The 190-point slide in the Dow Jones industrial average on Friday the 13th--coming less than two years after the 1987 crash--made many individual investors wonder again whether stocks are worth it.
They see the market as too volatile and risky, a crap shoot primarily for gamblers and professional traders in which small investors don't get a fair shake.
"The poor individual investor thinks there's no hope for him," says Peter Lynch, portfolio manager of the Fidelity Magellan mutual fund and one of the nation's most successful money managers. "These violent declines are terrible," because they make individual investors think that investing in stocks is like "owning a lottery ticket."
Yet a close look at market trends reveals that although stock investing is indeed risky and no one knows for sure how well equities will do in the future, many fears of individual investors are largely unjustified.
Despite greater hour-to-hour price swings caused by computerized program trading, the market on a month-to-month basis has actually gotten less volatile, statistics show. Stocks--although risky over short periods--generally have continued to outperform other investments.
And while individuals perceive that professionals have an advantage, most pros on average fail to beat the major market indexes. Small investors who simply buy and hold stocks often beat many pros.
The problem, however, is that many small investors aren't disciplined. They invest emotionally, buying when stocks are expensive and selling when they are cheap--just the opposite of prudent strategy.
"People go in for the wrong reasons," says Kenneth L. Fisher, president of Fisher Investments, a Woodside, Calif., money management firm.
Here are answers to many of the questions asked by individual investors about whether stocks make sense for them:
Are stocks more volatile?
Not really. People think that they're more volatile because daily point swings are greater and occur faster. Before October, 1987, the Dow Jones industrial average had never moved 100 points in a day, not to mention in an hour, which was the case again in the 190-point free fall earlier this month.
But looked at in percentage terms, the volatility story is mixed.
True, minute by minute or hour by hour, the market is more volatile that it used to be, according to studies by Ibbotson Associates, an investment research firm in Chicago. (Ibbotson compares price movements of the Standard & Poor's 500-stock index using statistical measures called standard deviations.) That is largely because of computerized trading programs, which allow big pension funds and other institutional investors to trade millions of dollars of stocks quickly.
"Before computer trading, the market changed slowly, and minute-to-minute volatility was much less," says Larry Siegel, a managing director at Ibbotson.
Measured day to day, however, volatility in recent years is only slightly above historic averages, Siegel says. Month to month, it is about the same--except for October, 1987--and year to year, it has been less volatile in the 1980s than in any other decade of the 20th Century, he says. In effect, minute-to-minute or hour-to-hour moves cancel each other out, except in unusual situations such as that of October, 1987, and Friday the 13th, Siegel says.
Using a different measure, volatility has actually declined this year. The average daily change in the Dow industrials has been only 0.61% so far this year, even including the 190-point plunge, says Norman Mains, director of research at Bateman Eichler, Hill Richards, a Los Angeles brokerage. That compares to 0.76% in 1988 and 1.19% in 1987. The average for this century so far has been 0.71%, he says.
Money manager Fisher adds that daily trading volume is much higher now than ever before. "It takes more trading to move the market than 15 years ago. So the market is not nearly as volatile as people think it is."
Do professionals have
Yes, but managers of pension funds, mutual funds and insurance company portfolios have disadvantages, too. Sure, they hear about economic or company news first, watch their investments more closely and can more easily analyze company financial statements or technical stock data.
But because of the millions of dollars that they must invest, they often lack flexibility. They often cannot buy or sell their entire holdings of one stock at once. And their transactions are so big that they run the risk of moving the prices of stocks that they buy or sell.
Also, even with their ready access to information and other advantages, most professionals do not consistently beat market indexes such as the S&P; 500, says Spero Kripotos, executive vice president of CDA Investment Technologies, a Rockville, Md., firm that tracks money managers. When transaction costs, management fees and other expenses are added in, at least 60% of managers don't beat the market over a period of at least five years, he says.
That is why more and more institutions and individuals are using index funds that simply buy all the stocks in the S&P; 500 or other indexes. "If you can't beat it, join it," Kripotos says.
Do stocks outperform other investments?
Yes, over the long run. Since 1926, stocks as measured by the S&P; 500 have gained an average of 6.7% per year, adjusted for inflation and including reinvested dividends as well as price appreciation, Ibbotson says. Riskier small-company stocks have gained even more: 8.9% per year. By contrast, long-term corporate bonds have gained only 1.9%; long-term government bonds, 1.2%; five-year governments, 1.7%, and Treasury bills, 0.5%.
Put another way, a dollar invested in 1926 in stocks would be worth $75.19 now, adjusted for inflation. That same dollar invested in small-company stocks would be worth $253.54. But in long-term corporate bonds, it would be worth only $3.50; in long-term government bonds, $2.38; in intermediate-term governments, $2.99, and in Treasury bills, $1.36. In residential real estate, it would have been worth $20.25 at the end of 1987.
Stocks have outperformed all other investments during any 20-year period between 1926 and now, Ibbotson's Siegel says.
But over shorter time periods, stocks are not always superior, he says. Over the decades of the 1970s and 1930s, for example, stocks actually lost money on average each year. On Oct. 19, 1987, the Dow fell 22.6%. Between September, 1929, and July, 1932, the Dow lost a whopping 89%.
The lesson: The longer you hold stocks, the greater the chance you have of earning superior returns. Over the long run, greater risk will be rewarded with greater returns.
When do stocks perform best?
The evidence shows that stocks generally like periods of low or decreasing interest rates. They also love a declining rate of inflation (although not deflation, as in the early 1930s). In times of inflation equities perform better when the inflation rate is low, rather than high.
The proof: In the low-inflation 1950s and 1980s, stocks earned average annual returns (appreciation plus dividends) of 17.2% and 7.8%, respectively, Ibbotson says. But in the high-inflation 1970s, stocks fell an average of 0.4% per year.
How can the small investor reduce risk in stocks?
--Take a long-term perspective and avoid emotions. Learn to accept short-term volatility as part of the territory. Realize that violent, hour-to-hour swings often cancel each other out in the long run.
"Like the earthquake in San Francisco, individuals should stay indoors until it's over and not run out on the street and panic," says Sharon Gamsin, a spokeswoman for the New York Stock Exchange. "Those individuals who acted as investors rather than traders over the long run have done extremely well and often outperformed professionals."
--Don't invest money you can't afford to lose. "If you need money next April 15 to pay taxes, you shouldn't buy stocks with it," Ibbotson's Siegel says. Many advisers say the amateur investor should view stocks or stock mutual funds as at least a two-year commitment.
--Buy low, sell high. This is a basic principle of investing, but many don't follow it because it goes against their basic emotions.
"When things look bleakest, you're supposed to be buying, and when it's good you're supposed to be selling," Fisher says. But instead, people tend to hold stocks until the market gets terrible, and then sell.
--Diversify. Just because stocks have generally outperformed other investments in the past doesn't guarantee that they will do so in the future. So don't put all your money into stocks.
Divide your investments among stocks, bonds, real estate, and money market funds or savings accounts. If stocks and bonds do poorly because of high inflation, real estate will do well. One of the best decades for housing was the 1970s--one of the worst for stocks.
Also, diversify your stock portfolio. Don't put all of your money into one or two issues or one or two industries. If you don't have at least $50,000 to invest in a diversified portfolio of stocks, then consider mutual funds. They provide instant diversification for far less money.