But I have often asked myself: "Why should this be good advice?"
Stock indexes have always been an indicator of the broad market movements that affects all stocks simultaneously. Mutual fund managers traditionally compare their performance against that of a stock index. Hence the term "beating the market". Around forty years ago, some very intelligent people thought it will be easier to start a fund that mimics the performance of stock indexes instead of trying to beat it.
And this was how index funds came about.
However, the whole deal about "investing in the market" hinges on the crucial assumption that the stock market tend to go up over time. How can I be sure that this remains true in the future? I thought it would be wise to look at the data.
AN APPLE INC. A DAY
The S&P500 is one of the most popular stock index in the financial arena. Consisting of 500 stocks of mostly US companies, it serves as an indicator of how the world's largest economy is doing.
Performance of the S&P500 from 1980 to 2000:
(Click image for a clearer view. source: yahoo finance)
It is not hard to see why investing in stock indexes is so compelling. In the 20 years between 1980 to 2000, the US stock market has experienced impressive growth.
THROUGH THE LOOKING GLASS
The performance of the S&P500 during the years 1998-2007, however, paints a difference picture:
(Click image for a clearer view. source: yahoo finance)
If this chart consists of the lifetime performance of the stock index, i don't suppose many investors would agree that stock index investing is a good idea!
Joining the two charts together, we get a view of the entire history of the S&P:
(Click image for a clearer view. source: yahoo finance)
The uncertainty about the S&P's future performance is clear:
Given the run up in stock prices during the period of 1980 to 2000, I might be tempted to conclude that investing in the stock index is a good idea. However, the volatility of the S&P in recent years does not appear to support that notion. Volume too has risen considerably during recent years (lower part of the chart). Is this an indicator that the markets have changed?
Could the returns of the past be a statistical illusion? Or will it persists into the future despite the recent changes in the performance of the index?
A FALLING INDEX IN THE LAND OF THE RISING SUN
Japan is the world's second largest economy, behind the United States of America. (in terms of nominal GDP) The Nikkei225 is a stock index comprised of Japanese stocks. It is the most watched index in Asia and has a well populated futures market.
This chart shows the performance of the Nikkei225 over the last 23 years:
(Click image for a clearer view. source: yahoo finance)
Surprisingly, stock index investing never worked for the Nikkei225 even as the Japanese economy is growing. For example, if i had invested in the index at its peak in 1990, i will still be stuck with a net loss 17 years later today!
How do I know whether the same thing would happen if I try to invest in other, more optimistic looking indexes?
CONCLUSION
Scottish philosopher David Hume once said that if all the swans we saw were white, we would conclude that all swans are white until we discover Australia and find black swans. Likewise, I have always assumed that stock indexes tend to rise in the long run (and hence are great long term investments) until I saw data on the S&P and that of the Nikkei225.
So is stock index investing a sham? Given that many economists, including Nobel Prize winners, advocate a index fund approach to stock investing, I certainty wouldn't dismiss it as a sham!
However, the data presented in this blog post does raise some interesting questions.
P.S.
Please don't take the title seriously. :)
5 comments:
People should invest in stocks if they have a long investment horizon. Indices generate 8-12% return over the long run on average. (Long run means at least 10yrs, but optimally 20-30yrs or more).
The Nikkei is a bad example of stock index investing bcos of the asset bubble in Japan in 1990 that distorted returns. If you took a chart of the Nikkei from 1970 till now, I would say that the average rate of return should look better.
When investing, it is impt to look at the PER which measures the cheapness of the index. In 1990, the PER of the Nikkei was 40-100x. In 2000, the PER of the S&P was 40x. Which implies over-valuation. One should buy only when the PER is low, not when it's high.
Personally, I think PER above 20x is very high.
My question is: How do we know if investing in stocks yield 8-12% return over the long run on average?
There might be rigorous proofs for this but for most investors this is just an assumption derived from historical data.
How do we know that what happen in the past will happen in the future? (Indexes of the future could return 1% from today onwards) How can we be sure that the same thing that happened in Japan won't happen in the index we are currently invested in?
NOT trying to argue with you or taking any sides in this issue. I am just sitting on the fence and asking questions.
Thanks for dropping by man, I enjoyed reading the postings on your blog. :)
Hi Economist,
That's a fair statement. Returns can dwindle to 1%. In fact, academics are arguing that might be the case bcos global growth may slow.
Global GDP growth has average 3-5% for the past 30 yrs (I think) driven by population growth and productivity gain.
Companies are in the forefront of this growth. Encouraging innovation, productivity gain, creating employment etc. Hence it is not a wonder why companies did 8-12% return for the longest time, 3-4x higher than GDP growth. And as an investor, this is where money should be put into.
If global growth slows to 1% or even negative, then stocks may not give 8-12% but so would all other kinds of investment, bcos ultimately it's global growth that would determine return on all forms of investments.
However, I don't think global growth will ever slow to 1% or -ve, bcos productivity gain and innovation just keeps it going. That's evolution!
The post "Is stock investing a sham?" seems to be using retrospective returns subjectively as the benchmark to determine whether to invest in stock index or not.
When one puts money in stocks or bonds or treasury bills or under the bed, one is preferring one risk-return profile over another.
As it is difficult to forecast future returns of each asset class, we can only make to with a long historical risk-reward profile for each asset class.
The academics recommend stock index investing due to a few reasons. One, stocks tend to offer relatively higher rates of return compared to other asset classes. Two, while stock indices offer people who are not interested in stocks to have a very low-cost hands-off approach to enjoy the stock market returns.
Three, as the market is always moving towards greater efficiency, it is getting harder to beat the market especially after the fees charged by fund manager. Hence, stock index investing may provide better returns than managed funds.
this is a stupid post
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