Introduction
What history tells us
What drives sharemarket performance
Common market myths
Some market truths
Expanding your horizons
What does the future hold?
Managing the risks
The low cost way to invest in the sharemarket
The indexing pioneers
Introduction
Just as life has two certainties, the same is true for investing. First and foremost is the reality that future investment performance is impossible to predict. In fact, this is the premise of economist and author Burton G Malkiel's random walk theory. In his best-seller A Random Walk Down Wall Street Malkiel explains, "A random walk is one in which future steps or directions cannot be predicted on the basis of past actions." When applied to the stock market this simply means, "short-run changes in stock prices cannot be predicted".
The second certainty of investing is that markets will go up and markets will go down.
One thing past sharemarket volatility teaches us is that investors need to be aware of the risks as well as the rewards when investing in shares. Sharemarket investing is a long-term investment strategy, and as this Plain Talk® guide will demonstrate it can be volatile over the short-term.
While past performance is no guarantee of future performance, this Plain Talk guide examines the relationship between risk and reward over 50 years of sharemarket returns. It aims to help investors understand what is and what isn't realistic to expect from their share investments.
What history tells us
The Australian sharemarket has enjoyed bull market conditions delivering returns in excess of 25 per cent over the three calendar years to December 2006.
If history is anything to go by, returns of this magnitude are notsustainable over time. In fact, the Australian sharemarket has not produced 25 per cent plus returns for three consecutive years for 20 years.
For the 50 years to 30 June 2007, Australian sharemarket returns have averaged 12.8 per cent annually (see table opposite). While this long-term average is impressive and demonstrates the rewards of long-term investing, it hidesthe volatility of the market over shorter time periods.
The good news with sharemarket investing is the longer your investment timeframe the better your chances of riding out the ups and downs and enjoying steady marketgrowth.
While 50 years might be too long for most people to contemplate, it could be relevant if you have just embarked on your working life and started contributingto superannuation.
Tracking investment returns over short periods (lessthan five to seven years) can be misleading. After all,past performance is not a reliable indicator of future performance.
Long-term historical averages can provide an indicationof what to expect in the future, but they are not a guarantee.
What can help investors establish realistic expectations about the future is gaining an understanding of why sharemarkets behave the way they do and understanding the distinction between long-term and short-term investing.
While shares and property securities tend to have more volatile returns over the shorter term they have the potential to provide higher returns over the longer-term timeframes as demonstrated in the following graph.
| Beware of irrational exuberance Irrational exuberance is a phrase coined by former Federal Reserve Board Chairman Alan Greenspan three years before the dot-com crash of March 2000. Greenspan was referring to how speculation was inflating asset values during the US technology stock market boom of the late 1990s. The dot-com era had begun with new start-ups emerging almost every day. Many of the start-ups were trading at values far beyond what their balance sheets and business plans warranted. The NASDAQ Composite Index more than tripled in value from late 1998 to March 2000, peaking at 5,048 points, only to fall 64 per cent in the following year. The NASDAQ has failed to gain its previous heights and at the time of writing is trading at around half its March 2000 high. |
What drives sharemarket performance
Share prices are affected by a number of forces, many of which areconstantly shifting. For instance, prices on a single day can be affected by emotional reactions to news of a change in interest rates, inflation, company profits, dividends, economic growth figures and the rise or fall of our dollar.
Just as powerful are the effects of changes in domestic and international politics and the mood swings of investors themselves. As history tells us, fear and greed can play a significant role in themovement of markets. Time and time again unsustainable marketprices, propped up by speculation, have come undone when investment fundamentals and common sense have prevailed.
Jack Bogle draws on wisdom from British economist Keynes in his Little Book of Common Sense Investing when explaining the long-terminvestment performance of the sharemarket. He writes, "the stateof long-term expectation for stocks is a combination of enterprise[forecasting the prospective yield of assets over their whole life]and speculation [forecasting the psychology of the market]. The latter refers to the impact of changing price/earnings multiples on stock prices.
