Author: Chong Ser Jing

Yesterday, I published Staying Calm Through The Recent Big Fall In Stocks. In the article, I shared how US stocks fell by a stunning 20.5% in one day on 19 October 1987. This event is now infamously known as Black Monday.

I used Black Monday as an example to show that incredibly sharp short-term declines have happened in the past. Yet, US businesses and the stock market as a whole have continued growing significantly. I thought Black Monday was an apt example, given the current climate – on Monday night (9 March 2020), US stocks declined by 7.6%.

In Staying Calm Through The Recent Big Fall In Stocks, I wrote that “when Black Monday occurred, it was likely an extremely stressful time for investors.” I could not find any data or anecdotes to illustrate how investors must have felt back then. As the market gods would have it, I just found one.

Ben Carlson once received a message from a reader who experienced Black Monday. Carlson is the Director of Institutional Asset Management at Ritholtz Wealth Management who blogs at A Wealth of Common Sense. This is what the reader wrote to him (italics are mine):

“As one who was actually invested in 1987 (and since 1973), I still have vivid memories of that market crash. It is oh-so-easy to look today at a long-term chart having a tiny blip and say “So what! . . . of course the market recovered . . . those who sold were fools.”

In 1987, market news was nothing like it is today. We had no Internet. We had the next day’s WSJ [Wall Street Journal] and Friday’s 30-minute Lou Rukeyser’s Wall Street Week; we subscribed to a few stock newsletters (delivered by snail mail) and Kiplinger and Money magazines . . . that’s about it.

Therefore, though I heard about the crash on the radio as I drove home from work on Black Monday, I was not prepared to find my wife in tears . . . her first words were “You’ve lost our retirement!” (Reading it does not convey the impact of hearing it.)

In real time, the crash was a VERY big event. Fear for a changed future was the natural response. Talking heads were saying “This worldwide event could last for years; our children will have a lower standard of living than we have.”

Long story short— she insisted we sell everything the next day (which was also a significant down day); we eventually re-entered the market.”

I can’t prove it, but I guarantee that many investors are today having similar thoughts as what I highlighted in the quote above. It was fortunate that Carlson’s reader eventually re-entered the market. Black Monday turned out to only be a painful blip in the short run (see chart below). From 13 October 1987 (before Black Monday happened, meaning stocks were at a higher price than after the 19 October 1987 crash) to 9 March 2020, the S&P 500 increased by 773% in total, or 6.9% per year. With dividends, the S&P 500 was up by around 2,100%, or 10.0% annually, according to data from Robert Shiller.

Black Monday was monumental for those who lived through it. But if those investors had the courage to stay invested, they would have been amply rewarded.

What we experienced on Monday night and for the past few weeks, feels similar to what Carlson’s reader described. But I also think the chances are very high that in five, 10, and 20 years from now, we will look back on our experiences in the past few weeks and think “What a time it was to live through. But I’m glad I stuck with stocks for the long haul!”

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Yesterday night, the S&P 500 in the US swiftly fell by 7% when the market opened, triggering a circuit breaker that halted trading activity for 15 minutes. The index resumed trading, but eventually registered a drop of 7.6% for the day.

The decline in US stocks was sharp and it likely had hurt some investors, if not psychologically, then literally (because of fear-induced selling, or the activation of stop-losses). Some of you are also likely worried about what could happen next.

History is and will never be a perfect guide for the future. But a look at the past can give us context on what just happened and prevent us from committing emotion-driven mistakes.

19 October 1987 is known as Black Monday in the investing community. That’s because the S&P 500 fell by 20.5% on that day alone. What deepened the pain was that the US stock market index had already declined by 10.1% in the three days preceding Black Monday. So in the span of four trading days, from the close on 13 October 1987 to 19 October 1987, the S&P 500 sunk by a mighty 28.5% in total.

The chart above illustrates how brutal Black Monday was. But for another perspective, the chart below shows how the S&P 500 did from 13 October 1987 to 13 October 1992, a five-year period. It was up 30% in all. Not fantastic, but there was still a gain. 

Let’s zoom out even further, with a chart that shows the performance of the S&P 500 from 13 October 1987 to today:

Turns out, the S&P 500 has climbed by 773% in total, or a solid 6.9% per year.

