What to Expect, Part 1
Over the last 30 years, the share markets in Australia and the United States have returned 9.2% and 10.2% per year, including dividends. Each year Vanguard provides a useful chart showing these returns alongside several other asset classes (bonds, property, cash) and the cost of inflation (as measured by the consumer price index, or CPI) over the same period.
Of course this assumes that someone invested exactly 30 years ago. What if they invested everything at the top of the market? Despite all the doom and gloom in the media, they would still have received a return of at least a 6% per year if they held on for 20 years—no matter which 20-year period.
While this might not sound like a huge number, the effect of “compounding” on an investment over long periods of time is enormous. This is where investment profits are continuously re-invested alongside the original sum and also earn a return. It was famously quoted by Albert Einstein:
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
An investment of $10,000 returning 6% per year will turn into $13,382 over 5 years, $17,908 over 10 years, $32,071 over 20 years and a staggering $184,202 over 50 years (excluding any fees and taxes).
This is strong evidence to support the statement by investing great Warren Buffett, CEO of Berkshire Hathaway, that:
“Compounding investment returns over a life-long investment program is your best investment strategy, bar none.”
What to Expect, Part 2
Of course, nothing in life comes easily or happens in a straight line. Share prices can be very volatile, with huge swings based on sentiment. These price movements do not indicate the risk or the value of these investments.
Prices will often rise too high when the economy is booming and investors are feeling confident, and there will be times when market prices fall dramatically for any number of reasons, such as war, pandemic, or a financial crisis.
The size and timing of these ‘market crashes’ is impossible to predict, so it’s important to prepare in advance—both psychologically, because it will be terrifying at the time, and with regard to your investments.
It’s important to select companies that have the ability to withstand these ups and downs, and to choose investments that you know you can stick with through thick and thin. This way you can remain invested, which is extremely important because the share market can recover very quickly without warning as you can see below.
It’s worth keeping in mind that these difficult times can actually benefit strong businesses, because their weaker competitors can struggle and sometimes go out of business.
What’s more, share market “corrections” can also create opportunities to buy more shares at extremely good prices. In fact, shares bought during crises are likely to be some of the best in your lifetime. As the great value investor Shelby Cullom Davis famously said,
“You make most of your money during a bear market; you just don’t realise it at the time.”
The key things to remember are that over short periods of time (say less than 2 years), the ups and downs of a company’s share price are mostly driven by sentiment—whether a company is liked or disliked at that particular moment for a variety of reasons (such as the part of the economy that the company operates in is doing well or it’s in a segment that is a new popular trend).
Over longer periods of time though (meaning at least 3 years and probably 5 or more, it’s not an exact science), the change in the share price will largely match the growth in the company’s profits.
Investors can take advantage of these swings in the market’s mood by buying when shares are out of favour and selling when the market is too exuberant. In the meantime, investors benefit from growth in the value of the company’s profits.