’t know if you have ever seen a deer in the wild, but if you have, you will know that they are hyper-sensitive to any sort of danger. They run first and ask questions later. This is due to a brain feature known as the amygdala, which is common to all mammals including humans. The amygdala is quick to react to perceived dangers with responses ranging from aggression to anxiety and an overwhelming urge to flee. It is what keeps deer wary of every sound lest they become a predator’s lunch.
The brain and its amygdala have evolved over hundreds of millions of years while stock markets have barely been around for a couple of centuries. So, when the market crashes, the amygdala creates a strong urge to sell. Basically, your brain does not want to become the stock market’s “lunch”. This is not mere guesswork, researchers at Caltech have shown that individuals with properly functioning amygdalas are much less likely to take financial risks than those whose amygala is damaged.
Here’s the thing : if you are investing for the long haul, say 15-20 years, the chances are very high that at least once during that time you will go through a severe stock market crisis. And when that happens, you will really, really want to sell regardless of all the wisdom you might have read. It is biology, your very DNA!
It is very difficult to hold on through a severe stock crisis like 2008. This doesn’t just happen to the common person – I have seen professionals with decades of experience struggle to control this instinct though they still do better than the common person. Rest assured that holding on to your stocks through a real crisis will be among the hardest things you will have to do.
Take a look at this chart from Gallup:
The 2008 stock market crisis lasted until about February 2009. As you can see, ownership of stocks went down from 65% to 57% i.e. probably around 8% of households sold every single stock they owned. The problem was worse than that. Other data indicates that even those families that did not sell everything still ended up selling a big piece of their stock portfolio right at the bottom. Not only that, the ownership of stocks kept falling all the way until 2013 – people were so spooked by what happened in 2008 that they dared not get back into the stock market. But from 2009 to 2013, when people were frightened of stocks, the S&P 500 actually rose by 85%. It recovered all its losses and then some!
This kind of event where people sell at the bottom and sit out the recovery is very common. Not only do you have to guard against it, you have to think about how much risk is right for you. It may well be that a 100% stock portfolio is not for you even though in theory you “plan” to hold on for the next 20 years. You have to reckon with your amygdala. Think about situations in your life where you or a loved one were in some sort of danger and how you reacted. If you were cold as steel, then maybe you are OK with a 100% stock portfolio. If not, think again.
You need to be in a portfolio that you are capable of holding on to in the event of a market crisis.
It is useful for investors to realize that everyone is not Warren Buffet. Most people need to go beyond a buy and hold strategy and diversify their portfolio with less risky assets such as bonds. I will talk in another post why bonds are less risky and how they can help your portfolio in a stock crisis. But for now, have an honest chat with your amygdala.