Investment Basics - Course 103 - Investing for the Long Run

By: Steve Bauer | Wed, Sep 15, 2010
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This is the third Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still a proactive asset manager and consultant / mentor.


 

Course 103 - Investing for the Long Run

Introduction

In the last lesson, we noticed that the difference of only a few percentage points in investment returns or interest rates can have a huge impact on your future wealth. Therefore, in the long run, the rewards of investing in stocks can outweigh the risks. We'll examine this risk/reward dynamic in this lesson.


Volatility of Single Stocks

Individual stocks tend to have highly volatile prices, and the returns you might receive on any single stock may vary wildly. If you invest in the right stock, you could make bundles of money. For instance, Eaton Vance (EV), an investment-management company, had one of the best-performing stock for the last 25+ years. If you had invested $10,000 in 1979 in Eaton Vance, assuming you had reinvested all dividends, your investment would have been worth $10.6 million by December 2007.

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment. There are hundreds of recent examples of dot-com investments that went bankrupt or are trading for a fraction of their former highs. Even established, well-known companies such as Enron, WorldCom, and Kmart filed for bankruptcy, and investors in these companies lost everything.

Prof's. Guidance: That's why you are taking this course. There are financial advisors who can identify the winners and there are those who just - can't and don't. You should focus on learning how to understand, when a salesperson or mutual funds says: I can manage your money - - Will you have the right questions to ask or just believe them? In the last decade the later has been very expensive!

Between these two extremes is the daily, weekly, monthly, and yearly fluctuation of any given company's stock price. Most stocks won't double in the coming year, nor will many go to zero. But do consider that the average difference between the yearly high and low stock prices of the typical stock on the New York Stock Exchange is nearly 40%.

In addition to being volatile, there is the risk that a single company's stock price may not increase significantly over time. In 1965, you could have purchased General Motors GM stock for $50 per share (split adjusted). In the following decades, though, this investment has only spun its wheels. ByJune 2008, your shares of General Motors would be worth only about $10 each. Though dividends would have provided some ease to the pain, General Motors' return has been terrible. You would have been better off if you had invested your money in a bank savings account instead of General Motors stock.

Clearly, if you put all of your eggs in a single basket, (diversification) the basket may fail, breaking all the eggs. Other times, that basket will hold the equivalent of a winning lottery ticket.

Prof's. Guidance: So, it is really up to you, not the financial salesperson or mutual fund. Don't be "DEPENDANT" - learn how to find the people you can trust and work with them as a team.


Volatility of the Stock Market

One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a portfolio. However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly. You may experience large losses over short periods. Bear Markets and Market Dips are sometimes significant.

Prof's. Guidance: By studying and simple paying attention to these on going fluctuations - much of the downside can be avoided.

For example, consider the Dow Jones Industrials Index, a basket of 30 of the most popular, and some of the best, companies in America. If during the last 100 years you had held an investment tracking the Dow, there would have been about 10 different occasions when that investment would have lost 40% or more of its value.

The yearly returns in the stock market also fluctuate dramatically. The highest one-year rate of return of 67% occurred in 1933, while the lowest one-year rate of return of negative 53% occurred in 1931. It should be obvious by now that stocks are volatile. But don't worry; there is a bright side to this story.


Stocks Are Still Best Investment

Despite all the short-term risks and volatility, stocks as a group have had the highest long-term returns of any investment type. This is an incredibly important fact!

So after the stock market has crashed, the market has always rebounded and gone on to new highs. Stocks have outperformed bonds on a total real return (after inflation) basis, on average. This holds true even after market peaks.

Prof's. Guidance: As the song goes: Pick yourself up, dust yourself off and start all over again. That's only after continuing to study.

If you had deplorable timing and invested $100 into the stock market during any of the seven major market peaks in the 20th century, that investment, over the next 10 years, would have been worth $125 after inflation, but it would have been worth only $107 had you invested in bonds, and $99 if you had purchased government Treasury bills. In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, merely kept up with inflation.

