If I had a penny for every time I’ve heard about the Dow 20,000 for the last couple of months, I’d probably have about $2.47. And I would promptly invest it back in the stock market. But what’s all the fuss about record market highs and should we be worried? Having asked that question, I thought I’d better answer it. So, fasten your seatbelt because we’re going up, up and away!
Stating the Obvious
I’m told it’s rude to start a sentence with “Obviously”. Apparently that makes too much of an assumption about the reader, so I’ll refrain. Instead I’ll start by stating that if you’ve read any dividend investing blog, you’ll have come across Compound Interest and its ever-increasing, wealth-generating, general awesome-ness.
It’s a financial perpetual motion machine. Interest earned on money, if re-invested, earns even more interest, which if re-invested, events even more interest, which if re-invested earns even more interest…well I think you get the picture. There is a reason Einstein called it the eighth wonder of the world, after all.
In financial growth terms, it’s usually written as “CAGR” since Compound Annual Growth Rate is too long. This is the average percentage which is added to the total every year. So $10,000 which grows at a CAGR of 10% grows to $11,000 in the first year. In the second year that $11,000 grows another 10% to $12,100. In twenty year’s time, that would result in $67,275 as shown below with a little help from my friend, Buzz.
Historically, stock prices have increased over the long-term. In fact it’s probably true to say that the stock market has an innate nature to increase because it’s a reflection of the value / size of the companies in the economy.
Company growth is typically driven by more consumption of products, which partly comes from a larger population of people hungry for those products. Expensive market campaigns and strong brands help of course, but population growth provides new customers even if the market is saturated.
So, given an ever increasing world population, there’s a natural pressure on the stock market to go up. That means new market highs.
The trouble with averages
Growth isn’t always constant, however. Wars, natural disasters, complicated banking derivatives, poor mortgage loans or <insert future calamity here> can all reverse or slow growth. But on average, over a long period, stock prices will go up.
Here’s a fun fact. Half of your friends are below average. The next time you’re having dinner with three friends, you can decide who is above average. Now, this is a mathematical truth since it’s the very definition of average.
Similarly, for stocks to have an “average growth” over a long period of time, there must be periods when it’s growing faster than the average, and periods when it’s growing slower.
It’s important to keep in mind that the “average growth” is a result of the amount of growth and not the driving factor. The stock market doesn’t think “Oh I’ve been growing at 12% for four years now, I’d better go negative for a bit because my average growth has been 10% and I’m out of line.”
The term “reversion to the mean” means exactly that however. Assuming that that average historical growth is (say) 10% and the last three years have grown at 12%, then eventually growth will slow and “revert” back to the historical average. Given a long enough time period, the average should be good enough. Except there’s no guarantee that the historical average is applicable to the future.
What is the average growth rate of the stock market?
Instead of simply stating the average stock market growth rate, I thought I’d generate my own chart using real data instead of hypothetical values from an index. It’s good to channel my inner math geek sometimes.
Here’s how $10,000 would have grown if invested in VFINX back in 1980. VFINX is a low-cost Vanguard fund which tracks the S&P 500. This is the Investor class, it would have been better to buy the Admiral version, VFIAX, if you had $10,000.
$10,000, if invested at the start of 1980 and left untouched with dividends re-invested, would have grown into $398,472.55 at the end of 2016. Not too shabby.
I calculated the average growth / CAGR needed to produce that result. It came out to be 9.95% assuming 252 banking days a year. I’ve shown it in the chart as the black line. But don’t pay too much attention to it since it’s a backward-looking value over the 36 year time-period in question and doesn’t mean anything about the future.
In fact, looking at the black line, it would seem the market has to grow even faster for a while longer since it’s been “under” for the last couple of years. But who knows if 9.95% is the future average. I certainly don’t.
And imagine that it’s 1994 and you’re looking back at the last fourteen years of the market. The average growth from 1980 to 1994 was around 4.2%, not the 10% we see now.
How many market highs have there actually been?
I’m glad you asked that question as I calculated the answer just in case it came up. I really should have been a boy scout, not an engineer.
The grey lines in the chart represent the day that the investment reached a new total return high (not just a new highest share price).
There have been, since 1980, seven hundred and sixty-six days where a new market high was reached in the VFINX investment. That’s 766 days out of 13,512 banking days (about 5%). They’re clustered around periods when the market is increasing as you’d expect.
So what can we take away from all this?
Don’t sell stock just because of the headlines
There’s no ‘guarantee’ that a correction is coming when new market highs are reached. Don’t act based on emotion.
Do rebalance per your strategy
It’s okay to rebalance your portfolio (e.g. sell stock and buy safer assets) if the asset allocation is out of bounds per your defined investing strategy. This should tell you when and how you can rebalance.
In closing, since the stock market has a tendency to increase, record high stock prices should be regularly reached and aren’t to be feared.
Quote of the Day
Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.