January 15, 2016
Investing and Action Movies
When we go to a good action flick, we enjoy the suspense and surprises, but no one wants that experience when investing. James Bond and Mission Impossible would not be box office hits without some interesting plot twists, and an occasional victory by the villain, and yet the end result is usually something we expect – the good guy wins.
Unfortunately, investing can be a lot like a good action movie, and it is important to remember that 2015 was just one scene, where the villains had some success, but it is not the whole story. While we have experienced 9%-10% returns from the stock market over time, we usually get something different. Those expected returns only emerge over long periods of time. Like the plot of an action movie unfolding, it requires some patience, and tolerating our hero experiencing some setbacks.
The S&P 500 has produced an annualized return of 9.7% over the past 50 years, but looking at those 50 separate one-year periods, we see something very different. In 11 of those years the return was negative; 2015 is not one of those years as total returns with dividends were 1.4%. Still, with a long-term return of 9.7% we might expect most years to have returns close to that, say a range of 5%-15%. Surprisingly, 40 of the 50 one-year returns were outside that range, either less than 5% or greater than 15%. So what we expect for the average is quite different than what we experience year to year.
One of the problems we have as investors is our tendency to overemphasize near-term performance. Behavioral economists have labeled this the recency effect. It explains why people want to buy what just went up, and sell what just went down (usually a bad strategy), and it can also explain why it is so hard for investors to maintain a long-term perspective. This is one reason we recommend investing based on decades of performance data, not months or even years.
The markets are starting the new year with plenty of volatility and negativity. Perhaps if we think of it as the unfolding plot of a good action movie, we will be more comfortable enduring the inevitable ups and downs, which must be endured to achieve our long-term expectations.