May 242014
 

To become successful investors we have to think like marathon runners, because we have to stay committed to the long run 😀 So when it comes to the stock market the short term fluctuations are not important. Our perception of risk and performance should be placed on looking further down the road.

14-05-funny-Netflix-Marathon-TV-running

Below are two made up scenarios for the stock market. Let’s pretend they are index funds that track the overall market performance. Both indexes start at $100 per share and play out for five years. If we were to consistently invest $10,000 every year into one of these funds, which of the two scenarios would likely make us more money by the end? Take a guess 🙂

14-05-stockscenarios stock market perspective performance

If you picked the bottom red chart then congrats! Because you will probably learn something new today and become a smarter investor 😉

At first glance the red chart appears to be more favourable. A consistently rising stock market has got to be better than the volatile nature of the other graph right? Well not necessarily. Since we are contributing $10,000 a year into the stock market, the larger fluctuations from the blue chart in scenario 1 means we can buy more shares when the price is lower. In year 3 for example, we can buy 200 shares of the fund in the blue chart with our $10,000 because each share is only worth $50.

What that means is by the end of the 5 year period we would have accumulated 703 total shares from the blue chart. Each share would be worth $90, giving us a portfolio worth $63,250. Meanwhile we would have only accumulated 416 total shares from the red chart which would put our portfolio value at just $58,211. Which is less than the blue chart results, despite the final share price of the red chart being 55% higher ($140/$90.)

So during the accumulation stage of our investment careers we don’t actually want our portfolios to consistently increase because we are still contributing money into it.

If you look at the latest 5 year stock performance of the S&P 500 index in the U.S. you’ll see that it looks pretty much like the red chart in scenario 2. In fact it just reached a record high yesterday. Lots of people who are invested in the markets are feeling really good right now. But is this a false sense of security? 😕 For most people who are not yet retired this will actually hurt them in the long run. It’s like sprinting to get ahead in the beginning of a marathon. Personally I look forward to a market correction so I can buy cheaper stocks like the blue chart scenario, which is very similar to what happened during the last recession 🙂 Many people were spooked by the markets around 2008/2009, but those who still had jobs and had the temperament to continuously make regular contributions actually made a lot of money from that solemn economic time.

The trick is to buy companies when they become undervalued. Below are the 2006 to 2010 financial details of one of my favourite companies, Disney! Its “Earnings” in 2008 and 2009 were lower than in the previous year due to the recession. Its “Sales” also fell slightly in 2009. I’ve circled where these numbers are.

14-05-disneyincome stock market perspective

These figures tell us that even in 2009 Disney still made $3.3 billion in profit. Sure it was 25% less profitable than a year ago in 2008 but it still generated massive wealth for shareholders. Naturally the stock price should have also dropped by 25% to keep the valuation of the company consistent. However, Disney shares fell a lot more than that.

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Wow, that’s almost a 60% drop from 2008 to early 2009. A company that was worth $35/share a year earlier was then trading at $15/share. Talk about a bargain! We could have picked up more than twice as many shares for the same money invested as before.

People line up for hours to buy TVs on Black Friday, yet when stocks go on sale people don’t seem to care as much, lol. So the next time the stock market takes a dive, don’t pull out of the game. Just remember that we’re in it for the long run and simply buy more stocks at a discount 🙂 A disciplined, long term, steady approach to saving and investing will always win out in the end 😉

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Random Useless Fact: Practice good posture. You burn 10% more calories when you sit up straight.

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Liquid IndependenceWes Tibbetts, CFA® (@GenWiseWealth)financejourney.comCharotteThe Wallet Doctor Recent comment authors
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debt debs
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Brilliant! Now I’m looking forward to the next stock market tumble. Bring it on! 😛

Asset Grinder
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I would welcome a huge drop in the market. I would just triple up on everything. Maybe even sell my house to buy more lol

DivHut
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I think a lot of us are waiting for these lofty valuations to come back down to earth a bit. I have a feeling there will be a lot of buying going on.

The Wallet Doctor
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Very interesting! I think you have illustrated an important point very successfully here. I’ll definitely start being more aware of when stock goes on sale!

Charotte
Guest

Really great post, interesting stuff. Back In January when the market dropped a bit, I made sure to pick up more than extra then to get a good return. That being said, my automatic investment contributions went through on Friday and I cringed. I know it’s natural for the market to ebb and flow but being such a young investor, I really wouldn’t mind if it dropped for a while! 🙂

financejourney.com
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Well said, psychologically we (human) happy when our stock portfolio go up all the time, but in reality our shares should go down so we can buy more units for low price, and more units mean more dividend income :D.

Wes Tibbetts, CFA® (@GenWiseWealth)
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Good words of advice…dollar cost averaging when stocks are cheap!