Short-Term Patience, Long-Term Rich

Anyone investing in the stock market over the last two decades knows the pain of the saying, “easy come, easy go.” It’s been a bitter lesson for many that the real, long-term wealth in the stock market comes from not expecting huge annual returns but investing for stable and reasonable gains.

Unfortunately, this lesson is also easily forgotten. I do not know if it is human nature to overreach or if it is the pressure of the crowd but stock market bubbles and their eventual bust seem inevitable.

The next big is probably the next big bust

At the heart of stock market bubbles are expectations and greed.

Greed causes people to disregard their own analysis and pay more for stocks than they should, all on the hope that returns will keep skyrocketing. Greed also sets investors up to be victims of fraud. No investment is fool-proof and none, other than U.S. Treasury Bonds, can guarantee a percentage return. Most people realize this but let greed get the better of them when some charlatan sells them an investment with a, “guaranteed 20% return.”

CNBC host Jim Cramer has a pretty powerful saying, “Bulls get rich, Bears get rich but pigs get slaughtered.” Do not let greed affect your judgment in investing.

At the height of its recent value, shares of Tesla (TSLA) had jumped almost five-fold in less than a year. The stock seemed unstoppable, even as the company’s own CEO said that the shares were not worth that much. He was right and the greedy got slaughtered when the shares dropped 38% in less than two months.

Expectations for rational profits are the first to break-down when a stock market bubble inflates. While a company or the overall economy may grow fairly quickly over a short-period, there are limits to this growth over longer periods of time. Since investing is just buying a share ownership of a company, or the overall market, then there must be limits to the profits on invested dollars.

The problem is that investors hear get-rich stories about their cousin making 20% every year on a hot stock or a trading strategy and they want in on the action. As more people jump into the investment, the price increases and seems to justify all their hopes. Eventually, reality sets in and the company is unable to meet the ultra-high expectations for growth. Investors sell out as quickly as they bought into the shares and the stock, or the entire market, plummets.

What can I expect from investing?

The stock market consists of three basic components: dividends, growth in company earnings and changes in the amount investors are willing to pay for those earnings (the price-earnings multiple). Over short periods, the price multiple can rise and fall dramatically and drive returns one way or the other. Over longer-periods, it is earnings growth and dividends that drive returns so that is where you should look for long-term expectations.

Earnings growth, a function of sales growth and profit margins, has increased by about 6% to 7% over the long-term. Growth in sales may increase faster after a recession or may slowdown after many years of a booming economy but tends to even out over periods more than a decade. Profit margins change with costs and interest rates but are fairly consistent over time.

Dividends for companies across the market are fairly stable as well, ranging from 1.5% to 3.0% over the long-term. When you combine the two components, you get a range of 7.5% to 10% for reasonable expectations of stock market returns.

Over the twenty years to December 2013, the S&P500 has returned 9% on an annualized basis. Some economists and analysts are saying this long-term return may come down because of debt burdens in large countries like the United States and Europe but I think investors can still expect a range of between 6% and 8.5% over the long-term.

This modest return is well below the 17% annualized return investors have seen in the five-years to December 2013. The higher annual return on the market could continue for another couple of years but, as is always the case, a price correction will bring the long-term average down. Rational investors are reducing the amount of risk they have in their portfolios so their investments will not lose as much when that correction comes.

With the expectation of earning between 6% and 8.5% a year over the long-term, you can begin to look at individual stocks and the stock market in a more informed light. If investors are paying so much for a share of stock that it would take growth of 30% or 40% for many years to justify the price, then maybe it is not one for rational investors. If the market has increased by upwards of 20% year after year, then it is quite possible that things are heading for a letdown.