I have two points to make here. First, significant short-term declines in stocks have happened before. When Black Monday occurred, it was likely an extremely stressful time for investors [link added on 11 March 2020]. But the sun still rose and the world went on. According to Robert Shiller’s data, the S&P 500’s earnings per share (EPS) has also compounded at 6.9% per year from October 1987 to today. In fact, the S&P 500’s EPS in December 1987 was higher than it was in October 1987 (US$16.41 vs US$17.50). And if the S&P 500’s dividends were included, the index’s return from October 1987 to today would have been around 10% per year, based on Shiller’s data.

The second point is that we need to separate business performance – especially long-term business performance – from stock price movements when investing. As I just mentioned, US businesses were growing (in the form of higher EPS) despite Black Monday’s occurrence, and continued to grow over the long run. Yesterday night’s 7.6% fall in the S&P 500 was driven by a slew of factors, with one of them being fears related to the new coronavirus, COVID-19. I described some of the virus’s negative impacts on business conditions worldwide in a recent article:

“Global corporate giants such as Apple, Visa, and Mastercard have warned of pressures to their businesses because of COVID-19 (see here, here, and here). Airlines are some of the worst-hit groups of companies, with UK airline Flybe entering bankruptcy earlier this month; last week, Southwest Airlines in the US warned of a “very noticeable, precipitous decline in bookings.” In China, the PMI (purchasing managers’ index) for February 2020 came in at 35.7, the lowest seen since tracking began in 2004 (a reading below 50 indicates a contraction in factory activity). In 2008 and 2009, during the height of the Great Financial Crisis, China’s PMI reached a low of 38.8. ”

So yes, there’s a very real threat to the short-term health of many businesses because of COVID-19. But will the virus have any lasting negative consequences over the long run? It’s possible, but I think it’s unlikely. I’m not alone. During an interview with CNBC late last month, billionaire investor Warren Buffett shared his thoughts on how investors ought to be dealing with COVID-19. He said (emphasis is mine):

“Look, the tariff situation was a big question market for all kinds of companies. And still is to some degree. But that was front and center for a while. Now coronavirus is front and center. Something else will be front and center six months from now and a year from now and two years from now. Real question is — where are these businesses gonna be five and ten and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well — you know, it has since 1776…

…We’ve got a big investment in airline businesses and I just heard even more flights are canceled and all that. But flights are canceled for weather. It so happens in this case they’re gonna be canceled for longer because of coronavirus. But if you own airlines for 10 or 20 years you’re gonna have some ups and down in current. And some of them will be weather related and they can be all kinds of things. The real question is you know, how many passengers are they gonna be carrying 10 years from now and 15 years from now and what will margins be and– what will the competitive position be? But I still look at the figures all the time — I’ll admit that…

…[Coronavirus] makes no difference in our investments. There’s always gonna be some news, good or bad, every day. In fact, if you go back and read all the papers for the last 50 years, probably most of the headlines tend to be bad. But if you look at what happens to the economy, most of the things that happen are extremely good. I mean, it’s incredible what will happen over time. So if somebody came and told me that the global growth rate was gonna be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price at which — and I like the prices better today than I liked them last Friday…

… We’re buying businesses to own for 20 or 30 years. We buy them in whole, we buy them in part. They’re called stocks when we buy in part. And we think the 20- and 30-year outlook is not changed by coronavirus.”

But not every company is facing the same level of long-term risk because of COVID-19. Some companies are at higher risk of failing or having their health permanently impaired. These are companies with debt-laden balance sheets, lumpy revenues, and an inability to generate healthy free cash flows. Such companies have always faced a higher level of existential risk compared to companies with healthy balance sheets (that have minimal or reasonable levels of debt), recurring revenues, and strong free cash flows. But COVID-19 has raised even more questions on the survivability of the former group because of the intense short-term hit to business conditions worldwide.

We always need to tread carefully with the types of companies we invest in – more so today. But there’s no need to panic. Fear could be the biggest contributor to our investing-losses, even more than actual risks.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

I started a recent article with the sentence: “It’s an understatement to say that stocks have been volatile of late.”

From 14 February 2020 to 8 March 2020, the S&P 500 in the US has declined by 12.1%. I mention the US stock market because it is by far the largest in the world. I’ve never thought it makes sense to find reasons for the short-term movements of stock prices. But I think it’s pretty clear that the coronavirus, COVID-19, is the key reason for the declines seen in recent days.

