Who’s afraid of the market highs?

Wall Street bull, New York, New York LCCN2011630801
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.

Chart showing growth of $10,000 at a CAGR of 10% reaching $67,275 over twenty years' time.

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 slowย 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.

Growth of $10,000 invested in VFINX, an S&P 500 fund, in 1980 showing a final balance of $400,000.

$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.

Summary

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.

Obviously.


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.

16 thoughts on “Who’s afraid of the market highs?”

  1. it is scary to buy in times of market highs like we are seeing. but history will tell you that this happens over and over. market highs become a “new record” all the time. It doesn’t take long (years) for the old record to be broken. Over time, 10-20 years the stock market we have now will be small compared to the future stock market.

    1. Hi BHL,
      Exactly. Stocks are for the long-term. It’s okay to lock in some gains at market highs in the form of rebalancing if it’s due to a strategy, but it should never be because of some new headline in the news.
      Thanks for your comment!
      -DL

    1. Hi DM,
      For sure. I’d much rather that the stock market dropped in value than kept climbing since I’m still in the accumulation stage. It’s just that a record market high isn’t all that “newsworthy” in my mind. We adjust to the higher values and move on.
      I appreciate your comment, thank you!
      Best wishes,
      -DL

  2. Great Piece DL!!!
    What can I say apart from the fact that I totally agree? Investors are the heart of the problem of course, there are many people who invest and do not have any information on how things go, this means faster growth rates when things are great and terrible pitfalls when the next Twit hits public opinion in the wrong way… The conclusion is solid. Stick to the plan.
    Ciao ciao
    Stal

    1. Hey Stal,
      Thanks, and I totally agree with your comment ๐Ÿ™‚
      I can certainly understand that, after being continually told about the next correction that’s ‘due’, people might consider a new market high to be ‘the last one before the fall’. But it’s best to just follow the plan as you say.
      Cheers,
      -DL

  3. DL,

    I understand the math, however, I’m still a little hesitant. What are your thoughts on contributing slightly less than usual to your holdings and holding a little more in cash due to uncertain conditions? As the saying goes, and I’m paraphrasing, when everyone is thinking something, it might be best to consider the opposite.

    Erik

    1. Hi Erik,
      Good question! Buying is a different aspect, I was really just focusing on the “not selling” part in this post.

      Typically you consider all your ‘investment’ portfolio as one big account and say something like “I want 20% of my investments in cash / bonds; the other 80% in stocks / stock funds”. And if the percentages get too far out of whack you sell the one that’s too high and buy more of the one that’s too low. Usually this isn’t done too often (say once a year). Conversely, when there’s a stock market crash, the cash/bond percentage will be higher and you can use some of that to buy lower priced shares and restore the balance.

      But each month , if the market is going up stocks will typically grow faster than say the cash /bonds. So maybe the allocation is slowly changing from 20:80 to 18:82. In that case, whenever you have new money to invest you can simply direct proportionately more of new money into the “lower performing” asset. Which, in the case you mention would essentially be “saving cash”.

      So it’s not at all wrong to “buy less due to buying something else” when the market is high, just that normally it’s a result of your target asset allocation. But as an extreme example, thinking that “the market is high so I’m going to buy only cash / bonds this year” can result in a change to your target asset allocation as well as your actual asset allocation, which is not a good approach.

      Best wishes,
      -DL

    1. Hi DIB,
      I’m glad you found it useful! How are you being influenced by the market highs at the moment?
      Best wishes,
      -DL

  4. I find it interesting that for each of the bubbles the higher above the CAGR it went the more it dropped below when they crashed. Given that how much will the next “reversion to the mean” be? It is fun to watch and won’t stop me from investing in good companies.
    Happy new year DL,
    DFG

    1. Hi DFG,
      Yes it seems that the market is much more volatile. Maybe it’s all the instant communication / 24 hour news cycle that causes such reactions. Either way, I’m still buying monthly like you, and if there’s a correction then I’ll be getting even more value for my money.
      Thanks for stopping by,
      Best wishes,
      -DL

  5. For an average investor buying at market lows can be just as scary as buying at market highs. Actually it’s a good indication of a market high when everyone is buying no matter what.
    You said right: Just disregard the headlines and stick to your strategy. The rest will come over time.
    I like the quote ๐Ÿ™‚

Leave a Reply

Your email address will not be published. Required fields are marked *