Dividends and earnings growth - the keys to market growth
Enterprise as Keynes described it is derived from a company's dividend yield and earnings growth and is one of the most fundamental drivers of long-term market growth. The dividend yield on shares is calculated by dividing the annual dividends paid, by the current share price, and expressing this as a percentage.
While long-term average dividend yields can provide a clue to expected long-term yields from the sharemarket, actual yields canchange dramatically from year to year. If company profits are not growing at the same rate as the increase in their share price, then the dividend yield might be expected to fall.
The graphs below show the total returns and dividend yields of the Australian sharemarket over each of the last 20 years.
Common market myths
Declining markets are the best time to buy
While declining markets usually recover, it can take time. Some investors see a price drop as an opportunity to buy securities at a discount, while others see it as the start of a deeper downturn.
Predicting the bottom of the market is difficult, if not impossible. Most investors would be better off staying in the market and using a dollar cost averaging strategy instead of investing all their money at once, they drip feed it into the market so they can average out share prices over time. This has the effect of averaging out market fluctuations over time.
Mistiming is a huge risk and can often backfire. Investors may miss the rebound completely and have to pay a higher price to get back into the market. They also risk the opportunity of missing out on market growth. It is important to keep in mind there is no guarantee that share prices will recover to their previous value. Sometimes, there is a good reason why individual share prices fall, reflecting underlying poor corporate health.
Sell when the market drops
Investors with a short-term view of the sharemarket are most likely to sell when the market starts to fall. The fight or flight response is a natural human reaction to panic. Unfortunately, fleeing the sharemarket when things turn sour crystallizes your losses. It can be costly in terms of transaction costs and capital gains tax - something investors often overlook. It also means you may be out of the market when it rebounds and miss out on future market growth.
With hindsight, many investors who play the game of market timing realise just how much better off they would have been simply riding things out. While the last decade has been tumultuous on the global economic and political front, the Australian market has proved its resilience. The US invasion of Iraq, September 11 terrorist attacks, dot-com crash, Asian financial crisis and rising world oil prices have all provided short-term setbacks, the Australian market has continued to enjoy long-term growth.
Some market truths
"I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently."
Jack Bogle, Founder, The Vanguard Group Inc. on market timing.
It's time in the market, not timing the market
Timing the markets for the best time to invest is easier said thandone. Sharemarkets are unpredictable and if you try to time the market, you have to get not one, but two important decisions right: when to get out and when to get back in.
Intuition tells us that the best time to buy is when prices are down, and the best time to sell is when prices are up. Trying to pick the top and the bottom of the market is not easy and you risk being out of the market when it rebounds. Even professional fund managers find it difficult to continuously time the markets for the right time to invest.
Long-term investing isn't about chasing the hottest performing stocks. It's about taking a long-term view and staying the course. It won't protect you from market downturns, but it ensures you are 'in the market' during times of growth.
The best and worst performing asset class can vary from year to year. One way to reduce your exposure to market volatility is to hold a diversified portfolio of different asset classes (ie cash, bonds, property and shares). Returns from better performing investments can help offset those that underperform.
The sharemarket can be volatile
Between 1950 and 2007 the Australian sharemarket providedannual returns ranging from a low of -39 per cent (for the year ending September 1974) to a high of 86 per cent (for the year ending July 1987). This extreme volatility is the major risk of investing in shares, which tends to be forgotten after lengthy periods of positive returns.
Investors who have not experienced a bear market might underestimate the volatility of shares. A bear market is generally defined as a decline in the sharemarket of at least 20 per cent over a period of two months or more. A bear market is not unique to shares and can also occur in bond and listed property markets.
Time greatly reduces - but certainly does not eliminate - thevolatility in returns from shares. The chart above shows the range of returns for the Australian sharemarket over different investmenttimeframes. As the diagram illustrates, over time, the ups anddowns of investment markets tend to even out and the gap between the highest and lowest returns closes. This is why it is important to consider your investment timeframe when choosing your investments.