The number of people who are infected with COVID-19 has been rising significantly, with the death toll tagging along. The virus is also making its way into more countries over time.

Global corporate giants such as Apple, Visa, and Mastercard have warned of pressures to their businesses because of COVID-19 (see here, here, and here). Airlines are some of the worst-hit groups of companies, with UK airline Flybe entering bankruptcy earlier this month; last week, Southwest Airlines in the US warned of a “very noticeable, precipitous decline in bookings.” In China, the PMI (purchasing managers’ index) for February 2020 came in at 35.7, the lowest seen since tracking began in 2004 (a reading below 50 indicates a contraction in factory activity). In 2008 and 2009, during the height of the Great Financial Crisis, China’s PMI reached a low of 38.8.

We’re clearly in an environment now where stocks are volatile and the world is grappling with a public health crisis and recessionary fears. Many of you are likely wondering what you should be doing now with your investment portfolios. If you invest in stocks, I think there are five questions you should always ask yourself. But they are even more prominent now given the current situation:

1. What is my investing time horizon? If you’re investing in stocks with capital you need within the next five years, it’s always dangerous to do so. The danger is amplified given the current situation. Stocks are volatile over the short run, sometimes without reason. But over the long run, stock prices reflect business fundamentals and have delivered great returns.
2. Do I have a sound investment framework? An investment framework guides the way you select your investments. I have my own personal criteria to find businesses that can grow at high rates over a long period of time. It has served me well for nearly a decade. But that’s not the only way to invest. Do you have a framework that is based on sound investing logic? If you don’t, it’s always a dangerous time to invest – doubly so, now.
3. Do I have a sound investing plan? An investing plan is like an investing schedule – it guides us on when we put money to work in stocks. Some investors prefer a dollar-cost-averaging strategy, where a certain amount of capital is invested in stocks at regular intervals. That’s fine. Some prefer to be fully-invested at all times. There are also others who prefer to have a cash cushion that they will deploy depending on the magnitude of the market’s decline. These are all fine too. There are two crucial aspects to an investing plan: (1) Does it fit our temperament; and (2) does it make investing sense? If the first aspect fails, it does not matter how good our plan is – we will not stick to it. The second aspect is important for self-explanatory reasons. 
4. Do I have a basic understanding of market history? Knowing what has happened in the past can give us context for what to expect next. It can also prevent us from panicking when stocks decline. Some critical information to know include: (1) How often do stocks decline? (2) How have stocks performed over the long-term through recessions? (3) Are short-term declines common even when stocks climb over the long run? I have shared these things before and they can be found here and here.
5. Do I understand my own investing temperament? How we react to market declines can have a tremendous impact on our returns as investors. The investors of legendary fund manager Peter Lynch made only 7% per year despite him producing an incredible annual return of 29% for 13 years; that’s because Lynch’s investors had poor temperament, selling quickly whenever there was a short-term decline in his fund. If you know you have a poor investing temperament, then set up an investing plan that can save you from yourself.

These questions won’t guarantee that you will come out ahead when the COVID-19 crisis blows over. But I’m sure they’ll greatly increase your chances of success.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

It’s an understatement to say that stocks have been volatile of late. This is what the S&P 500 in the US has done since last Monday:

• 24 Feb 2020: -3.4%
• 25 Feb 2020: -3.0%
• 26 Feb 2020: -0.4%
• 27 Feb 2020: -4.4%
• 28 Feb 2020: -0.8%
• 2 Mar 2020: +4.6%
• 3 Mar 2020: -2.8%
• 4 Mar 2020: 4.2%

And at the time of writing (10:00 pm, 5 Mar 2020 in Singapore), the S&P 500 is down by 2.8%. Deutsche Bank analyst Torsten Slok said last Friday that the speed of the S&P 500’s decline “is historic.” Many are surprised by the ferocity of the recent fall in US stocks.

It’s oh so common

Given the current state of affairs, I think it’s an apt time as any to revisit an important fact about stocks: Declines and volatility are common. I wrote recently:

“Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century.”

At this point, some of you may be wondering: Why are market crashes so common? This is what I want to discuss in this article too. For an answer, we’ll need to turn to the late Hyman Minsky.

