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Investor Psychology

The Past Is Still a Guide

I prefer history, for all its flaws, to my own subjective guesses about the future.

The witty Danish physicist Niels Bohr once said: "Prediction is very difficult, especially about the future." The future is, of course, unknowable. No one has ever been there. But our lives require forecasts about what it will be like, and we have to base those forecasts on something. Our choice, usually, is history. And so it is with investing.

When you invest, you forgo the immediate gratification your money could purchase and instead put your cash away, to be recovered later, when, you hope, it will be worth more.

The key word is hope, but the past teaches us that:

  • Stocks have outperformed bonds by a wide margin.

  • Stocks have been volatile over short periods but stable over long periods.

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  • A diversified portfolio provides extra stability.

  • Therefore, the best strategy is to buy a diversified portfolio of stocks and hold for ten years or more.

Short-term investing is risky. From 1926 through 2007, a broadly diversified portfolio of large-company stocks (as represented by Standard & Poor's 500-stock index) produced losses in 23 out of 82 calendar years. But when you examine returns over holding periods of ten years (that is, from the beginning of 1926 to the end of 1935, from 1927 to 1936, and so on, up to the present), you find that losses occurred only twice.

Minimal losses. The negative periods were during the Great Depression: 1929Ð38 and 1930Ð39. The declines were small: 0.89% and 0.05% annualized. Over the 73 overlapping ten-year periods between 1926 and 2007, a portfolio of large-capitalization stocks has failed to at least double in value only 19 times. These statistics -- and others I cite here -- come from Morningstar's Ibbotson subsidiary.

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Enter the disaster of 2008. The S&P 500 plunged 37% in 2008, and the ten-year period that ended December 31 became the worst since Ibbotson began keeping records: an annualized loss of 1.4% -- or roughly 4% after taking inflation into account. Since then, stocks have continued to tumble. The 120-month period that ended February 28, 2009, produced the worst real loss (5.8% annualized) of all 880 such periods studied.

A single outlying result should not invalidate a strategy based on more than 80 years of history. But the results of the past decade do make investors extremely nervous, and with good reason. Is the past still a guide to the future in investing? Doubts are growing.

Perhaps some profound change has occurred in the economic and social fundamentals that underlie financial investments, making history an invalid prologue. Perhaps the United States is growing weaker and can no longer compete with China. Perhaps we are following a disastrous public-policy route -- failing, for example, to prevent health-care costs from gobbling up the entire economy. Or perhaps the markets are looking to the future -- to huge deficits or the probability of more serious terrorist attacks.

While I share such concerns, I don't buy the notion that it's different this time. I prefer history, for all its flaws, to my own subjective guesses about the future.

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Still, we need to recognize that history has serious limitations. The world is not a wholly rational place. Peter L. Bernstein, in Against the Gods (Wiley, $19.95), his brilliant book about risk, quotes the English writer G.K. Chesterton: "The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it ... looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."

This wildness is what we are witnessing today. Its foundation is mass psychology -- our tendency to get caught up in a craze, which, in retrospect, appears illogical in the extreme.

Charles Mackay, the Scottish poet and journalist, first catalogued the phenomenon 168 years ago. Mackay wrote Extraordinary Popular Delusions and the Madness of Crowds, an account of such investment lunacy as the South Sea Bubble in England in the 18th century and Holland's tulip mania of the 1630s.

A financial mania leads to a bubble. The bubble pops, asset prices fall to earth, and, especially when that asset is bought on credit, the damage spreads to the economy as a whole. That is what happened recently with residential real estate.

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But aren't such bubbles part of the record of the past, the market history we use as the basis of prediction? Yes and no. Large bubbles -- and other shocking dislocations, such as a terrible war -- don't happen often enough to have a major impact on the data. The risk of such wildness is real, but it is hard to quantify because it is so rare.

