Whether we like it or not, we investors are always making bets. We invest our capital with the expectation that down the road we will be able to recover all of it plus some. But since the future is unknowable, we implicitly make a bet every time we invest.
Specifically, investors make bets on future returns of the stock market. If I invest X dollars for Y number of years, what are my odds of making a profit? And how much profit? The time period is very significant here. Without knowing specific duration of the bet, our odds would be all over the place. For instance, a one-year prediction has very different odds than a five-year one. In technical terms, the scope of our prediction is its time period.
Philip Tetlock in his excellent book Superforecasting talks about this scope sensitivity of predictions. His super-forecasters—those who excelled in making good predictions—tend to be very scope sensitive. He considers it a hallmark of a good forecaster.
To understand this by way of an example, let’s say you are estimating odds that the Dallas Cowboys would win Super Bowl this year? You assign a number to it. Now let’s say you are asked a slightly different question: Are the Dallas Cowboys going to win a Super Bowl in the next five years? All else being equal, the team’s chances of winning a championship during the next five years ought to be higher. If you didn’t assign it higher odds then you are neglecting the scope of your prediction. It’s called scope neglect.
In the same vein, what is the probability that I as an investor in the stock market can achieve positive return in one year? Or in five years? Or ten?
If I were thinking that the odds would be the same regardless of how long my capital stay invested, then I’d be wrong. I’d be falling into the same scope insensitivity trap. Stock market history also does not bear this out. On average, stocks go up as the country’s GDP grows. See this post. Stocks are also very volatile over short time periods. So it makes sense that odds of my achieving positive return over next five years ought to be higher than what I could generate over a one year period.
The history of the US stock market is our best guide in assessing odds of successful investing. Here’s some good data taken from Professor Shiller’s web site (http://www.econ.yale.edu/~shiller/data.htm) with stats computed by DQDYJ (https://dqydj.com/sp-500-historical-return-calculator/). I calculated annualized returns for rolling 1-, 5-, and 10-year periods for the S&P 500 index. I broke out the results in three separate tables—one for each period. Here’s the first table with one-year returns. All negative returns are highlighted in red.
Out of total 146 one-year periods of the US stock market shown in the table, there were 40 periods where investor returns were negative. That amounts to a loss probability of about 27%. Also, an investor could have lost up to 39% of his capital in just one year.
Now compare it with five-year returns shown in this table.
You can see how negative returns had dropped considerably. Only 15 out of 144 five-year periods resulted in a loss. And the worst-case return was better than negative 3% annualized.
This next table is for rolling 10-year periods.
Since the World War II, the US market only had two rolling 10-year periods where overall returns were negative. That occurred during the Great Financial Crisis of 2007-2008. Two years ago, I wrote a blog post on this so-called lost decade and showed how investors could still have made money in that period if they were patiently investing every year. See this: Revisiting the lost decade of US stocks.
Now let’s imagine a scenario: An investor considers investing his yearly savings into the US stock market. He’s given a special coin that he flips once a year to determine what returns he’d get for the following year. Heads, he makes a profit. Tails, he loses a portion of his capital. This coin is special though. It does not have a 50-50 chance of landing heads. Instead, this loaded coin lands tails up only 27% of the time (about one in four) – causing loss to the investor. Further, this loss could be as high as 39% in a year.
If you were this investor, would you invest this way with your savings? I wouldn’t. 27% chance of a loss is lot better than 50-50 of a fair coin but coupled with the possibility of up to 39% loss in a given year, it’s just not worth taking that level of risk with my hard-earned savings.
Let’s do another scenario: Here, an investor would again be giving a chance once a year to invest. But this time, his money will be locked up for five years, with no possibility of early withdrawal. Return for the locked-up period would again be determined by a special coin. This coin is even more biased in the investor’s favor with 90% chance of landing heads and therefore profits. Moreover, if/when this coin lands tails, worst-case annualized loss would only be 2.66%. Even though the money would be locked up for five years, but a coin flip will take place every year since this investor is saving new money every year.
Would you play this game with your money? I would, by all means. The odds are stacked in my favor. Not only that I win 9 out of 10 coin tosses but even bad coin landings result in modest losses. Of course, I’d be careful in investing only the money that can stay locked up for five years. If I play this game long enough, any losses I incur in those unlucky five-year periods would be more than compensated by my winning periods.
This is why I do not ever invest my capital for less than five years. And most of the time, even longer. My chances of achieving positive returns are much higher over longer time periods. In previous blog posts, I have written extensively about my minimum five-year holding period: here and here. There is only a small chance of a loss in any given five-year period. I can keep investing new money in stocks every year and hold on for five years. I might not make money in some of those rolling five-year periods, but I will more than make up for it in other periods.
Successful professional investors also prefer longer time duration for their stock positions. For instance, Barron’s recently profiled Diamond Hill Large Cap (DHLAX) fund performance. This fund has handily beaten the Russell 1000 Value index and its large value category peers over a one-, three-, five-, and 10-year time frame. Barron’s says this about its fund managers:
When researching companies with their team of analysts, Bath and Hawley look at incremental returns on capital and the potential growth of that investment over time, with the plan to keep the stock at least over the next five years. [Emphasis added]
Along the same lines, we can also consider ten-year locked-up scenario where the coin would land favorably 98% of the time. You see where I am going with this. I am just applying the odds from previous tables. These odds are based on actual US stock market returns over the last 150 years. The longer my locked-up period, the higher my odds of profitable outcome.
This in a nutshell is what long-term patient investing is all about. It’s long-term because we investors need to give ourselves time to flip the proverbial coin many many times over. And we need to stay patient because our capital will be “locked up” for the period we choose.
As you probably already guessed, in real world there is no enforcement of this lock-up period. I shared some real-life stats in a previous blog post here. Newbie investors often fail in enforcing this patient lock-up period mindset in their investing. By some measures, even experienced investors sometimes fall into this trap—panicking and withdrawing early when the market turns lower.
It would be great if we could discipline ourselves to stay put in good or bad times. Especially in bad times. And keep flipping that loaded coin.