Stability is destabilising

Minsky was an economist. He wasn’t well known when he was alive, but his views on why an economy goes through boom-bust cycles are thought-provoking and gained prominence after the 2008-2009 financial crisis.

In essence, Minsky theorised that for an economy, stability itself is destabilising. I first learnt about him, and how his ideas can be extended to the stock market, a few years ago after coming across a Motley Fool article written by Morgan Housel. Here’s how Housel describes Minsky’s framework:

“Whether it’s stocks not crashing or the economy going a long time without a recession, stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.

It pretty much has to be this way. If there was no volatility, and we knew stocks went up 8% every year [the long-run average annual return for the U.S. stock market], the only rational response would be to pay more for them, until they were expensive enough to return less than 8%. It would be crazy for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned the same amount as FDIC-insured savings accounts, which is about 0%.

But there are no guarantees—only the perception of guarantees. Bad stuff happens, and when stocks are priced for perfection, a mere sniff of bad news will send them plunging.”

In other words, great fundamentals in the stock market (stability) can cause investors to take risky actions, such as pushing valuations toward the sky or using plenty of leverage. This plants the seeds for a future downturn to come (the creation of instability).

Why bother?

Some of you may now be thinking: if stocks are prone to exhibit boom-bust behaviour, why bother at all with long-term investing? Because of this:

I mentioned earlier that US stocks had frequently crashed from 1928 to 2013. The chart just above shows how the US market performed over the same period after adjusting for dividends and inflation. It turns out that the S&P 500 gained 21,000%, or 6.5% per year. Remember, that’s a 6.5% annual return, after inflation, for 85 years. Sharp short-term declines were seen, but there’s a huge long-term gain at the end.

Then there’s also this:

The US e-commerce giant Amazon (which is in my family’s investment portfolio) was a massive long-term winner from 1997 to 2018, with its share price rising by more than 76,000% from US$1.96 to US$1,501.97. But in the same timeframe, Amazon’s share price also experienced a double-digit top-to-bottom fall in every single year (the declines ranged from 13% to 83%). Again, sharp short-term declines were seen, but there’s a huge long-term gain at the end.

Missing the good times

Here’s another thought some of you may now have (I’m not psychic, trust me!): Why can’t we just side-step all the big downward moves and invest when the clouds have cleared? Wouldn’t this make the whole investing experience more comfortable?

Yes, you may be more comfortable, but you’re very likely going to earn much lower returns.

Dimensional Fund Advisors, a fund management company with more than US$600 billion in assets under management, shared the following stats in an article:

• $1,000 invested in US stocks in 1970 would become $138,908 by August 2019
• Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763

So, missing just a handful of the market’s best days will absolutely decimate our return. Unfortunately, the market’s best and worst days tend to cluster, as seen in the table below from investor Ben Carlson. As a result, it’s practically impossible to side-step the bad days and capture only the good days. To earn good returns in stocks over the long run, we have to accept the inevitable bad times.

Don’t be scared

Markets will crash from time to time. It’s something we have to get used to. Wharton finance professor Jeremy Siegel once said that “volatility scares enough people out of the market to generate superior returns for those who stay in.” So don’t be scared. And please don’t attempt to flit in and out of your shares – patience is what ends up paying in investing.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Stock markets around the world have fallen in recent times. For instance, the S&P 500 in the US was down by 6.6% from last Friday (21 February 2020) to Wednesday (26 February 2020). At our home in Singapore, the Straits Times Index has declined by 5.1% from 17 January 2020 to 26 February 2020. 

I hate to attach reasons to short-term market moves. But this time, it’s pretty clear that fears related to COVID-19, the most recently discovered coronavirus that has infected humans on a large scale, are the culprits.

What scares us

These fears exist for good reasons – there could be a global economic downturn in the works. Already, businesses of many large companies around the world have been affected by COVID-19. In the US, these include Apple, Microsoft, and Booking Holdings (which is in my family’s investment portfolio) just to name a few. In Singapore, property giant CapitaLand, airline caterer SATS, and even Temasek Holdings (one of the Singapore government’s investment arms), have enacted pay cuts because of difficult business conditions.

Plenty of human suffering have happened because of COVID-19, and sadly no one knows how widespread the disease outbreak will be. And from an investing angle, I don’t think anyone knows the eventual effects that COVID-19 will have on the global economy and financial markets (you should run from anyone who claims he/she does!).