What a difference a decade makes
Over the 50 years to June 2007, the Australian sharemarket delivered an annual average return of 12.8 per cent. When you break this performance down by decade, you will see that the returns achieved over each 10 year period have varied greatly. As the data shows (see
table), there is no guarantee you will earn the long-term average annual share return of 12.8 per cent, even over periods of two decades of more. Returns in the future can be higher or lower than those in the past. The table below shows the performance of the Australian sharemarket over the past 57.5 years, decade by decade.
Bear markets are part of investing
Over the past 50 years, the Australian sharemarket experienced what was generally regarded to be a bear market, on average, once every fiveyears. During the last major market downturn in October 1987, the ASX All Ordinaries Index dropped by 42 per cent over a month.
Although no one can reliably predict the timing of bear markets, or bull markets for that matter, investors need to be aware of the extent to which share prices can fall. The big danger from bear markets is that investors will panic and sell at or near the bottom of the downturn. Many investors did just that in the market decline of late 1987.
The graph below shows that an investment of $10,000 invested in June 1987 grew to $12,802 before it dropped to $7,408 in October 1987. It recovered to its original investment value of $10,000 around two years later. Investors who stayed the course, rather than selling and cutting their losses, would have received around $81,000 in June 2007 (before fees and expenses).
Expanding your horizons
Investing internationally can increase your diversification further and give access to industries and companies not available in Australia. After all, Australia represents less than three per cent of the total world sharemarket.
The Australian market is highly concentrated with a large representation in the financial services and resource sectors. The top 10 Australian companies make up around 40 per cent of S&P/ASX 300 Index, with four out of the top five companies in the financials sector.
Many industries are not represented or under represented in Australia. For example, the MSCI World Index has an allocation of more than 20 per cent to the fast growing information technology and healthcare sectors. By comparison, Australia has less than five per cent in these sectors. The graph below shows how diversifying your portfolio and including an allocation to international shares can help improve your return potential and potentially lower your risk.
The other benefit of investing internationally, is that investment markets tend to move in different cycles, driven by their economic health, and other factors. The graph below shows the annual returns of major international and Australian equity markets over the past 10 years.
What does the future hold?
No one can accurately predict what lies ahead. In fact, the only thing we can be sure of is that the market will go up, and the market will go down. To benefit from the long-term rewards of investing in shares you will need to learn how to weather rises and falls. An important part of any investment strategy is to have a plan. Having a clear idea of your investment objectives, timeframe and attitude to risk provides a solid basis on which to build your investment portfolio.
Historically, the ups and downs of the market have tended to even out over time. What has remained is a steady, upward trend reflectingthe long-term growth of company profits in an expanding Australian and world economy. This has been great news for investors who have stuck to their investment plan and stayed the course.
Predicting market movements
Investment markets move in cycles, reflecting the underlying strength of the economy, political factors, industry trends and market sentiment among other things.
Market timing is a lot easier in theory than in practice. It is very tough to predict market movements. For example, from January 2000 toJune 2006, the 20 best trading days accounted for 48 per cent of thetotal return. While the prospect of avoiding large market declines is appealing, there is the risk of missing the best trading days.
Approximately 75 per cent of the 20 best days followed one of the20 worst days by less than a month. These volatile days are often caused by major economic or geo-political events.
While market commentators are quick to pin the rise or fall of prices on a single factor, isolating the real cause of a day's market movement can be much more complex.
Managing the risks
You can never be certain of the best time to invest. What you can do is be aware of the risks and understand how they will impact your investment, so you are prepared for volatile times in the markets. If history is anything to go by, learning not to panic during market downturns and keeping a long-term perspective are two of the most valuable investment lessons you can learn.
Although risk is unavoidable when investing, one of the greatest risks can be not investing at all. Rising prices due to inflation can erode the real value, or purchasing power of your money. While we are lucky to be enjoying a golden era of low inflation and low interest rates, there is a risk that the real value of your money may actually fall over time.
| John C. Bogle offers some words of wisdom in his Little Book of Common Sense Investing. "My advice to investors is to ignore the short-term noise of the emotions reflected in our financial markets and focus on the productive long-term economics of our corporate businesses." |
Know what type of investor you are
Over longer time periods, share prices are mainly determined by fundamentals such as corporate earnings, dividends and interest rates on competing investments.
