The myths of market underperformance

By Dan Richards
Dan Richards is President of Strategic Imperatives and teaches in the MBA program at the Rotman School of Business, University of Toronto.



Psychologists talk about the human propensity to gravitate towards evidence that supports existing biases. What that means, quite simply, is that in buoyant markets, investors are prone to believe outrageous claims by market bulls - think no further than "the world has changed forever" rhetoric and best selling books like "Dow Jones 36,000" and Harry Dent's "The Great Boom Ahead" in the tech boom in 1999 and 2000.

In the same way, in negative markets such as we're experiencing right now, investors tend to believe even the most gloomy assertions from "media gurus" and self appointed experts - a recent New York Times article headlined "Forecasters race to call the bottom to the market" discussed the competition among market pundits to come up with the most dire possible predictions. (It's noteworthy that the same Harry Dent who wrote "The Great Boom Ahead" has just published "The Great Depression Ahead.")

Most members of the media strive for accuracy in their reporting and work very hard to get the facts right. The problem - many of the assertions that get the highest profile are based on flawed analysis of past stock market performance by pundits who distort history to get media coverage for their alarmist claims or by well meaning commentators who quite simply get the facts wrong.

Among the common cautionary claims about investing in the stock market:

1. Investors made no money in the market from the mid 60s to early 80s.
2. It took 25 years for the market to recover to the level reached in 1929.
3. When inflation is taken into account, investors have lost money for long periods of time.


Stocks made no money from 1965 to1982

As just one example, a cover story in a recent Newsweek article featured the statement that the stock market was no higher in 1982 (the Dow ended 1981 at 875) than in 1965 (when it ended at 969). This is the most often quoted fact when people make the case that stocks can go sideways for long periods - and on the face of it, it's hard to argue with this. unless we remember two critical points.

First, despite its prominence, the Dow Jones is only vaguely representative of the stock market as a whole. Because it only contains 30 stocks and is price weighted rather than market weighted (in other words a stock trading at $50 has five times the weight of a stock trading at $10), it doesn't truly represent how the overall market performs. In the 70's in particular, the Dow Jones was laden with large household names referred to as "the nifty 50" that were chronic underperformers of the market as a whole.

Second - and more important - looking at the overall price performance of any index ignores dividends, something that historically accounted for 40% of returns. Focusing on price performance of an index and excluding dividends isn't just something that the media does - it's a trap that many financial analysts and advisors fall into as well.

Here are the results from 1965 to 1982, using the Standard and Poors Composite Index, containing the 500 largest stocks by market value and if we include dividends.

Gain from Dec 31 1965 to Dec 31 1981:

Capital appreciation: 33%
Total return with dividends: 152%

The result is an annual return of 6% - well below the long run return on large U.S. stocks of 10% but still a very different proposition than being down over this period.

As an aside, people who use the period from the end of 1965 to 1981 are cherry picking one of the worst possible periods to make their case; here's the total return for 16 year periods starting one year earlier and one year later:

Dec 31 1964 to Dec 31 1980: 198%
Dec 31 1966 to Dec 31 1982: 240%

Note that excluding dividends in calculating long term returns isn't just a trap that the media falls into - many investment analysts who should know better make the same mistake.

Stocks took 25 years to recover to 1929 levels

A second common myth relates to how long it took for stocks to recover after the great crash. And if we look at just the price index, this is true - looking at year end price levels, it took until 1952 to match the high hit by the S & P index at the end of 1928 . appearing to be a disastrous experience for investors who held on after through the great crash. If we include dividends however, we see a different story - with dividends included, at the end of 1952 the S & P was four and a half times the level of 1928, for an annual return of over 6% and a real return of 4% per year.

Stocks lose money after inflation

Let's look a final example of fun with numbers.

An article in the November 8 Globe and Mail featured an interview with Edward Kerschner, chief strategist with Citi Global Wealth Management, stating that in real terms the Dow fell 47% from 1960 to 1980. Kerschner's point was that markets can be horrible places to be for long periods of time (especially with free spending presidents such as Kennedy, Johnson, Nixon - and perhaps Obama.)

Here are the year end numbers for the Dow, both before and after inflation:

Again, it's tough to argue with the argument that this twenty period was disastrous for investors in real terms - until we look at a broader based measure of stock market performance and include dividends. S&P 500 from Dec 31 1959 to 1979

On a total return basis, the annual real return in this 20 year period was 2% - because of a combination of lower stock market returns and much higher inflation than the historical norms, this period did indeed substantially underperform the historical real return of 7% (a gain of 10% less 3% inflation). Still, underperforming with a real return of 2% is a very different story than losing almost half your money. And again, on the theme of cherry picking time periods, if we use the 20 year period starting one year later, from the end of 1960 to the end of 1980, real returns are more than 50% higher at 71%.

None of this is intended to say that stocks will always be a safe or pleasant haven for investors. And despite the overwhelmingly positive returns that long term investors in U.S. stocks have seen across virtually every time frame, there is always the possibility that it could be different going forward. Just remember, though, the only guide we have going forward is what happened in the past. And in looking at the past, we need to look at all the facts - not just those selected by people looking to grab newspaper headlines.

Special to the Globe and Mail