Lessons from the past

History is not, and will never be, a perfect guide for the future. But in an uncertain time like this, studying the past can give us context and soothe our nerves.

I’m looking mostly at the US stock market and economy, since there is good long-term data for me to work with.

The chart below shows all the recessions (the dark grey bars) in the US since 1871. You can see that recessions in the country – from whatever causes – have been regular occurrences even in relatively modern times. They are par for the course, even for a mighty economy like the US.

The following logarithmic chart shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over the past 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy having encountered numerous recessions. If you’re investing for the long run, recessions can hurt over the short-term, but they’re nothing to fear.

Having an idea of how often stocks have fallen – for whatever reasons – is also useful to put the current mini-meltdown in stocks into perspective. Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century. Over the same period, US stocks have climbed by 283,282% (including dividends), or 9.8% per year. Stocks frequently decline hard even while they’re in the process of earning good long-term returns for investors. So when stocks fall, it’s not a sign that something is broken – it’s just a natural part of the game.

It’s worth noting too that global stocks have registered solid long-term gains despite multiple occurrences of deadly disease outbreaks in the past. This is shown in the following chart:

Some of you might be thinking: Now that there’s a heightened risk of a global recession, should we try to time the stock market? I don’t think so. Why? Look at the chart below. The red line shows the return we could have earned from 1980 to today in the US stock market if we had sold stocks at the official start of a recession in the country and bought stocks at the official end. The black line illustrates our return if we had simply bought and held US stocks from 1980 to today. It turns out that completely side-stepping recessions harms our return significantly, so it could be better to stay invested for the long run.

This does not mean we should stay invested blindly. Companies that currently are heavily in debt, and/or have shaky cash flows and weak revenue streams are likely to run into severe problems if there’s an economic downturn. If a global recession really happens, and our portfolios are full of such companies, we may never recover. It’s always a good time to re-evaluate the companies in our portfolios, but I think there’s even more urgency to do so now.

A sage’s wise words

I want to leave the final words in this article to Warren Buffett. In an interview with CNBC earlier this week, the Oracle of Omaha shared his thoughts on how investors ought to be dealing with COVID-19. He said (emphasis is mine):

“Look, the tariff situation was a big question market for all kinds of companies. And still is to some degree. But that was front and center for a while. Now coronavirus is front and center. Something else will be front and center six months from now and a year from now and two years from now. Real question is — where are these businesses gonna be five and ten and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well — you know, it has since 1776…

…We’ve got a big investment in airline businesses and I just heard even more flights are canceled and all that. But flights are canceled for weather. It so happens in this case they’re gonna be canceled for longer because of coronavirus. But if you own airlines for 10 or 20 years you’re gonna have some ups and down in current. And some of them will be weather related and they can be all kinds of things. The real question is you know, how many passengers are they gonna be carrying 10 years from now and 15 years from now and what will margins be and– what will the competitive position be? But I still look at the figures all the time — I’ll admit that…

…[Coronavirus] makes no difference in our investments. There’s always gonna be some news, good or bad, every day. In fact, if you go back and read all the papers for the last 50 years, probably most of the headlines tend to be bad. But if you look at what happens to the economy, most of the things that happen are extremely good. I mean, it’s incredible what will happen over time. So if somebody came and told me that the global growth rate was gonna be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price at which — and I like the prices better today than I liked them last Friday…

… We’re buying businesses to own for 20 or 30 years. We buy them in whole, we buy them in part. They’re called stocks when we buy in part. And we think the 20- and 30-year outlook is not changed by coronavirus.”

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Since the start of 2010, the US stock market – as measured by the S&P 500 – has nearly tripled, from 1,124 points to more than 3,300. This meteoric rise in US stock prices has prompted plenty of commentary within the investment community on its underlying drivers.

A frequent “culprit” cited is the Federal Reserve in the US. Many investors and market commentators have blamed the US central bank for driving stock prices higher because of its interest rate policy (of keeping rates low) and quantitative easing (the act of pumping money into the economy via the purchase of mostly government-related financial assets).

I have rarely seen this being talked about:

The chart above is plotted with data from Nobel Prize-winning economist, Robert Shiller. It shows changes in the S&P 500’s price, dividends, and earnings since the start of 2010. Over the past decade, all three numbers have basically increased hand-in-hand. Put another way, the meteoric rise in the S&P 500 I mentioned earlier could be explained by a similarly big jump in the fundamentals of American businesses. 

