21st Century Economics

What makes any given stock go up or down almost defies logic and analysis. So many things can affect a stock’s value that the only successful investors are ones that totally involve themselves in every nuance of the business they are investing in. They know every aspect of the business, often better than the owners and managers of the business itself. There have been only a few such investors in all of the history of the stock market.

Peter Lynch, the portfolio manager of Fidelity Magellan Fund, was one such investor. He had a well-known reputation for knowing everything about a business before he invested in it. But what he was really doing is establishing a baseline or reference of performance on a company in order to more accurately predict what its future will be. This often took weeks or months of on-site study for each investment decision.

The attraction of most investors to put money into a single stock is the hope they will find the next Microsoft or Bell Telephone and their stock will skyrocket in value. Unfortunately, it can also lose everything. In fact, statistically speaking, the vast majority of initial price offerings (IPO’s) (what they call a new stock that is being introduced to the market for the first time) fail and the initial investors usually lose most or all of their investment. Although there are companies that can show very rapid gains, no one has figured out a way to precisely determine exactly which companies will fly high and which will fail.

As you can imagine, this investment decision process is very complex and requires the consideration of hundreds of parameters about the investment candidate. As a non-professional investor, you do not have the skills, time or access to do this kind of analysis and neither do most other investors.

As an alternative, they rely on investments in a broad range of stocks called mutual funds. These are groupings of individual stocks into a large collection of similar kinds of investments. For instance, they might all be from the same or related industries, such as automotive or health care; or, they may all have the same kind of investment strategy such as growth or income stocks or government bonds.

The objective is to average out the fluctuations and effects of any one stock in order to gain a more modest gain across a much larger group of stocks. It must work because that is where the vast majority of investors are now putting their money.

Peter Lynch studied and analyzed each stock that he invested in to establish a baseline or reference of past performance that he used to make investment decisions. So, too, must there be a reference for the groups of stocks that make up mutual funds. To meet this demand, Wall Street has created numerous “indexes” that plot the averages for dozens or hundreds of stocks. The most famous of these indexes is the Dow Jones Industrial Average (DJIA) which reflects the averages of only 30 industrial stocks that are suppose to be indicators of what the entire economy is doing. Another well known index is the Standard and Poor’s Stock Price Industrial Index or the S&P 500. This averages a dynamic list of the top 500 stocks on the New York Stock Exchange.

There are many others but they all have a common purpose - to supply the needed baseline or reference of performance on a group of stocks in order to more accurately predict what the investment potentials will be.
As we go from the performance of a single stock, to the performance of indexed stocks like the S&P 500 and to the mixtures contained in mutual funds, we get two characteristics:

As the number of stocks grouped together increase, the fluctuations of any one stock have less and less effect on the total value of the group. This is for two reasons:

(a) each individual stock makes up less and less of the total as the group gets larger and

(b) as one stock goes down, others in the group may go up, resulting in a more consistent and steady response to the changing economy.

As the number of stocks grouped together increases, the gains and losses tend to move into much more modest swings so that the average gains or losses are smaller than the gains and losses that you might get with a smaller group.

The swings of gains and losses is called volatility and is directly related to the risk you have of sharp and frequent changes in the value of the investment. In general, mutual funds are less volatile than an individual stock will be. The larger the mutual fund, the more likely it is to be stable and non-volatile.

As the average investor, you need a reference of performance that you can easily understand and easy to follow. Ideally, you would want to find a “megatrend” that you can invest in and be reasonably confident that it will result in profit. Use of indexes like the DJIA or the S&P 500 are a step in the right direction but if you look at a long term graphic chart of these indexes, you will see lots of fluctuations. It’s hard to base your investment decisions on a performance index that has an inconsistent trend. What we need is some other index that let’s us KNOW we will make money.

One impact of the two characteristics listed above is that although the high highs and the low lows are averaged out across the entire group of stocks, the end result is that your losses will always be less and your gains will be less than for a single stock. The larger the group you average together, the more they will tend toward a single average of gain or loss.

For instance, if you looked at investments in all of the various stocks related to railroads over the last 50 years, they would have an overall trend downward. A similar examination of all the various stocks related to the insurance business would show a general trend upward.

This kind of trend discovery also develops as you average a longer and longer period of time. For instance, if you average across one year, the S&P 500 was down by 1.54% in 1994 but up by 34.11% in 1995; however, it has shown an average gain of 11.54% over the last 15 years. These trends begin to emerge only when you average over a long enough period of time.

If we combine the idea of averaging across a large number of stocks and across a long period of time, we can discover if there are some megatrends that are inherent in the entire stock market.

Someone has done exactly that for the largest possible group of stocks and for the longest period of time possible. The result is the ultimate performance reference for the stock market investor.

Professor Jeremy J. Siegel has created an index for the entire stock market called the “real-total-return” trend. It considers all the stocks, not just the groups that make up various indexes or mutual funds. It also adjusts for inflation and considers the capital gains and dividends of the stocks. The period of time he considers is from 1801 through 1998.
That is as long as there are records to support an analysis. The resulting graphic overlooks the year-to-year fluctuations and economic turbulence and displays a remarkably stable long term total return on equities of 6.8% per year over and above inflation.

This is a remarkable discovery. It means that the overall basic trend of the stock market is increasing by that much every year for the past 197 years. The effect of that would be that if you invested just $1.00 in the market in 1801, you would have $561,264 dollars today (equal to more than $1,000,000 in 1801 adjusted dollars).

This is a useful performance index that you can use to make shorter term investment decisions, as you will see if you read the section about Regression to the Mean investment strategies.