Investment Misconception #1: “Equities are not as risky as people make them out to be, since markets tend to rise”
Why is this an investment misconception?
On average and over the long term, markets have returned approximately 7% per annum. That seems to suggest that if you hang in through a rough patch here and there, you’ll be ok.
If this is the case, then why are equities so risky?
Equities are risky because averages are actually extremely deceiving. And they deceive us in our misunderstanding of both I) market cycles and II) market dynamics.
I) Market Cycles.
1) Down/flat markets are more common than we think
2) Down/flat markets can be longer-lasting than we think
The market’s historic return of 7% doesn’t give us any information on measuring risk until we understand how those returns were achieved.
Over a 100 year period, what we see aren’t up/down years, but cycles that last as long as 1-2 decades. Decades where the markets provides years of extraordinary growth, or decades of zero return – also known as “Structural Bear Markets.”
These bear markets demonstrate that the notion of markets reliably returning 7% a year is an investment misconception, because it’s possible that any 20 year cycle can offer you nothing for your investment. Obviously this is an inconvenient fact for the deep pocketed promoters of mutual funds that have been “educating” investors for decades about the fabulous prospects of holding stocks, without spending too much time on the risks involved.
II) Market Dynamics.
1) Fewer stocks contribute to growth than we think
2) Fewer stocks survive than we think
A number of years ago, there was a 25-year study conducted on the 8,000 largest stocks traded on each of the largest exchanges. This study was aptly labelled the Capitalism Distribution Study.
The results were shocking!
- 6,000 (75%) of all stocks offered 0% return
- 25% of stocks accounted for all market gains
- 39% of stocks lost money during the period
- 19% of stocks lost at least 75% of their value.
- 64% of stocks underperformed the Russell 3000.
ONLY 6.1% of stocks dramatically outperformed!
Besides fewer companies driving all the returns in the market, the lifespan of these companies is likely shorter than we would like to believe. 88% of companies in the Fortune 500 in 1955 are now gone – either gone bankrupt, failed to meet exchange requirements, were merged or privatized.
The life expectancy of a Fortune 500 firm was over 70 years in 1930s. Today, it’s less than 15 years and progressively declining. And today, when a growing share of the S&P 500 are technology companies like Facebook, eBay, Google, Oracle, SalesForce, Intuit, etc., it’s safe to say that over the next 15-20 years many of these will be replaced.