In his doctoral dissertation, published as Risk, Uncertainty and Profit in 1921, a young Midwesterner named Frank Knight drew a distinction between risks we can count (and count on) -- gleaned through data points of history -- and what he called "a higher form of uncertainty not susceptible to measurement and hence to elimination."

The kind of risk we can "eliminate" -- or prepare for -- is the sort that takes place with a coin flip. We know the odds are that half the time heads will come up and half the time it'll be tails. You can get a run of ten heads in a row, but on each new flip the odds are 50-50 that heads will appear, and over thousands of flips, heads and tails will each win about the same number of times.

You should have enough capital to withstand losses from, say, ten tails in a row. History assures us that stocks will lose money only a few times over ten-year periods and never over 20-year periods, and that on average they'll deliver annual real returns of about 7%.

Knightian uncertainty is something else entirely. It is a bolt from the blue -- the toppling of the World Trade Center towers, the severe economic contraction produced throughout Europe in the 1720s after the collapse of John Law's Mississippi Scheme, or the five-month shutdown of the London Stock Exchange after World War I broke out.

Your choices. There are two ways to respond to these kinds of uncertainties as an investor. The first is to take your chips off the table. If you can't calculate the odds, refuse to play. The second is to ignore the risk and assume that a logical system, even if severely buffeted, will eventually prevail.

If you believe you can recognize a mania as it develops, then, certainly, exercise your good judgment. Few have this talent. One who did -- at least according to legend -- was Bernard Baruch, the financier and political adviser.

Baruch wrote the foreword to the 1932 edition of Mackay's book. While he was fascinated by Mackay's stories, he observed, "No preventive is anywhere suggested." Still, he believed that if you spot the early symptoms of these maniacal episodes, you may be able to "avoid the more harmful of their full effects."

He concludes, "I have always thought that if in the lamentable era ... culminating in 1929 ... we had all continuously repeated 'Two and two still make four,' much of the evil might have been averted. Similarly, even in the general moment of gloom in which this foreword is written, when many begin to wonder if declines will never halt, the appropriate abracadabra may be: 'They always did.'"

A few suggestions, then, for those who believe that logic and history will ultimately prevail: An excellent way to gain access to the broad large-cap U.S. market is through low-fee index funds, such as Vanguard 500 Index (symbol VFINX) and SPDR S&P 500 ETF (SPY), an exchange-traded fund.

Those who prefer to buy individual stocks should consider General Electric (GE), the best-run diversified giant in the world. As of March 6, with its share price at $7, GE was as cheap as it was in 1995. Because of its large financial-services business, GE is definitely risky, but potential rewards are great. Also worth adding to your shopping list is Warren Buffett's Berkshire Hathaway (BRK-B). At $2,327, the stock has fallen by half since early October, even though Berkshire owns great companies and has a gorgeous balance sheet.

As Chesterton said, the world is rational, but not always and everywhere. Still, we have to proceed as if it were, especially at times like these.

It can't get much worse

The market's horrific performance in 2008 and the first two months of 2009, coming on top of the 2000-02 downturn, has made this one of the worst decades ever for stocks. In fact, if you take into account the impact of inflation, the ten-year period that ended in February is the market's worst ever, going back to 1926.

ANNUALIZED TOTAL RETURN
10-yr. period ending Return
August 1939 -5.0%
May 1940 -4.2
June 1939 -3.9
February 2009 -3.4
July 1939 -3.4
April 1939-3.3
March 1939 -3.1
September 1939 -3.0
March 1938 -2.9
January 2009 -2.7
ANNUALIZED TOTAL RETURN AFTER INFALTION
10-yr. period ending Return
February 2009-5.8%
January 2009 -4.9
September 1974 -4.3
November 1978 -3.8
December 2008 -3.8
July 1982 -3.8
December 1974 -3.8
October 1978 -3.6
June 1982 -3.5
November 1974 -3.5
Source: Ibbotson Associates, a Morningstar Inc. company.

James K. Glassman, former Under Secretary of State, is President of The World Growth Institute.