Chart of the Week: Market Declines Can Be a Huge Benefit for Long Term Investors

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This week we are looking into the idea of stock market sell offs being a GOOD thing.

Earlier this week we looked at a quote from Jason Zweig from his commentary in Ben Graham’s Intelligent Investor, about a hypothetical financial news channel that would report market crashes as a good thing.

 

But why would anyone actually cheer for market sell offs? Doesn’t anyone who owns stocks want them to go up?

Here is why those of you with decades left to invest should be getting on your knees and praying for cheaper shares.

 

Which situation do you think would produce the best outcome for an investor with a 10+ year investment horizon?

 

Scenario 1: An investor who invests $500 per month in an S&P 500 index fund for a decade in a stock market that goes up little by little every day. In fact, this tremendous market never EVER has a down day for 10 years.

 

Or,

 

Scenario 2: An investor invests $500 per month in an S&P 500 index fund starting in 2004, sees decent growth until 2008 when the bottom starts to fall out. In fact, it would turn out that this investor had been buying stocks right before the worst economic decline since the great depression, and saw their stock holdings drop more than 50%, one of the steepest declines on record. However, this diligent investor continues to invest $500 per month into an S&P 500 index fund until today.

 

 

What environment would you rather be investing in? What scenario leads to better investment returns?

Scenario 1, what many investors would call a “Perfect market” – one that never goes down, only rises day after day.

Or Scenario 2, which puts you right in the middle of the worst economic crisis in 80 years?

 

The two scenarios are shown in the chart below. Here the S&P 500 index fund we are using the ETF: SPY – SPYDR’s S&P 500 index fund.

On October 1st of 2004, SPY was at a dividend adjusted price of $92.27, and on October 1st 2014 SPY was at a share price of $194.35.

The “perfect” market sees SPY’s share price go up $0.84 each and every day.

The real market (that is, the real price of SPY) over the past 10 years is shown in green in the chart below:

Perfect_Market_vs_real_market

 

 

Scenario 1 sounds much better right? Imagine never having to watch the value of your portfolio decline! No roller coasters, no scary headlines of impending doom like we see today. Just slow, methodical growth.

Who wouldn’t want that?

 

It turns out, for an investor willing to invest $500 per month from 2004 until 2014, the crisis that was 2008 lead to a much better end result than the hypothetical “perfect” market:

 

Perfect_Market_vs_real_market_-_investment_value

 

 

The ending numbers are $103,018 for the real market vs. $86,583 for the “perfect” market, a nearly $20,000 BENEFIT from having the worst economic crisis and stock market sell off in 80 years smack dab in the middle of your investing career.

 

 

How can this be so?

Warren Buffett describes why this is the case perfectly in his 1997 letter to shareholders:

 

“If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves. But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

Warren Buffett, chairman’s letter, Berkshire Hathaway annual report, 1997, http://www.berkshirehathaway.com/letters/1997.html

 

 

 

So next time some market “expert” on CNBC tells you to be scared because the market is falling, you should rightfully ignore him.

 

Want to read more? See our article on Dollar Cost Averaging to see more examples (like how investors in 1929 and 2000 would have benefited from a little patience!)

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