Understanding your attitude to risk and return is arguably the most important insight you can discover when investing. You might be attracted to the prospect of great performance, but how much risk are you willing to take to achieve it? Are you likely to get caught up in market hype when markets are performing well, only to pull out when things turn sour?
Investing in the sharemarket is a long-term strategy and is not for the faint hearted. Successful investors acknowledge the presence and power of emotion and try to understand their own investment psychology.
Keep your balance
Spreading your money across a range of investments such as shares, property, bonds and cash, is one of the best ways to reduce your exposure to market risk. This way you are not relying on the returns of a single investment. Finding the right balance is a matter of weighing your investment objectives, risk/return profile and investment timeframe.
Tune out market 'noise'
It is human nature, at the first sign of trouble, to become nervous and want to save your investment value from falling. Market downswings can cause even resilient investors to have second thoughts. One factor you need to get used to as an investor, is that markets run in irregular cycles and good and bad markets come and go. Reassure yourself that you are investing for long-term growth rather than trying to avoid
short-term losses.
Long-term investing isn't about chasing the hottest performance. It's about taking a long-term view and staying the course. It won't protect you from market downturns, but it ensures you are 'in the market' during times of growth.
A long-term investment strategy should be based on your objectives,time horizon, risk tolerance and personal financial circumstances, and not determined by short-term market performance or 'market noise'.
Time in the market is everything
When it comes to investing, one of your greatest allies of all is time. It has a moderating effect on sharemarket risk, and the longer you hold an investment, the more likely you are to enjoy market growth.
Regardless of how high share prices are one day, it is no guarantee of their price the next day. If you have a short-term time horizon, such as five years or less, sharemarket investing might be a risky option.
Review your plan when your circumstances or goals change
It is a good habit to review your investment plan on an annual basis to make sure it still meets your needs. Perhaps your investment objectives or circumstances have changed. Or you may have decided that your original goals are not important any more and your focus has changed. At times like this it's a good idea to revisit your investment strategy.
Invest often
Timing the markets for the best time to invest is easier said than done, which is why many investors use a dollar cost averaging strategy. With this strategy, rather than investing in a single lumpsum, you drip feed your money into the market in smaller regular amounts. This strategy has the tendency to average out market fluctuations over time.
The low cost way to invest in the sharemarket
For many investors, buying and holding a diversified portfolio of investments is the most effective strategy over the long run. In the 1996 Berkshire Hathaway Annual Report legendary investor Warren Buffett wrote, "Most investors, both institutional and individual, will find that the best way to own common stocks [shares] is through an index fund that charges minimal fees. Those following this path are sure to beat the net results [after fees and expenses] of the great majority of investment professionals".
One way to gain broad exposure to the sharemarket, both local and overseas, is through an index fund. Index fund managers aim to match the performance of a market index by investing in all or a representative sample of the securities in the index. A benchmark index measures the performance of a basket of securities. For example, the S&P/ASX 300 Index measures the performance of about 300 companies listed on the Australian Stock Exchange.
Because index funds usually invest in all or most of the securities in the index, they provide diversification, which means lower risk.
By adopting a 'buy-and-hold' approach the cost of investing can be significantly reduced over time and lead to better returns in the long term, especially on an after-tax basis.
Unlike active fund managers, index fund managers don't try to outperform the market. Rather, they invest in all or a representative sample of the securities in the index and let markets do their work over the long term.
The indexing pioneers
Vanguard pioneered the concept of indexing, introducing the first retail fund in the US in 1976. Vanguard has since become one of the world's most experienced and successful indexing specialists. In fact, the Vanguard Group manages more than $1.4 trillion worldwide.
Vanguard recently celebrated 10 years in Australia, managing more than $65 billion on behalf of Australian and international clients as at 30 June 2007.
Vanguard® index funds
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