I was inspired to plot my chart after I came across the following tweet by Morgan Housel, one of my favourite finance writers:

Why the market went up. pic.twitter.com/sLpAUF9nfl— Morgan Housel (@morganhousel) February 23, 2020

Housel’s chart showed that the S&P 500’s price and its dividends have climbed in lock-step since 2010. This suggests that the US market had been driven higher because of improvements in its underlying business fundamentals. But I was curious to know if the increase in dividends is sustainable. This is why I plotted my own chart which included earnings growth. Turns out, there has been a commensurate increase in earnings for the US market. The S&P 500 has done what Warren Buffett wrote in his 2018 Berkshire Hathaway shareholders’ letter:

“On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance.”

None of the above is meant to say that the S&P 500 will continue climbing over the next year, or the next 10 years. Over the short run, sentiment can change on a dime; a rise in investors’ pessimism over the future – whether warranted or unwarranted – will drag stock prices lower. Over the long run, if the rise in earnings for US businesses in the past was unsustainable, then there could be a collapse in the S&P 500 in the future.

But what we do know now is that there is a very good reason why US stocks prices have grown so much over the past decade – their businesses have done very well too.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Here’s a common misconception I’ve noticed that investors have about the stock market: They think that it’s easy to figure out when stocks will hit a peak. Unfortunately, that’s not an easy task at all.

In a 2017 Bloomberg article, investor Ben Carlson showed the level of various financial data that were found at the start of each of the 15 bear markets that US stocks have experienced since World War II:

The financial data that Carlson presented include valuations for US stocks (the trailing P/E ratio,  the cyclically adjusted P/E ratio, and the dividend yield), interest rates (the 10 year treasury yield), and the inflation rate. These are major things that the financial media and many investors pay attention to. (The cyclically-adjusted P/E ratio is calculated by dividing a stock’s price with the 10-year average of its inflation-adjusted earnings.)

But these numbers are not useful in helping us determine when stocks will peak. Bear markets have started when valuations, interest rates, and inflation were high as well as low. This is why it’s so tough to tell when stocks will fall.

None of the above is meant to say that we should ignore valuations or other important financial data. For instance, the starting valuation for stocks does have a heavy say on their eventual long-term return. This is shown in the chart below. It uses data from economist Robert Shiller on the S&P 500 from 1871 to 2019 and shows the returns of the index against its starting valuation for 10-year holding periods. It’s clear that the S&P 500 has historically produced higher returns when it was cheap compared to when it was expensive.

But even then, the dispersion in 10-year returns for the S&P 500 can be huge for a given valuation level. Right now, the S&P 500 has a cyclically-adjusted P/E ratio of around 31. The table below shows the 10-year annual returns that the index has historically produced whenever it had a CAPE ratio of more than 25.

If it’s so hard for us to tell when bear markets will occur, what can we do as investors? It’s simple: We can stay invested. Despite the occurrence of numerous bear markets since World War II, the US stock market has still increased by 228,417% (after dividends) from 1945 to 2019. That’s a solid return of 11.0% per year. Yes, bear markets will hurt psychologically. But we can lessen the pain significantly if we think of them as an admission fee for worthwhile long-term returns instead of a fine by the market-gods.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Having a good framework to find investment opportunities in the stock market is important. But it’s equally important – perhaps even more important – to have the right mindsets. Without them, it’s hard to be a successful investor even if you have the best analytical mind in the world of finance.

There are six key mindsets that have served me well in my investing activities in the stock market, both on a personal as well as professional basis. I want to share them in this article. 

The first mindset

Here’s a chart showing the maximum peak-to-trough decline for Amazon’s share price in each year from 1997 to 2018:

It turns out that Amazon’s share price had experienced a double-digit top-to-bottom fall (ranging from 13% to 83%) in every single year from 1997 to 2018. Looks horrible, doesn’t it?

Now here’s a chart showing Amazon’s share price from 1997 to 2018:

The second chart makes it clear that Amazon has been a massive long-term winner, with its share price rising by more than 76,000% from US$1.96 in 1997 to US$1,501.97 in 2018. Amazon does not look so horrible now, does it?

