“Patience is a Virtue”. We have all heard the phrase, likely echoed down from a parent or grandparent at a time when it was the last thing we wanted to hear. The proverbial phrase was first coined in the 14th century by the English poet William Langland in the work Piers Plowman. Piers Plowman preceded and may have even influenced Geoffry Chaucer’s Canterbury Tales. The poem, considered by literary critics to be one of the great works of English literature of the Middle Ages has stood the test of time no less than the phrase it gave the world.
But what exactly does the enduring phrase mean and how is it relevant to investing? While we all hear that we should be thinking “long-term” when making investments it may be helpful to illustrate and put patience into context when investing in the U.S. stock market.
Must Have a Long-Time Horizon
Many investors instinctively know the importance of having a long-time horizon. In an effort to shed light on just how important it is to have a long-time horizon we have analyzed stock market returns going back nearly one hundred years. In the chart below you will see trailing one-year returns for the S&P 500, a broad and widely accepted measure of the U.S. stock market. What this chart shows is revealing. If you have a one-year time horizon you have a wide range of potential returns. A majority of the time you will experience a positive return, as the stock market tends to go up more than it goes down. However, it is important to note that you may find yourself at points in time with significant negative returns.
The chart below displays data from the past one hundred years but now includes rolling returns if you had a 5-, 10-, or 15-year time horizon. As you can see, the returns are significantly smoothed out, and it is very rare to experience a negative return. In fact, there have only been two periods of time which yielded a negative annualized return for those with a 15-year time horizon. Having a long term time horizon sets you up for success when investing in the stock market.
Must Hold and Not Trade Around
It is important to have a 5, 10, or 15-year time horizon because you have a much higher likelihood of experiencing a positive compounded return. The second point which cannot be stressed enough is the importance of not trading around; buying and holding is the best approach. To illustrate this point, we have analyzed the same one hundred years of stock market returns and have removed the top 1%, 2%, and 5% of monthly returns.
In other words, if you miss out on the top 1%, which is only 3 months, your return over the course of 30 years is cut nearly in half. Nobody in the world can consistently forecast the stock market’s near-term movements and this table shows just how detrimental it can be to miss out on the best months. If you have a long-term time horizon and move in and out of the stock market, you are likely going to miss some of the best performing months. This is going to have a dramatic negative impact on your returns.
Must be Able to Stomach Significant Drawdowns
In addition to having a long-term time horizon and not trading in and out of the market, investors in the U.S. equities must be able to endure significant drawdowns. Investors should EXPECT and anticipate drawdowns. Put within the greater context of a long time horizon there will be plenty of character-testing fluctuations around a gently rising path. There will be times within any long-term time horizon where the stock market will experience significant declines on the order of magnitude of 40-50%.
Berkshire Hathaway Vice Chairman Charlie Munger famously says that if investors cannot endure a 50% drawdown they have no business investing in the stock market. One famous stock market quote tells it all, “The purpose of bear markets is to separate the pretend owners of capital from the rightful, long term owners of capital.”
Time to Recover to Highs
Setting expectations when investing is a must. While stock market investors must set out with a long time horizon and be able to weather significant drawdowns, they must also know that there will be times when they must endure long recoveries. The chart and table below detail the historical data and show just how long investors should be prepared to wait. The average time it takes to recover from a bear market is 3.2 years; which may sound like a long time but this is precisely when it is helpful to dollar cost average and continue to build your stock exposure at lower prices.
Try and Buy More When Valuations are Low
As a long term investor, you can set yourself up for success and dramatically increase your future returns by 1) having a greater than 5-year time horizon; and 2) setting your investments and not trading around. Having the expectation that there will be significant drawdowns at the outset helps investors to endure these painful periods but can also provide the bedrock upon which opportunity abounds. Going through significant drawdowns can be some of the most rewarding times for investors who seize upon the opportunity to buy when valuations are cheap.
Over time, the primary and overwhelming sources of stock market returns come from compounding earnings and dividends. Investors buying into the S&P 500 are, as Warren Buffett says, “buying into the future of American capitalism” which has produced miraculous results since our country’s inception. Stock market valuations gyrate around the steadily rising cash flows of American business. Using periods when valuations are cheap, with metrics such as the Price-to-Earnings ratio (P/E for short), investors can capitalize on the opportunity to increase their long term investments at attractive prices and increase their prospective returns.
How to Buy Stocks in a Bear Market
“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.” – Warren Buffett 2016 Annual Letter
At this time, we find ourselves in the midst of a painful and serious market drawdown brought on by the spread of COVID-19 and dramatic curtailing of economic and physical activity. How investors should react is at the forefront of everybody’s mind, and interest in the stock market is at an all-time high. For investors with a long time horizon, as discussed previously, this could be a fantastic time to dollar cost average and buy into equities at an attractive entry point.
While nobody can consistently call market bottoms, investors can look at several indicators for determining when stocks are more attractive. The P/E Ratio has historically been a good guide of when to become more serious about buying. Buying into the stock market when valuations have fallen has historically paid off as evidenced by the two charts below which show the forward 10-year compound return at each valuation level. If you can be buying into the stock market below 15x you have historically been rewarded in the future.
Valuations today have come down from elevated levels. While the market has been very volatile it has been hovering around 16-18x last year’s earnings.
While having patience under some circumstances can appear difficult and not worth the effort, there is no doubt that patience yields tremendous results for U.S. equity investors. Given a sufficient time horizon and the fortitude to stay the course, investors increase their likelihood of success and tilt the odds in their favor. In conclusion, the keys to investing in U.S. equities are having a long time horizon, staying the course, weathering significant drawdowns, and using drawdowns/reductions in valuation to dollar cost average your U.S. equity position.
I leave you with another poignant and relevant Warren Buffett quote, “Someone’s sitting in the shade today because someone planted a tree a long time ago.” Buying stocks for the long-run has historically rewarded the patient investor.