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Sunday, April 20, 2014

How to win at a winning game

Published on Apr 20, 2014

Consistently invest in diversified stocks, don't bail out in bad times, minimise cost

By Teh Hooi Ling

It is a fact. A lot of novice investors in equities ended up losing money.

Consider the track record of Mr Peter Lynch who managed Fidelity's Magellan Fund from 1977 to 1990. He beat the S&P 500 Index in all but two of those years and averaged returns of 29 per cent a year.

That's mind-blowing. It means that $1 grew to more than $27. Had you invested as little as $37,000 with him in 1977, you would have been a millionaire in 1990.

You would imagine that most of the investors who put money in the fund would have made money. But guess what? Mr Lynch himself once said that he believed more than half the unitholders in his fund had lost money. It depended on when they had bought and sold Magellan.

Mr Martin Zweig, a market analyst and investment manager, commissioned Morningstar, the mutual fund research organisation, to track the cash flows in and out of the leading growth funds in the United States in the 1990s.

The contrast between the returns of the investments themselves and the returns of the investors was absolutely breathtaking: The 219 growth funds averaged an annual compounded return of +12.5 per cent for the five years ended June 1994.

But, the investors did much worse. They apparently didn't make any money at all; instead, they lost 2.2 per cent a year with the same group of growth funds!

Both of these findings point to the same conclusion, that is: As a group, investors do a rather poor job of deciding when to buy or sell their investment funds.

The chart on top shows the movement of the Dow Jones Industrial Average (Dow) in the US in the past 10 years. A typical inexperienced investor will probably behave as follows:

July 2005:The market has been quite steady and trending up for the past 21/2
years. All the market experts are saying that prices will continue to go up. OK, I'll invest $10,000 to test the water first.

April 2006: The $10,000 that I invested is now worth $10,816. That's a return of more than 8 per cent in one year. Not bad. Market looks firm. I think I'll invest another $50,000.

May 2007: My capital of $60,000 invested so far is worth $71,682. Wow, this definitely beats leaving my cash in the bank. OK, I'll transfer another $100,000 from my fixed deposit and invest in the market.

January 2008: What's all this news about the sub-prime market? Market is choppy. But it's OK, these investments are for the long term.

January 2009: Oh no! There doesn't seem to be a bottom to the market. Now people are talking about the possibility of another Great Depression. During the Great Depression, the Dow fell from a high of 386.17 on Sept 3, 1929 to a low of 40.56 on July 8, 1932. That's a plunge of some 90 per cent. The market did not recover to the 1929 levels until 1954, some 25 years later! Now my portfolio is down by about 35 per cent only. I'd better take out what I have left.

So the investor exited the market in early February 2009, and got back $103,730 of the original $160,000 invested. As it turned out, the investor withdrew his money near the bottom of the market. Just over a month later, in the second week of March 2009, the market hit bottom, and stock prices rebounded sharply from there.

If the investor had stayed invested and held on to his shares, his $160,000 would have been worth $211,308 as at March 1 this year. All the numbers above exclude transaction costs and dividends received.

Because of this emotional tug of war between greed and fear, many investors effectively manage to lose at a winning game.

So how exactly do we ensure that we win at this winning game?

First, understand that when you invest in a diversified basket of stocks, you are investing in a slice of the economy. As long as we need to buy and sell things - there is no question about this here because we can't possibly produce all the things we need ourselves - then there will always be a value to productive companies.

Second, don't exit the market when everyone else is rushing for the exit. Then, you will not get a fair value for the businesses that you own.

Third, all the more you should buy when you see businesses going on sale at a cheap price.

Now, let's see how someone would have done if he had kept investing in the stock market through the Great Depression. We know that the Great Depression was the worst period the stock market had ever gone through in history - it was many times worse than the recent global financial crisis and the Asian financial crisis. We know that the Dow lost a whopping 90 per cent of its value in the three years between 1929 and 1932 and it didn't climb back to its 1929 level until some 25 years later.

Did an investor who put money into the market during that period see zero or even negative return?

The chart at the bottom shows an investor, let's call her Mary, who started investing in the US market in early 1926. She put in $100 into the market every year. Her investment did well in the first four years. Then the crash of October 1929 happened, to be followed by the Great Depression. Mary watched in horror as her hard-earned savings shrank by the day. But she kept faith. She believed in the continued functioning of the modern economy. As long as companies are allowed to produce what people want and need, they will make money, and the stocks she has invested in will have a value, she told herself. So she kept investing $100 into the market every year.

By the end of 1950, Mary would have put $2,500 into the market. Her portfolio value as at December 1950 was $4,239. This, despite the Dow still being 38 per cent below its September 1929 peak.

Mary managed to grow her capital by 4 per cent a year by consistently putting money into the stock market even through the worst of times. She managed to beat the inflation rate of 1.3 per cent during that 25-year period. In other words, she generated for herself a real return of 2.7 per cent a year in the most adverse of situations.

So, to recap, the secret to winning in a winning game is:
One, consistently invest in a diversified basket of stocks that represents the real economy - especially when prices are cheap. (Some Asian markets are still relatively weak vis-a-vis the US market now. So it may not be a bad time to put some money into those markets.)

Two, don't bail out at the worst of times. All the more, if you can afford it, put in more money at the most depressed of market conditions.

Three, try to minimise your cost as much as possible when getting your equity exposure.

Keeping to these three golden rules will ensure that your savings will grow faster than inflation, and that you will tremendously increase your odds of meeting your financial goals.

The author, a CFA charterholder, is head of research in no-management fee value fund manager Aggregate Asset Management.

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