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moneysense.ca, 19/10/08
Why lower stock prices should make us smile
If you are a long-term investor, lower equity prices are excellent news. To quantify how the fall in stock prices over the past year benefits investors who are planning on holding stocks for at least 20 years, I ran some numbers. Let’s assume that last October with the TSX Composite at around 15,000 (it doesn’t matter much which stock market we are talking about as all of them have fallen by pretty much similar amounts), investors could have expected a nominal return of 6% over 20 years (slightly better than bonds). With stock prices now about one-third lower, the expected return is now much higher at 8.31%.
An investor putting $1,000 in the market last year could have expected her savings to grow to $4,049 in 25 years at a 6% expected rate. A similar amount invested this year at much lower prices would grow to $6,272 or 55% more and take one year less to do so! Our investor’s total investment of $2,000 over the two years has grown into $10,321. Without a stock market fall, she would instead have $7,869 or 24% less. Bear markets such as these are painful in the short run but long-term investors should instead wish that the bear isn’t going into hibernation anytime soon.
moneysense.ca, 19/10/08
This only makes sense if you assume that the long term average growth of the TSX remains constant regardless of short term changes. You didn’t state that in your article though, so am I off the mark? How do you get 8% now instead of 6%??
Sean,
Assuming the markets will end up at the same closing value 25 years from now, our average annual rate of return increases as the market falls. I think that’s what CC is emphasizing…great post, CC!
Ever the optimist I agree with you on the one C.C., just hope things stay down while my investing cash “frees up”.
C8j
I agree with CC that the best time to buy is during a market downturn. There won’t be a bell rung when the stock market bottom is hit. If you panic now, you will pay dearly 2-3 decades from now.
I agree with CC that lower markets equals higher future returns and visa versa. Maybe he could comment on the criteria on which he bases his assumptions.
I think what people are worried about is that the stocks were overpriced due to a discount rate that was too low for the risk level.
If that is the case, the net result of all that is happening is a higher weighted average cost of capital for companies, and their earnings will suffer. This could mean that 6% nominal returns moving forward FROM THIS POINT are to be expected.
Again, I agree with CC and perhaps the nominal returns before we got in this mess were more likely to be, s ay, 4% but perhaps he can weigh in with some follow-up comments of his own.
I was actually thinking the same thing about the stock market. We need a good drop every once in awhile so that smart investors (ie long-term) can get some good deals. The real estate market is the same way. Looking at prices last year and assuming continuous growth, I would never be able to afford to purchase my own home. Now things are looking a little more promising..
I agree that now’s a great time to buy, but the dramatic downturn has made me appreciate the importance of the one big exercise in market timing that I’ll have to undertake when I get closer to retirement: the decision of exactly when to start moving money out of index funds and into something less risky. Ulitimately, my growth rate will be determined by decision.
Sean: Like Blogging about Money explained, if I expected stocks to return 6% last year, assuming that the level stays the same in 25 years, falling prices have increased our average rate of return.
Rob: A nominal expected average rate of return of 6% from stocks would have been a pretty conservative assumption even last year at what turned out to be the peak of the bull market. The dividend yield was just shy of 2%. Earnings growth could be expected to clock in at 5%. Assuming a slight fall in p/e values that reduces return by 1% per year we could have reasonably expected stocks to return 6% (dividend yield + earnings growth + change in p/e ratio) last year.
brad: It’s true that a portfolio will become more conservative over time. But fortunately, it doesn’t happen overnight but over a long period of time. We might have 20% in bonds at 30 years, 30% at 40, 40% at 50 years of age and so on. Part of the change in targets would be through rebalancing but part (most?) of it would be through regular additions to the portfolio. I haven’t run numbers but it should be an interesting exercise.
makes sense CC – thanks
The average annualized 20 year total return (including dividends) for the S&P/TSX Composite Index ending in 1976-2007 was 10.45%. The range of 20 year returns is between 6.7% and 13.48%. I would expect that 20 year returns from the recent lows would be in the upper end of this range.
I’m glad I have you optimists to remind me of long term growth. For a person whose only invested for the last 10 years, dollar cost averaging, our portfolio is looking very meagre!
[...] been a lot of talk recently about how the recent dramatic drop in the stock market has presented buying opportunities. Why I do not disagree with that analysis, we must ever be mindful of walking before we run. On the [...]
The consenus is that stocks with low P/E price to earnings ratios will do well over the long term. The problem we face today is it is hard to predict earnings for the future.
Historically, during a secular bear market, stocks tend to bottom when their trailing P/E ratios fall into the mid-single digits (i.e. 6-8). We have many sectors that have fallen to those levels, and we should see things improve from here. Growth companies that many of us would never touch (why should we buy a company for the price of its next 30 years earnings?) will probably continue to fall, as their last couple of years’ earnings are not the average of their trailing earnings.
Bottom line: we are in a better position to buy now than we were one or two years ago, and we are in a much better position than when the markets were priced like this in 2003 and 1998 (earnings have grown into the lofty P/E ratios of those years past).
Investing for returns that will be realized after 2-3 decades, a tough wait. Downturn is the best time to buy, buy. It is directly dependant on your portfolio mix. There are upcoming enterprises in a new industry/sector, which are out there to make quick fill of the demand-supply in the market – 5 years is maximum for them. Decade long wait is void there.
5 years of market trend study is enough to make a better portfolio decision. The 25 year wait may come at any point of upside turn. The timing of selling determines what percentage you are making.
John
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