Thoughts on Long Term Investing

By Clemens Kownatzki - 12 October, 2009

After last years financial tsunami, calls for an end to long term investing and a departure from the Buy & Hold investing mantra have been at the forefront of discussions between investors and the financial services community. But despite the poor performance of stock markets over the past decade, there is ample evidence suggesting that stock picking and other active investing strategies will not produce superior returns over a buy and hold strategy e.g. via a low cost index fund. As they say, the more you turn, the more you burn. The mathematical rationale for that is quite simple: The probability of outwitting other investors in a zero sum game such as trading stocks is 50/50, minus transaction costs. Unless you are an above average investor (trader), you wont beat the crowd; bluntly put, an active investment strategy must on average under-perform the market by the amount of transaction costs incurred. Assuming you are an average investor, you are best advised to use a simple aged-based asset allocation method to determine the amount of cash/fixed income components of your portfolio. For instance, at age 50, half of your portfolio should be in income producing assets where the principal is guaranteed i.e. cash, CDs and Treasury Bonds - not very exciting, but safe(r). The other half could be allocated to one or several low cost index funds and, depending on your risk and investment profile, you could consider additional diversification into other asset classes such as Gold, commodities and ideally some incoming producing assets. For U.S. investors, ideal index funds would be the major market index trackers such as Spydrs (SPY) or some of the lowcost Vanguard Index funds. Further still, one could also consider international diversification, either by creating some international equity exposure (again via low-cost index trackers) or with direct holdings of foreign currencies, particularly if you are a U.S. or U.K. resident1. To better assess how to allocate your assets and to properly diversify we need to look at various possible long-term scenarios. My scenarios and assumptions are somewhat U.S. centric, but they can be applied to other countries through comparative data analysis. Expecting the expected Based on long-term historic data, one can make a number of easy to derive predictions. For instance, assign an inflation rate of 3.8% per year (average inflation from 1950 to 2009) to any asset price and consider the future value from compounding the annual inflation. If the S&P 500 was trading at 1,000 today, it would have to be at least at 2,108 twenty years from now just to be at the same value in real Dollar terms2. The expectation of course is to outperform inflation by a considerable margin. Based on historic returns from 130 years of data on the S&P500 Index, the average return (before inflation and taxes) over a longer time horizon approaches 9.4%. As the chart below suggests, the range of possible short-term returns can be anywhere from +150% to -75% which makes short term investing questionable for an average investor. Given the historic perspective for an adverse scenario, one should be prepared to allow for a 15 year time horizon just to break even.

Source: Political Calculations

With a 20 year or longer time horizon however, returns even out considerably. If one were to compute the hypothetical future value of the S&P 500 trading at 1,000 today and imputing an average compounded return of 9.4% over twenty years the index would then be at 6,030. Linear regression analysis is another approach to consider hypothetical future prices of an investment. Mathematicians and statisticians may not agree on its usefulness for long-term data projections however, this is a simple tool (available in Excel) which is based on the fact that prices typically revert to the mean over certain periods of time. Based on daily data since 1950, we can draw an assumed growth period of an asset and project future values3.

Using S&P composite data going back to 1871, the slope of the expected trendline is not as steep but one can also see the reversion to the mean more clearly. Having just recently completed almost two decades above the regression trendline, it may also suggest that US markets could be in for a protracted period of below par performance before reverting to the mean.

Source: www.dshort.com

These are just some brief thoughts on assessing future prices in addition to the typical economic forecasts one can read in the financial press. As I mentioned earlier, one can apply these forecasts to other countries and asset prices where similar data are available. Having said all this, and while we are still digesting last years financial chaos, it should be clear to everyone that we must not just expect the expected but prepare for the unexpected. There is obviously much more to long-term investing and financial planning than simply drawing a few lines on a chart. Future prices can be influenced by myriad of factors including economic, political, environmental and country specific factors, all of which are difficult to predict. In expecting the expected scenario, we assume that there are no major changes to the above named factors impacting financial assets. We shall examine the unexpected, particularly with regard to impacts of emerging economies, in an upcoming paper - stay tuned!
The writer is a registered investment advisor representative at FX Investment Strategies LLC.

This is based on the writers assessment of historic trends which indicate that the long term value of the US Dollar as well as the British Pound (both historic global reserve currencies) will erode and depreciate over time compared with other major currencies. 2 Estimating future prices based on imputed long term inflation rates is a useful method for most assets except for currencies because countries may experience similar inflation rates and potential increases in exchange rates would cancel each other out. 3 The usefulness of linear regression analysis may not work for every asset class and for every time frame. The growth of stock prices can be exponential (in theory) and a linear method may not be appropriate. It is included here for its ease of use and graphical representation of a trend.