I do very much enjoy the old myth that stock markets like the FTSE 100 go up in the long run. It’s always good for a chuckle. But not much more.
Once you scratch the surface, even just a little bit, it’s easy to see the claim is nothing more than a bait and switch marketing technique for the finance industry.
It makes investing seem like a no-brainer. Especially passive investing – putting your money into the index and not worrying about it.
Then the problems, disappointments, rude surprises and poor returns begin. For those who bother to check their accounts.
The myth of stock markets inherently going up in the long run also excuses underperformance and prevents people from holding financial institutions to account by moving their money elsewhere.
I’m surprised the investment industry is even allowed to make the claim these days. Perhaps, as the economist Keynes said, we’re all dead in the long run, and so nobody is around to call out the passive investing promoters.
No doubt they think this is a good business model.
But high rates of inflation may be the final nail in the coffin of the myth, as far as the public’s perception is concerned. If you had bought the FTSE 100 in 1999 at 6,900, you would’ve made a measly profit of about 12% by today, when it sits at 7,750, near an all-time high…
Not great.
But adjust that for inflation, as the Bank of England’s inflation calculator does the maths, and you’ve lost ground badly.
The FTSE 100 would’ve had to be above 12,300 just to keep up with inflation.
What about dividends and reinvesting them? That’s what passive investors turn to when their claims about stocks going up in the long run are exposed. Which is why I see the claim as bait and switch. Promise capital gains and deliver reinvested dividends…
Anyway, the FTSE 100 Total Return Index (helpfully known as “the Trix”) tries to measure how an investor who reinvested their dividends might’ve performed. The Trix rose from 3,000 to 8,000 between 1999 and today. That’s better than keeping up with inflation, which would’ve needed a level of 5300 to break even.
But if you factor in taxes on dividends and the costs of their reinvestment, as well as capital gains taxes on selling the stocks at the end of the holding period, I’d be surprised if you break even in the end.
Remember, you get taxed on the capital gains that have happened because of inflation.
The FTSE 100’s inability to go up in the long run isn’t an unusual position.
The Japanese stock market is still down badly on the 1980s. And that’s after tripling since the financial crisis…
Germany’s DAX index, which includes reinvested dividends, has kept ahead of inflation since the launch of the euro in 2000, before you adjust for costs and taxes. But only by doubling since the European Sovereign Debt Crisis. It spent more than a decade struggling to keep up with inflation.
Historically speaking, we get the same phenomenon. The US’ Dow Jones Industrial Average was at the same level in 1982 as 1916, once you adjust for inflation!
There are many other problems inherent in the belief that stocks inherently go up in the long run. Let’s quickly review one more before we get to the real point – how you should invest instead.
A well-known flaw in the presumption of rising stock market indices is known as survivorship bias. The stocks in the index don’t remain the same, after all. In fact, over long periods of time, almost all stocks eventually fall out of the index as new ones enter it. Few of the FTSE 100’s original constituents remain, 40 years after it was created.
This means that the stock market index reflects how successful companies perform and ignores those which were unsuccessful. It leaves out the losers who drop out of the index and are no longer counted.
Investors who mimic the index will, however, also own the stocks that fall out. They’ll constantly be buying the stocks that have already gone up in order to get into the index, and sell the stocks after they’ve plunged out.
That’s not a recipe for investing success – buying high and selling low.
It’s also possible to take advantage of this particular phenomenon. You buy the stocks that are likely to barge their way into the FTSE 100 index in the next few years and sell the ones that are likely to fall out.
This surfs the waves of passive investors’ money which flows into and out of stocks depending on their FTSE 100 status. But it’s hard to know who will be in and who will come crashing out.
The surprising thing about the stock market’s poor long-term performance is that it’s surprising at all. The truth is that stocks rarely boom. Usually, the heavily lifting is done by inflation and dividends.
And when they do boom, it’s often just a bubble, as US investors discovered in the 1920s, 1950s and 2010s. Stocks had surged, but then returned to their previous levels.
When it comes to the FTSE 100, the only real boom that held up under the quicksand of inflation was that of the 90s. It’s the only rally that led to new highs that weren’t subsequently recaptured by inflation or a bursting bubble’s crash.
The idea that stocks can outgrow everything over long periods of time is a bit odd if you think about it carefully. At some point, the stock market’s valuation relative to the rest of the economy would just be too absurd. The FTSE 100 cannot simply diverge from the economic and financial reality around it.
Even if the presumption were plausible, it would mean that we should all leverage ourselves up to the hilt to buy stocks and just ride out the volatility. But once you think about the opportunity like that, you begin to smell the rat. It’s just not plausible we could all do that.
Something tethers stock market prices to a reality that upends the claim that stocks simply go up in the long run.
The truth is that there are two ways a stock can go up in price (adjusted for inflation, which is what we care about, especially lately). One is valuations and the second is earnings, better known as profits.
If a company earns greater profits, its share price eventually goes up. But can profits grow exponentially forever? Of course not. And so neither can stocks.
Valuations is the idea that investors are willing to pay higher prices for the same thing. This also has an obvious limit. At some point, stocks are simply too expensive.
Instead of going up exponentially forever, both earnings and valuations are cyclical. They go up and down.
A company’s lifecycle is a journey of being unprofitable, profitable but investing the profits into growing the business, reaping the profits and sending them back to shareholders, and then decline.
A stock market index is just a collection of companies that are performing well. So it captures a segment of companies’ life cycles.
By piggy backing the segments of that life cycle which features a boom, stocks always seem to be surging. But the truth is that the stocks which make up the index are constantly changing, with struggling companies falling out of the index and getting ignored by everyone except those who owned it.
Anyway, instead of holding your nose and buying some reflection of the FTSE 100 in a passive investing style, only to achieve mediocre returns (by definition), why not try and do better?
How?
There are many methods to consider.
Value investors try to find companies at low valuations. By buying a company while it’s cheap, you benefit from the valuation eventually turning higher.
Thematic investors make a prediction about the future and try to find a way to profit from it. If, for example, you think net zero is going down in flames, that implies far more gas demand in the future. And so you buy gas stocks.
Some investors focus on what a company actually sells and whether that’ll be successful. Do people really want their groceries delivered by Ocado, or do they want to go to Tesco? Investors can place their bets.
Other investors look at a company’s growth prospects. Invest early in a company that’s growing fast and your shares could be worth plenty in the future, when dividends begin to flow.
The list of methods goes on. But the point is that you need one if you’re going to succeed.
That’s why we exist. To publish those ideas.
And why we’ve published a list of five wealth accelerating stocks which we believe reflect how you should invest to target superior returns to the FTSE 100.
Until next time,
Nick Hubble
Editor, Fortune & Freedom
