Sunday, July 3, 2011

Investing is believing that things will get better


You read everyday expert predictions of impending doom. But really, if the world is about to collapses then why invest? The investor hopes that the companies he/she invests in will make higher profits. The investor hopes that the economy, notwithstanding temporary setbacks, will advance, that business will innovate and increase productivity and that problems will be sorted out.

Some investments seem geared to profit from doomsday scenarios such as short selling and gold. But their performance is only beneficial to fight portfolio volatility. Some stock market researchers see price movements as a 'random walk' akin to Brownian motions of particles suspended in fluid. But guess what, short term the particle motion may be random, but overtime these particles will settle on the bottom of the lab beaker!

Just like there is long term direction in the lab beaker, there is long term direction in real estate and stock markets. Our houses get better; our land becomes more productive and our economy evolves with mankind. Look at the figure below, despite all setbacks, over the last 40 years both real estate and stock prices have increased. That is what investing is about – rather than consuming your net worth now, you invest in the future; you express your believe that tomorrow will be even better than today.

 Nothing goes up in a straight line. Even rockets don't. Does a rocket launched in China go up in space or does the one launched around the globe in Europe go up? In an earlier post, I discussed risk: All Kinds of Risk and I depicted the graph below. Markets go up over time, but price movements oscillate around the trend line. You could buy at the blue market peaks and still have a handsome profit when you reach point E. People say, "I won't buy now; I'll wait until the next crash. Only when you are near the top of a market like at Blue B in the figure and you wait until Red C you may have a bit of an advantage. A bit of an advantage if you don't count the dividends that you missed out on while waiting for the crash.

In an earlier posted series of market simulations titled Next Time I won't sell! , I assumed we bought shares at 20% below the average market, so during a bear market, then we held the shares for 35 years. The result was a return of investment of 12.1% per year compared to 11.3%. A $100 portfolio was after 35 years worth $3,541 versus $2,753. When the simulation bought at a peak (i.e. 20% above average market value), the return fell to 10.32% or $2098. Yes, a substantial difference in performance that illustrates the value of investing in good companies during a recession. However, buying at the peak still gave good returns, provided you do not panic and sell during a bear market. Hold for the long term!

You may think that my optimism displayed in previous posts about China and the new economy is naive. That is because I refuse to get beaten down by a continuous stream of depressing news from the media. In fact, such news makes me even more upbeat, because during downturns I can buy more good companies at a discount. This may sound like a cliché and that is true, but the cliché is stating an investment principle that works!

In some ways advocates of index investing are right. Buying individual stocks is riskier than buying the entire market. On the other hand, by buying individual stocks I, the investor, may be able to separate the excellent companies from the bad and get slightly better returns. This is more risky and I am not always right so I still need to diversify. Overall, good stock selection can improve your returns but only few investors or investment managers do outperform the markets consistently. That is why I suggest to starting investors to buy ETFs, to stay in the market at all times and especially during down turns to buy more. Always look for dividends. My favourite ETFs are mimicking the TSX and TSX60; they pay currently dividends at yields of around 2.4%. Some experienced investment advisors suggest owning a dividend six pack portfolio. Examples are Gordon Pape and Michael Graham who suggest a portfolio that typically includes companies such as BCE, the Canadian banks, TransCanada Pipelines and even Manulife. However no matter the details of their strategies, investors believe that over time things get better.

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