This is the whole reason to go through the effort of first learning and second investing in stocks. Again, even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for stocks than either bonds or cash. Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Prof's. Guidance: There are many strategies for investing. Some of them - simple don't work and others do very, very well.


Time Is on Your Side

Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be. With time, your chances of making money increase, and the volatility of your returns decreases.

The average annual return for the S&P 500 stock index for a single year has ranged from negative 39% to positive 61%, while averaging 13.2%. After holding stocks for five years, average annualized returns have ranged from negative 4% to positive 30%, while averaging 11.9%.

These returns easily surpass those you can get from any of the other major types of investments. Again, as your holding period increases, the expected return variation decreases, and the likelihood for a positive return increases. This is why it is important to have a long-term investment horizon when getting started or continuing in stocks.


Why Stocks Perform the Best

While historical results certainly offer insight into the types of returns to expect in the future, it is still important to ask the following questions: Why, exactly, have stocks been the best-performing asset class? And why should we expect those types of returns to continue? In other words, why should we expect history to repeat?

Quite simply, stocks allow investors to own companies that have the ability to create enormous economic value. Stock investors have full exposure to this upside. For instance, in 1985, would you have rather lent Microsoft money at a 6% interest rate, or would you have rather been an owner, seeing the value of your investment grow several-hundred fold?

Because of the risk, stock investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses. More often than not, companies are able to generate enough value to cover this return demanded by their owners.

Meanwhile, bond investors do not reap the benefit of economic expansion to nearly as large a degree. When you buy a bond, the interest rate on the original investment will never increase. Your theoretical loan to Microsoft yielding 6% would have never yielded more than 6%, no matter how well the company did. Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.


The Bottom Line

While stocks make an attractive investment in the long run, stock returns are not guaranteed and tend to be volatile in the short term. Therefore, I do not recommend that you invest in stocks to achieve your short-term goals. To be effective, you should invest in stocks only to meet long-term objectives that are at least five years away. (After say - two to five years start enjoying (spending) some of those profits. And the longer you invest, the greater your chances of achieving the types of returns that make investing in stocks worthwhile.

Quiz 103
There is only one correct answer to each question.

  1. The average yearly difference between the high and low of the typical stock is between:
    1. 30% and 50%.
    2. 10% and 30%.
    3. 50% and 70%.
  1. If you were saving to buy a car in three years, what percentage of your savings for the car should you invest in the stock market?
    1. 50%.
    2. 70%.
    3. 0%.
  1. If you were investing for your retirement, which is more than 10 years away, based on historical returns in the 20th century, what percentage of the time would you have been better off by investing only in stocks versus a combination of stocks, bonds, and cash?
    1. 50%.
    2. 100%.
    3. 0%.
  1. Well known stocks like General Motors:
    1. Always outperform the stock market.
    2. Are too highly priced for the average investor.
    3. Can underperform the stock market.
  1. Which of the following is true?
    1. After adjusting for inflation, bonds outperform stocks.
    2. When you invest in stocks, you will earn 12% interest on your money.
    3. Stock investments should be part of your long-term investment portfolio.

 

Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.

 


Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer

Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.

Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.

Freshman Year

Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios

Sophomore Year

Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News xxx
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality

Junor Year

Course 301 - The Income Statement
Course 302 - The Balance Sheet
Course 303 - The Statement of Cash Flows
Course 304 - Interpreting the Numbers
Course 305 - Quantifying Competitive Advantages

Senor Year

Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill

Graduate School

Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips

This Completes the List of Courses.

Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.

Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.

 


 

Author: Steve Bauer

Steven H. Bauer, Ph.D.

Steve Bauer

Steve has several degrees, i.e. post graduate degrees and doctorate and a great deal of (too much) continued education. For seven years, he did a stent as a University Professor of Finance and Economics.

He owned a privately held asset management firm and managed individual investor and corporate accounts as a Registered Investment Advisor - for over 40 years.

Professionally he is a financial analyst and private asset manager / consultant / mentor.

Steve can be reach at senorstevedrmx@yahoo.com

Copyright © 2010-2011 Steven H. Bauer, Ph.D.

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