Buffett had a good quote about it once that I can't find now, but essentially during most of your life you will be a net buyer of stocks. Only at the end, during your retirement, will you be a net seller and only then will you want high prices.
Until then, the less you pay for your stock purchases, the better your long term gains will be.
Another way of thinking about it is: on average, stock value over the long term (20+ years) is very likely to be in range of, say, 5%/year, plus or minus (actual number is not that important for our purpose here), after adjusting for inflation. If stocks have been on a recent runup, gaining, say, 50% or 100% over a period of a few years, then they are very likely to grow more slowly than average (i.e., revert to the mean) over the coming years. If you buy during period of inflated prices you will realize a lower than average return if you're holding over the long term.
Robert Shiller (Yale finance professor, of Case/Shiller housing index) likes to make the following analogy. Predicting the stock market is basically the opposite of predicting weather. With weather our short-term predictions can be fairly accurate, but our long term predictions are very poor. With the stock market it's the reverse, short-term predictions are worthless, but long term predictions are generally fairly accurate.
> on average, stock value over the long term (20+ years) is very likely to be in range of, say, 5%/year, plus or minus (actual number is not that important for our purpose here), after adjusting for inflation.
The classic explanation is that the economy is growing and thus the overall "pie" being shared is growing even if individual pieces are not as predictable. But I think broader and broader participation in the market via government policies like 401(k) has to be part of the story, and also I worry how much we try to extrapolate from modern financial history which is barely more than a single human lifetime.
William Bernstein has argued pretty well that the growth of economies over the long term has held pretty stable over (surprisingly) the last several hundred years. See his book, "The Birth of Plenty": https://www.amazon.com/Birth-Plenty-Prosperity-Modern-Create...
The keys to economic growth he identifies are (1) property rights, (2) scientific rationalism, (3) capital markets, and (4) adequate transportation/communication. All of these appeared in sufficient form for prosperous growth several hundred years ago.
There is of course no guarantee of continued growth at same rate as last several hundred years. But given the conditions that have prevailed it has settled at a fairly stable rate as sort of a natural law.
This is the real cause of economic growth. The Soviet Union and the People's Republic of China industrialized at only a slightly slower rate then the West, despite not having much in the way of property rights or capital markets.
Without two hundred years of unsustainable consumption of fossil fuels, property rights or capital markets wouldn't have given us a fraction of the economic growth that we got. Stock exchanges don't do much for you when 97% of your population are either subsistance peasants, or make hand-crafted tools used by subsistance peasants, and you have to spend 8 hours a day banging rocks together to stay warm and to scare away mountain lions.
In one sense your question is similar to many others: Why should the sky be blue? Why should gravity at the surface of the earth accelerate objects downward at 9.8 m/s2? Of course, the answer to question of economic growth is more changeable, dependent on societal arrangements that are more likely to change than physical conditions governed by natural laws for the other two questions. But given the economic society we have, 4% or so is the observed stable growth, worldwide.
> they are very likely to grow more slowly than average (i.e., revert to the mean)
I mostly agree with you, but this is basically the gambler's fallacy.
If I'm flipping a coin every second for days, and I hit a run of 10 heads in a row, "reversion to the mean" just means that the next 10 flips are likely to be less extreme than the previous 10. It does not mean that I should expect "more tails than usual" for the next flips. We revert towards the mean, not past it.
No. The gambler's fallacy is when we ascribe dependency to independent events. Stock performance tomorrow is very much NOT independent of stock performance today, e.g. "market correction"
There is a pretty strong empirical support for the random walk hypothesis, the essence of which is that performance tomorrow is independent of performance today.
But shifts in the market aren't independent random events. You can definitely find examples of dramatic, real shifts in valuation but in the vast majority of cases business value is created over time. That rate of growth might be slightly faster or slightly slower, but you can be certain it's within reasonable bounds. So when speculation or scare drives the price higher or lower, you can be sure it will find its way back.
