The sound of cannon

Posted by on June 23, 2009 @ 8:39 am in Investing

Apparently the Rothschilds, the great banking family, had a saying about when to commit capital: “Buy at the sound of cannon; sell at the sound of violins.”

Although they probably were thinking about political instability, the saying has a contemporary lesson for investors. It’s a reminder that long-term cycles, from peak to trough, are embedded in the capital markets.

One way to visualize the long-term risk and benefits of stock market investing—the cannon and the violins—is through ten-year rolling returns, or the average annual return an investor would have earned over a given decade. For example:

Real 10-year rolling returns

For comparability’s sake, these figures assume a lump-sum investment at the beginning of each ten-year period. They are shown in real terms, after adjusting for inflation. The returns are based on index returns, not any specific investment. They don’t reflect the impact of any investment fees or taxes.

Over the entire period shown, the average annual ten-year return was 7.2% in excess of inflation. That rate of return, if you could bank it (which, of course, you can’t), would basically double your purchasing power—the real value of your investment—over a full decade. Again, this result would be before the impact of fees and taxes.

But what jumps out from the graph are the troughs: 1937–40 and 1973–82. Investors who had invested a decade earlier (during the periods 1927–30 and 1963–72, respectively) would have experienced poor returns over the subsequent decade. One of the worst was the ten years ended August 1974, when the average annual real return was –3.3%. That means a lump-sum investment would have fallen by about 30% in purchasing power over that period.

We are now in a similar slump. Ten-year returns today are at levels last seen in the 1970s and the early 1940s. So if you bought stock ten years ago, you bought during the great upswing of the late 1990s. And you’re now valuing those stocks in today’s severely weak economic and financial environment.

As I’ve written previously, the future evolution of stock prices over the next ten years is likely to depend on the state of the economy a decade hence—an unknowable fact today. If you believe economic conditions will be as bleak in the future as today, it’s hard to make a case for investing in stocks. On the other hand, if you believe conditions might improve, the odds are in favor of better returns—though positive returns, as the chart shows, are by no means assured. Risk is everywhere.

Last year, during the great financial and market crisis, it may have been the sound of cannon we were hearing. We can only hope for violins a decade hence.

Notes:

• All investments are subject to risk. Past performance is no guarantee of future results.

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