Thursday, August 30, 2007

View on long term investing

The major reason why investors lose money is: 1) they view stock market as some sort of magic expecting a dollar invested today to be worth two tomorrow (too short an horizon); 2) by paying the wrong price; 3) at times by paying the wrong price, there’s still a chance for recovery if the business economics will improve with time but then investors do not have the patience and sell themselves out early.

Investors of such practice simply are watching and following the wrong indicator of performance that tells the truth – they are just watching the price ticker. As if in watching a basketball game, the action is on the game floor, not on the scoreboard. It is what the players that are doing on the court that influence what will be shown on the scoreboard.

And then as if one is able to outscore every other player on the board, one tries to outmaneuver the other by trying to catch both the top and the bottom by pressing and squeezing harder than the one next door. These players are just influenced by trying to predict when the next storm is going to come. As a storm approaches, they try to run for cover totally but then a storm does not unroot all tress. Trees which are well deeply rooted are never in the long run destroyed by any storms. Thus, let us look a little in the history of stock which may give a little insight into what may happen in the future and thus improve the chances of investing success.

Firstly, investing is an act of faith. By investing a dollar today, we are entrusting to the steward in a corporation in the faith or at least with the hope that their endeavors will generate a rate of return that more than commensurate our investments. In this commitment of faith, we are committing our investment in the long term success of the corporation or economy at large and that the world’s financial markets will continue to march forward.

Any attempt to try to time, rather than price the market is an act of speculation. This action of timing is more to do with human psychology rather than wisdom. Market participants’ faith in investing has waxed and waned, kindled by bull markets and chilled by bear markets that happened from time to time, but over time the market has always remained intact. The market has survived the Great Depression, two world wars, the rise and fall of communism, two oil shocks, the assassination of a U.S. president, time of high inflation, shocks in commodity prices, among many others. In recent years (since 1982 though), our faith has been enhanced by the bull market in stocks and has accelerated, without much ado – perhaps only in early 2000s – until now.

In the event of both bull, many just can only see all things which are rosy and unfortunately, the reverse applies in the bear market as well where many just cannot see anything rosy except doomsday. Excessive behaviors always lead an investor to either bringing himself to be in a very risky position where he might make a lot but the price to be paid for the risk to be undertaken simply does not commensurate the price with the risk. On the other hand, in a frenzy market downturn, an investor may simply just head for any exit as long as he sees one where again, he will not consider the price he is selling commensurate with the value that he is foregoing.

Might some unforeseeable or unpredictable shock trigger another depression so severe that it would destroy our faith in the promise of investing? Possibility is always there. Excessive confidence in a smooth and rising sea can only blind us to the risk of storms. History is littered with episodes in which the enthusiasm of investors has driven equity prices to and beyond the point at which they are swept into the vortex of speculation, ultimately leading to unexpected losses. There is definitely little certainty in investing, at least for the short run. As long term investors, however, we must be aware of the past and cannot afford to let the ruinous possibilities frighten us away from the markets. For without risk, there is no return.

Here is a story about Chance. Chance is someone who knows about risk in all seasons because he is a gardener. His story contains an inspirational message to long term investors. The seasons of his garden are akin to the cycles of the economy and the financial markets. We can emulate his faith that their patterns of the past is an indication that may define their course in the future.

Chance is a gardener who works for a rich man in his mansion. He lives in a solitary world bereft of contact with the outside world. One day, the rich man dies, Chance wanders out on his first foray into the world. He is hit by the limousine of a powerful advisor to the president. When he is rushed to the advisor’s estate for medical care, he identifies himself only as “Chance the gardener.” In the confusion, his name is wrongly interpreted as “Chauncey Gardiner.”

When the President visits the advisor, the recuperating Chance sits in on the meeting. The economy is slumping; blue chip corporations are under duress and the stock market is collapsing. Unexpectedly, Chance is asked for his advice:

“In a garden,” he said, “growth has its season. There are spring and summer, but there are also fall and winter. And then spring and summer again. As long as the roots are not severed, all is well and all will be well.”

The president seems quietly pleased and delighted with the insightful thoughts of Chance. The president said: “I must admit, Mr. Gardiner, that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time. Many of us forget that nature and society as one. Like nature, our economic system remains, in the long run, stable and rational and that’s why we must not fear to be at its mercy. We welcome the inevitable seasons of nature, yet we are upset by the seasons of our economy. How foolish of us.”

This story may be fictional. But like Chance, I see the history of our economy to be similar. The economy has passed the test of any past disasters and remains as healthy and stable in the long run. No doubt, it is marked by seasons of growth, sluggishness and decline but its roots have remained intact and strong. Despite changing seasons, our economy has persisted in an upward course, rebounding from the blackest of calamities.

Just for some historical figures. The average annual nominal return for three different time periods are: 1) 1802 to 1870 is 7.1%; 2) 1871 to 1925 is 7.2%; 3) 1926 to 1977 is 10.6%. After accounting for inflation, the net real return is 7%, 6.6% and 7.2% for the same periods respectively.

For an eye opener, an initial $10,000 investment in stocks from 1802 on, with all dividends reinvested will result in a terminal value of $5.6 billion in real dollars. Yet more staggering result if the same $10,000 is invested in bonds rather than stocks, it will result in $8 million. Well, that is not the worst, the worst is to invest in lands or properties.

Well, of course, none of us can expect to live near to two centuries, much less one. But having 50 years of investing time period is certainly within the reach of most people and 50 years is certainly a long time period where many different seasons will come and then go and come again. And with the story of Chance, having a strategy like his will certainly be great for most investors, at least for those who don’t know what they are doing.


fishman said...

In my opinion, the conscious efforst to seek out securities of companies that are stronf fundamentally is a sign of wisdom!

Refreshing post!


What about not long term investing but not short term investing in between the two as it were seems about right.