The experience of the e-commerce giant is why Peter Lynch, the legendary fund manager of Fidelity Magellan Fund, once said:

“In the stock market, the most important organ is the stomach. It’s not the brain.”

We need the stomach to withstand volatility, the violent ups-and-downs of share prices. As Amazon has shown, even the best long-term winners in the stock market have suffered from sharp short-term declines. 

This is why accepting that volatility in share prices is a feature of the stock market and not a bug is a very important mindset for me. When stocks go up and down, it’s not a sign that something is broken. In fact, there’s actually great data to prove that volatility in share prices do not tell us much about how the underlying businesses are doing.

Robert Shiller is an economist who won the Nobel Prize in 2013. In the 1980s, Shiller looked at how the US stock market performed from 1871 to 1979. He compared the market’s actual performance to how it should have rationally performed if investors had hindsight knowledge of how the dividends of US stocks would change. Here’s the chart Shiller plotted from his research:

The solid black line is the stock market’s actual performance while the black dashed line is the rational performance. The fundamentals of American businesses – using dividends as a proxy – was much less volatile than American share prices. 

The second mindset

We cannot run from the fact that we humans are emotional creatures. When share prices fall – even with the knowledge that volatility is merely a feature in the stock market – it hurts. And when it hurts, that’s when we make stupid mistakes.

From 1977 to 1990, Peter Lynch earned an annual return of 29% for Fidelity Magellan Fund, turning every thousand dollars invested with him into $27,000. It is this performance that made Lynch a legend in the investing business. But shockingly, the average investor in his fund made only 7% per year – $1,000 invested with an annual return of 7% for 13 years would become just $2,400.

In his book Heads I Win, Tails I Win, Spencer Jakab, a financial journalist with The Wall Street Journal, explained why this big performance-gap happened:

“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.

He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”

In essence, investors in Fidelity Magellan Fund had bought high and sold low. That’s a recipe for poor returns, born out of our emotional reactions to the stock market’s volatility.

I think there’s a great way for us to frame how we think about volatility so that we can minimise its damage. This was articulated brilliantly by Morgan Housel in a recent blog post of his (emphasis his): 

“But a reason declines hurt and scare so many investors off is because they think of them as fines. You’re not supposed to get fined. You’re supposed to make decisions that preempt and avoid fines. Traffic fines and IRS fines mean you did something wrong and deserve to be punished. The natural response for anyone who watches their wealth decline and views that drop as a fine is to avoid future fines.

But if you view volatility as a fee, things look different.

Disneyland tickets cost $100. But you get an awesome day with your kids you’ll never forget. Last year more than 18 million people thought that fee was worth paying. Few felt the $100 paid was a punishment or a fine. The worthwhile tradeoff of fees is obvious when it’s clear you’re paying one.

Same with investing, where volatility is almost always a fee, not a fine.

Returns are never free. They demand you pay a price, like any other product. And since market returns can be not just great but sensational over time, the fee is high. Declines, crashes, panics, manias, recessions, depressions.”

This is why my second mindset is this: Instead of seeing short-term volatility in the stock market as a fine, think of it as a fee for something worthwhile – great long-term returns.

You might be thinking: Is the fee really worth paying? We saw the case of Amazon earlier, where the fee was definitely worth it. Thing is, the point I made about Amazon can actually be applied to the broader US market too.

A few years ago, Housel wrote an article for The Motley Fool that showed how often the US stock market – represented by the S&P 500 – had fallen by a certain percentage from 1928 to 2013. Here’re the results:

It’s clear that US stocks have declined frequently. But data from Robert Shiller also showed that the S&P 500 was up by around 21,000% from 1928 to 2013 after factoring in dividends and inflation. That means every $1,000 invested in the S&P 500 in 1928 would become $210,000 in 2013 after inflation. The S&P 500 has charged investors an expensive entry fee (in the form of volatility) for a magical show.

The third mindset

A common misconception I encounter about the stock market is that what goes up must come down. Yes it’s true that there’s cyclicality with stocks. But an important point is missed: Stocks go up a lot more than they go down. We’ve seen that with Amazon and with the S&P 500. Now let’s see it with stocks all over the world.