This is the definition of the gambler's fallacy. However, if you look at a chart of the stock market vs. a chart of a coin being flipped many times, they will look very different. While a coin being flipped will either asymptotically trend towards zero or a positive slope of .5 depending upon how it is charted, the stock market will have large peaks and valleys, meaning that after a period of high growth (overvaluation), the market will not continue to value these stocks at a steady growth of 10% per year. Instead, the market will correct the value of these stocks, which looks like a short term undervaluation and so we should expect "more tails than usual".
I recommend you look at the random walk hypothesis, the chart (not the average) of a coin flipped does not trend towards 0 and looks surprisingly similar to stock charts
>> If stocks have been on a recent runup, gaining, say, 50% or 100% over a period of a few years, then they are very likely to grow more slowly than average (i.e., revert to the mean) over the coming years
This is incorrect. Prior performance of the market over the span of years has little to no predictive power on future performance of the market.
Your statement is like saying: Because I flipped a coin and got heads 10 times in a row, I'm more likely to get tails in the future.
While it's true you should expect the market to revert to the mean over the coming years, there's no evidence that it will grow 'more slowly than average' in the coming years to 'make up' for the hyper growth in past years. If you were a betting man (and a non-sophisticated investor), you should bet that the future years will grow at exactly the historical mean.
Edit: I did some analysis on historical S&P 500 pricing to validate my intuition.
On average, the monthly growth rate of the S&P in a month following a bear month is -0.39%
On average, the monthly growth rate of the S&P in a month following a bull month is 1.08%
You might argue that it takes longer than 1 month for the market correction to occur, so I've included the script and data set I used here for you to play around with: https://pastebin.com/F78pLUka. You can use any cadence, and will find the same relationship.
Empirically, you cannot time the market, which implies future growth rate is not affected by past growth rate.
Stock prices aren't the outcome of lotto balls or coin flips. In theory, over the long-run, the price of shares will represent an equilibrium of investors' opinions of the intrinsic value of a company (divided by the number of shares). The intrinsic value is commonly modeled as the net present value of future cash flows plus a discounted terminal enterprise value.
For the same inputs (sequence of future cash flows, enterprise value, and weighted average cost of capital [discount rate]), the long-run value will be the same. If the near-term share price value rises more quickly than the long-run intrinsic value model, it is entirely reasonable to assume future growth of share price will moderate, as it must in order to converge on the same long-run value.
I think it's not at all like your example with 10 coin flips in a row.
There's some truth to the 'random variable' theory.
I think we only value stocks the way described (intrinsic value model) because its a cultural myth to do so. We can also think of stock certificates as baseball cards - of value mostly to other collectors. Sure there's a 'book value' or 'dividend value' behind them, but that's irrelevant most of the time for most stocks.
Absolutely not true. Days of stock market movement aren't independent events, they're loosely coupled together and with the economy overall. Your comment is a good example of, "Knowing just enough to get into trouble."
Right now we have high prices. We're also in the boomer retirement period, of 2014-2023 or so. I wonder what it's going to take to cause boomers to get skittish and panic sell their portfolio. In 2008, they still had time. Now it's a bit different.
There's also apparently something interesting happening with the bond market. A fairly standard retirement strategy is to gradually move your investments into more stable bonds as your retirement date approaches. Except that because of boomer retirement, there's quite a lot of people doing this - mix in some quantitative easing, and suddenly a lot of money is chasing a limited pool of bonds, causing low yields and other interestingness: https://www.wsj.com/articles/decade-of-easy-cash-turns-bond-...
Fundamentally, I think there might be a deeper issue at play here. There's a common (and dubious) argument that Social Security is a ponzi scheme because the payments to retirees come from funds contributed by new investors. On some level, though, all of retirement is a little ponzi-like; ultimately you're always relying on the current working population to pay for your retirement, no matter what investments you put into your pension fund. What happens if that goes pop?
On some level, though, all of retirement is a little ponzi-like; ultimately you're always relying on the current working population to pay for your retirement, no matter what investments you put into your pension fund.
