Are You an Active Investor in the Stock Market?

[BWV]

That's what I see reported, but I can't lay hands quickly on a running average calculation. Does someone have a source?

Look at Dimson's work on SSRN.com

for example:

We address the tendency of many investors to overestimate the rewards and underestimate the risks of investing in stocks over the long term - that is, investors' irrational optimism. In particular, we examine the widely held belief that stocks are a "safe" investment for the long run. The probability of experiencing a real loss on equities depends on the expected real return and standard deviation of stocks. Judgments about the future magnitude of these two parameters typically involve extrapolating from history. We use a global database of real equity returns from 16 countries during the 103-year period from 1900 through 2002 to confront the optimism of investors with the reality of history.

Since 1900, the worldwide real return on equities averaged close to 5 percent a year (before costs, fees, and taxes). This is appreciably lower than is frequently quoted from historical averages, a difference that arises because we use a longer time frame than other studies and adopt a global focus. Prior views on the long-run safety of equities have been overly influenced by the experience of the United States. Furthermore, the US evidence that, over the long haul, stocks have beaten inflation over all 20-year periods is based on relatively few nonoverlapping observations and is hence subject to large sampling error.

To counteract this dependency on projections of the US experience, we examine the histories of other countries. We find only three non-US equity markets (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return.

We also analyze the future shortfall risk of an equity portfolio. The base case for the projections is a worldwide historical volatility level of 20 percent and mean real return of 5 percent, and we also examine a lower return of 4 percent. The projected shortfall risk exceeds the historical risk of shortfall - partly because of the lower assumed real returns, and partly because, even though volatility was projected to be the same as in the past, the shortfall analysis focuses on the full range of possible future returns rather than a single historical outcome. By construction, historical returns converged on long-term realized performance, but the forward-looking analysis shows that there is always risk from investing in volatile securities.

Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=476981

 

[BWV]

Keep in mind that in order to be listed in the NYSE, much less be in an index such as the S&P 500, a company has to be of a certain size and stability. There is an awful lot of failure in small businesses and those failures are never seen in the stock market - only the successful ones ever survive long enough and grow big enough to be listed. So you should expect that the stock market will perform significantly better than the GDP.

Actually the stocks in the S&P should grow at a slower rate than GDP, because the faster growth comes from smaller startups and it is impossible for them to grow at a higher rate than GDP over the long run. However stocks are a present value of future earnings, not just the growth. A company that had 0% real earnings growth could in theory still deliver 10% returns to shareholders depending on how the market priced the stock

 

[CRGreathouse]

Actually the stocks in the S&P should grow at a slower rate than GDP, because the faster growth comes from smaller startups and it is impossible for them to grow at a higher rate than GDP over the long run. However stocks are a present value of future earnings, not just the growth. A company that had 0% real earnings growth could in theory still deliver 10% returns to shareholders depending on how the market priced the stock

Surviving small companies have high returns, but many small companies don't survive. The historical averages I've seen support the idea that return on small companies (surviving and otherwise) is similar to that at large companies, within a percentage point or so. Admittedly, the last 20 years have seen excellent performance for small-cap stocks, but in the long run that seems the exception.

 

[BWV]

Surviving small companies have high returns, but many small companies don't survive. The historical averages I've seen support the idea that return on small companies (surviving and otherwise) is similar to that at large companies, within a percentage point or so. Admittedly, the last 20 years have seen excellent performance for small-cap stocks, but in the long run that seems the exception.

You cannot directly comparison between GDP growth and stock price returns. GDP is equivalent to revenue and there is no valuation mechanism at play. There is value in companies with stagnant or declining earnings or revenue growth, and depending on how they are priced, a stock with declining earnings can outperform a stock with 30% annual earnings growth. The point here is that small companies - not neccessarily public ones - account for the bulk of GDP growth and that the revenue growth rates of larger companies will converge to nominal GDP. Something like over 50% of current GDP comes from small businesses. That many fail does not alter the fact that they account for most of the marginal GDP growth. A startup that goes from $1 to $10 million in sales over a couple of years & then fails makes a positive contribution to GDP growth.

On the separate issue of small-cap publicly traded stocks, a wide array of literature in financial economics has documented the fact that they have delivered abnormally high returns (above that which could be simply accounted for by their higher volatility) - to the point where it is referred to as an "anomaly". The main competing theories on this are A) that it is a mispricing that has now been discovered and therefore less likely to hold going forward or B) there are other risk factors not accounted for in a simple CAPM beta calculation.

 

[mheslep]

You cannot directly comparison between GDP growth and stock price returns. GDP is equivalent to revenue and there is no valuation mechanism at play. ...

Eh? Econ 101, GDP : The total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. In the case of a companies revenue stream, that certainly reflects valuation in the price the consumers are willing the pay.

 

[BWV]

Eh? Econ 101, GDP : The total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. In the case of a companies revenue stream, that certainly reflects valuation in the price the consumers are willing the pay.

By valuation I mean the discounting mechanism in stock prices. The value of a stock at time t is what the market thinks is the present value of its future cash flows at some discount rate. The price change to t+1 involves some change in expectations of future cash flows and/or the discount rate. GDP is analogous to the company's revenue on its annual income statement, not the change in stock price.

 

[OmCheeto]

Today was the very first time I have ever invested in the stock market.

I lost $7

But my broker says it's a long term deal. Be patient, he said.

I'm not one to dwell on finances, so could someone give me a poke in about 8 years so I'll remember to check my account balance?

Thanks!

 

[Office_Shredder]

I lost $7

Go to cash

This is not intended to be sound advice. I just like saying 'go to cash'

 

[russ_watters]

Today was the very first time I have ever invested in the stock market.

I lost $7

Does that include brokerage fees?

But my broker says it's a long term deal. Be patient, he said.

You have a broker?? You do know why they call them "brokers", right? Do yourself a favor and do your buying and selling yourself.

 

[OmCheeto]

Does that include brokerage fees?

It's an introductory offer. There are no brokerage fees for the first couple of months.

You have a broker??

Actually, he's a commodities broker that overheard me discussing the market one day.
He knows I have little money to invest so he pointed me to a company that can get me invested for less than I spend on beer in week.

You do know why they call them "brokers", right?

Do yourself a favor and do your buying and selling yourself.

The company does that for me. They steal $100 from my checking account on the first Tuesday of each month. They have 3 or 4 categories for people like me to invest in. High risk, medium risk, low risk, and too old to invest.

Since it's just play money for me, I went for high risk.

I've only 8 years till I retire, and my retirement package should be safe, so I'm just feeding the machine for fun.

The most I can lose is $100/mo*12mo/yr*8yr = $9600.

About 2 years worth of bar tabs for me.