Market Tends to Reward Stock Investor Perseverance

Welcome to today’s one-step-forward, one-step-back stock market -- a market that bears striking similarities to that of the 1970s, another time of rising inflation, climbing interest rates and a stock market stuck in a seemingly endless box step.

The bright side for today’s investor is that although the decade of the ‘70s ranked as the second-worst market in U.S. history -- just after the Great Depression -- it also was rife with opportunity for those with the time and the skill to avoid land mines. In the first half of this decade, which ranks as the third-worst bear market in history, a few lessons learned in the ‘70s may prove beneficial.

Lesson 1: Bad markets are good for those with time. To 20- and 30-year-olds, today’s market may look like a sorry deal. The decade started with losses -- 9% in 2000, 12% in 2001 and 22% in 2002, as measured by Ibbotson Associates’ large-company stock index. Then there were two good years before 2005’s lackluster 4.9% total return. This year, the market is barely treading water.

Investors tend to assume that whatever has happened lately is what’s probably ahead, said Hugh Johnson of Johnson Illington Advisors in New York. So these young investors may think real estate is a better investment than stocks. Big mistake.

The reason is the likelihood of “reversion to the mean.” Translation: At some point, lagging market performance will tend to catch up and deliver average returns over time.

For people who start investing in a bad market, that can spell opportunity.

Consider someone who put $1,000 a month into the stock market starting in January 1970. Over the decade, because of several years of double-digit losses, this investor earned a mere 5.9% compounded return.

But if he had the fortitude to stick with what appeared to be a stupid investment, he’d be richly rewarded because stock prices zoomed forward in the next two decades to catch up to their norms.

The average return in the 1980s was 17.55%, and it was 18.2% in the 1990s. The investor who stuck through 30 years making consistent investments every month would have ended up with $4.03 million.

What would happen if he earned the same returns, but in a different order -- the good returns early and the bad later? He’d end up with $3.08 million, or nearly $1 million less.

The trick? Investors who start in bad years suffer when they’ve got the least at stake and reap a windfall after they’ve been able to build up a nest egg.

Lesson 2: Rotten markets can last. The 1970s held a very different lesson for older investors: Markets turn around in their own good time, not yours. If your financial plan requires a set rate of return, leaving the bulk of your assets in stocks is foolish.

Money that can’t be left alone for long stretches belongs in more stable investments, such as medium-term bonds, certificates of deposit and money market accounts.

“That’s why we tell people that they have to have a long horizon,” said Roger Ibbotson, a professor at Yale School of Management and founder of Ibbotson Associates. “If you are going to get jumpy every time there’s a drop, you’re going to feel whiplashed by the stock market.”

That doesn’t mean that older investors should pull every dollar from stocks, said Christopher Orndorff, head of equity strategies at Los Angeles money management firm Payden & Rygel. Virtually anyone with a remaining life expectancy of 10 years or more should have some stocks. But the more you rely on income from your portfolio, the smaller that percentage ought to be.

Lesson 3: Get in gradually. The last couple of decades have delivered far more stable returns than is historically true, Ibbotson noted. In the ‘70s, the market was choppy, like it is today. That can be beneficial to those putting money into the stock market on a regular basis.

“Choppy markets are the norm,” Ibbotson said. “But as long as the market keeps returning to where it was, volatility is good.”

The reason: One month stocks will be up; the next, down. By pouring the same amount into the market in good times and bad, investors reduce their average cost and eliminate the chance of putting all their money in at the peak. Investing the same amount month after month is called dollar-cost averaging.

Consider how it would have worked for an investor who put $1,000 annually in big company stocks at the end of 1970 and continued investing through 1980.

Even though total inflation-adjusted returns amounted to a poor 3.7%, this investor would have reaped a 13% gain over the period because, by investing $1,000 each year, he bought more shares on market dips and reduced his average cost. Had the market been stable or steadily rising, he would have fared much worse.

Dollar-cost averaging has the added benefit of taking the emotion out of investing, Johnson said.

“If you let your emotions drive your investment decisions, you will be selling when there is widespread despair and buying when there is widespread euphoria,” he said. That’s the point when markets always make a U-turn, he added.

“It’s a mistake to get caught up in the current worries because what counts is not what happens in 2006 or 2007 or when earnings come out for the third quarter or what the Federal Reserve does in June,” he said. “What really matters is the very long haul. Over the very long haul, stocks have averaged 10% a year. If you are able to do that, over a long period of time, you will become immensely wealthy.”

Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com.