There are extremely three powerful statistics in investing. In fact, I believe they are the three most important pieces of information any investor can understand. They are incredibly simple, yet have far-reaching impacts.
- Most active investors fail to beat the market
- The S&P 500 has an inflation-adjusted historical return of 8.5% on average
- The market is extremely volatile
These statistics are far from secret, yet also curiously overlooked by a lot of media and investors alike. Human emotions are a powerful thing, I guess.
Active management underperforms index funds
Firstly, the statement that most active returns fail to beat the market is objectively true, as simple as that. For the avoidance of doubt, I am using the S&P 500 as a proxy for the “market”, so the 8.5% average is the benchmark to beat. Beating the market is hard.
Numerous studies have been done on this, and pretty much every single one has active investors failing to match the market over the long term. This is through a combination of fees: transaction fees, management fees, research fees, admin, analyst salaries etc – the list goes on, all eating into investor returns.
If you want to look into the evidence behind this more, this study shows that 87% of US managers underperformed the benchmark between 2005 and 2020. Perhaps more illustrative is this study from S&P Global, which paints a nice picture of the comparison year-by-year. No matter what the final number is, pretty much every study has backed up passive management.
The S&P 500 trends upward in the long-term
Let’s take a quick jaunt down memory lane:
- 1973 oil crisis and inflation spiral.
- Latin American debt crisis, 1980’s,
- 1990’s Scandanavian banking crisis.
- Dot-com bubble, early 00’s.
- 2008 financial crash.
- COVID-19 pandemic, 2020
That’s just a nice little selection of some crises that we have faced in recent history. And through it all, the stock market has still averaged 8.5%.
Granted, it feels like the world is falling in on us at the moment. It’s both depressing and surreal that we are in 2022 and there is a war in Europe. Inflation is spiralling to levels not seen since the 70s. The Federal Reserve is flailing around trying to rein it all in. International debt is at record levels. The long-term health of the entire economy feels as precarious as ever before.
And yet, take a look at the below chart.
The weight of history is on the side of the stock market.
If you have followed my work recently you will know that I am quite bearish about the economy. In fact, I am outright scared going forward. But is my gut feeling enough to overcome the power of the historical returns shown by the two headline statistics in this article? Who am I to think that I am so smart that I can beat the market, in the face of all this evidence?
My piece a couple of weeks ago outlined this well – I am as pessimistic as almost anyone about the future, yet I purchased my largest chunk of stocks of the year.
Time horizon and risk tolerance are important
Of course, the caveat here is that this is all anchored to whatever your time horizon as an investor is, as well as your risk tolerance.
Personally, I am young without children or a mortgage. My only large purchase in the near to medium term future is likely to be a bulk purchase of rice in Sainsbury’s (it’s so much cheaper to buy the big bags, and it saves many a supermarket trip).
But the short-term volatility of the stock market is a dangerous beast. In essence, that is why investors get paid 8.5% per year – to bear this volatility. If your portfolio goals and risk tolerance don’t allow you to bear this volatility, knowing that your investment could be 50% lower in a few months’ time, then it’s not the investment for you.
Again, a super simple chart below shows how up-and-down the market can be. Just look at 2008 (-37% return) to see how quickly things can change. Even nine months into the year, the market is already off 19% as I type this.
Should I buy stocks?
In the face of all this evidence, the argument to buy stocks– at least, an index fund – following the violent dip in markets is strong, if your time horizon is long.
The market goes up – that is inevitable. It’s just a matter of when, and how much pain you must bear in the short term. For me, my feelings on the impending doom of the economy are true, but history is too heavy – and my time horizon too long – for me not to be interested after this pullback. I’ll just have to grit my teeth and forget about prices for the foreseeable, and pray my hunch is wrong about the economy.