Well, no, not really. You're relying on the fact that you own some assets, which you can sell to someone else who wants to own those assets. That's very much not "ponzi-like".
You can't eat an asset. You can only eat what someone else produces, and then only if you can convince them to give you food in exchange for your asset.
This is counterintuitive, but globally saving is not possible, in a financial sense. IIRC from economic models it nets out to investment.
Which makes sense. Real world saving is amassing a grain store, or an oil stockpile in a strategic reserve, etc
And we can't do very much of that. Monetary savings depends on the ability to buy things of value from a later generation of producers.
A small country can use savings to buy from other countries. The larger the country, the less possible that is, as the large country becomes a significant portion of the world economy.
A simpler way of looking at it is: if the future generation started producing half as much, you wouldn't expect monetary savings to command the same worth in terms of real goods that they used to.
Yup. One area where this gets particularly interesting is healthcare - older people consume quite a lot of it, it's highly skilled and hasn't been particularly amenable to automation, it can't be stockpiled at all, and healthcare investment mostly seems to increase the amount people consume and the price of it.
Of course, generally you wouldn't exchange your assets directly for food or healthcare; more likely you'd have stocks and bonds and make money from some combination of selling on to non-retirees and taking some of the profits when they buy things from those companies, but it's ultimately what you're doing in the end.
You can definitely eat stuff bought with the earnings of assets.
Retirement is non-ponzi like because the assets appreciate in value due to increased predicted future earnings. This is totally different from paying out what others pay in.
Assets can appreciate in value and income even without new investment.
The earnings of the assets are generally like the assets: digital or paper currency, or their equivalents.
You can trade those for things, now. In saving for retirement, you're planning to trade the earnings from those assets for future things made by future workers.
Assuming the economy continues relatively normally, we'll be able to do that when we retire. (I don't think retirement is a ponzi scheme).
But, I do think it's worth considering things from that angle. For example, could everyone do FIRE (financial independence, early retirement)? No. At least, not unless in their efforts they created perpetually working robots to replace everyone who retired.
To put this in other terms, you could say I'm saying "if there aren't enough future workers, the future value of investments will decline, causing retirement shortfalls". Which, again, doesn't make retirement a ponzie scheme. I'm just providing another frame: money can be confusing. It doesn't work in the aggregate the way it does for an individual.
>You can definitely eat stuff bought with the earnings of assets.
Saving money is an illusion. The government can't just put your pension contributions into a savings account and withdraw it decades in the future. It must use the contributions of current workers to pay the pensions of current retirees.
Food doesn't last forever. If you buy food in your 40s the food is no longer edible in your 60s.
If you don't buy food and instead choose to save your money the food is still going to rot away.
You now have money but no food. As a retiree you are dependent on the current working generation to work for your food.
Those assets only produce income because of the current working population. This isn't strictly required of course, but it has been the case for a long time and is likely to remain mostly true for the foreseeable future.
This is some strange, broad descriptive logic that makes me think you just want to give credit to the working population for retirees. You could make similar claims about consumers or infrastructure being required for assets to make income, or any other facet of an economy.
It is, in the limited sense, that you need to find somebody to sell it to. That must be the current working populations in the end. Exception is if you just save money on account without interest.
>ultimately you're always relying on the current working population to pay for your retirement, no matter what investments you put into your pension fund. What happens if that goes pop?
Exactly. The corn you eat needs to be grown today.
Most people close to retirement who have been fortunate to build savings rotate slowly into a more conservative portfolio, and retirement is decades long not a binary event.
But it hardly means "a decline in the stock market indexes is good news for almost everyone". It could be true in some kind of isolated system where a global decline in share prices doesn't negatively affect many other areas of our lives.
The dip is good timing for Canadians, whose RRSP contribution deadline is coming up March 1st. If you're going to make a big 2017 RRSP contribution and buy ETFs, now is a good time.
Buffett first bought Wells Fargo in 1990 at a split adjusted price of roughly $2 per share. That doesn't include dividends, which are over $1 a share now.
Until then, the less you pay for your stock purchases, the better your long term gains will be.