The chart above plots the returns of the stock markets from both developed and developing economies over more than 110 years from 1900 to 2013. In that timeframe, stocks in developed economies (the blue line) produced an annual return of 8.3% while stocks in developing economies (the red line) generated a return of 7.4% per year. There are clearly bumps along the way, but the long run trend is crystal clear.

So the third key mindset I have when investing in the stock market is that what goes up, does not always come down permanently. But there is an important caveat to note: Diversification is crucial.

The fourth mindset

Devastation from war or natural disasters. Corrupt or useless leaders. Incredible overvaluation at the starting point. These are factors that can cause a single stock or a single country’s stock market to do poorly even after decades. 

We can study a company’s or country’s traits to understand things like valuations and the quality of the leaders. But there’s pretty much nothing we can do when it comes to catastrophes caused by mankind or Mother Nature. 

This is why my fourth mindset is the importance of diversifying our investments across both geographies and companies. 

The fifth mindset

We’re living in uncertain times. Toward the end of 2019, China alerted the World Health Organisation (WHO) about cases of pneumonia amongst its citizens that were caused by an unknown virus. That was the start of what we know today as COVID-19. Many countries in the world – including our home in Singapore – are currently battling to keep their citizens safe from the disease. When faced with uncertainty, should we still invest?

How do you think the US stock market will fare over the next five years and the next 30 years if I tell you that in this year, the price of oil will spike, and the US will simultaneously go to war in the Middle East and experience a recession? We don’t need to guess, because history has shown us.

The events I mentioned all happened in 1990. The price of oil spiked in August 1990, the same month that the US went into an actual war in the Middle East. In July 1990, the US entered a recession. Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.

What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table below – constructed partially from Morgan Housel’s data – illustrates. Yet, the S&P 500 has steadily marched higher.

Earlier, I talked about COVID-19. I think it would be appropriate to also show how global stocks have done after the occurence of deadly epidemics. 

My blogging partner, Jeremy, included the chart just above in a recent article. It illustrates the performance of the MSCI World Index (a benchmark for global stocks) since the 1970s against the backdrop of multiple epidemics/pandemics that have happened since. He commented:

“As you can see from the chart… the world has experienced 13 different epidemics since the 1970s. Yet, global stocks – measured by the MSCI World Index – has survived each of those, registering long term gains after each outbreak.”

So I carry this important mindset with me (the fifth one): Uncertainty is always around, but that does not mean we should not invest.

The sixth mindset

We’ve seen in the data that market crashes and recessions are bound to happen periodically. But crucially we don’t know when they will occur. Even the best investors have tried to outguess the market, only to fail. 

So if we’re investing for many years, we should count on things to get ugly a few times, at least. This is completely different from saying “the US will have a recession in the third quarter of 2020” and then positioning our investment portfolios to fit this view.

The difference between expecting and predicting lies in our behaviour. If we merely expect downturns to happen from time to time while knowing we have no predictive power, our investment portfolios would be built to be able to handle a wide range of outcomes. On the other hand, if we’re engaged in the dark arts of prediction, then we think we know when something will happen and we try to act on it. Our investment portfolios will thus be suited to thrive only in a narrow range of situations – if things take a different path, our portfolios will be on the road to ruin.

Here’s an interesting thought: If we can just somehow time our stock market entries and exits to coincide with the end/start of recessions, surely we can do better than just staying invested, right?

The chart below is from investor Michael Batnick. The red line shows the return we could have earned from 1980 to today in the US stock market if we had sold stocks at the official start of a recession in the country and bought stocks at the official end. The black line illustrates our return if we had simply bought and held US stocks from 1980 to today. It turns out that completely side-stepping recessions harms our return significantly.

This is why my sixth mindset is that we should expect bad things to happen from time to time, but we should not try to predict them.

In conclusion

To recap, here are the six mindsets that have been very useful for me:

• First, volatility in stocks is a feature, not a sign that something is broken
• Second, think of short-term volatility in the stock market as a fee, not a fine
• Third, what goes up does not always come down permanently
• Fourth, it is important to diversify across geographies and companies
• Fifth, uncertainty is always around, but we should still invest
• Sixth, we should expect bad things to happen from time to time in the financial markets, but we shouldn’t try to predict them

They have helped me to be psychologically comfortable when investing. Without them, I may become flustered when things do not go my way temporarily or when uncertainties are rife. This could in turn result in bad investing behaviour on my part. I hope these mindsets can benefit you too.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.