Wednesday, February 22, 2012

Why You Should Invest in the Stock Market

I've heard that everyone should be in the stock market because it gets, over the long haul, 12% returns. I've also heard that instead of trying to time the market and play games, you should get into an Index fund and just ride it out. Instead of just taking that advice at face value, I delved into it to see what is really going on.

I took the value of the Dow Jones Industrial Average as the basis for my investigation. I downloaded the full history available from Yahoo!.
I took the closing value of the Dow on the first of January of each year. The average gain from one year to the next was 6.55%. Not the 12% I've heard, but better than the around 1% rate on savings. The average inflation during that period was 3.23%, leaving our actual gains to be around 3.27%. Still, better than stuffing your mattress or putting the money in a savings account.

However, most of us do not have the luxury of going back 85 years to put our money in the stock market. This is why the phrase "past performance is not a guarantee of future returns" was invented. If we take a closer look at the average gains in each decade we can get a clearer picture of what might be going on.

Imagine if you picked the 70's to get started investing in the stock market. By the 90's you'd be pretty impressed with yourself as an investing guru. So it really depends on when you get in and when you get out, timing the market.

Let's take another look at the Dow. Compare the chart below to the Dow chart I started out with.
Notice any similarities? The first chart was the entire history I got of the Dow from Yahoo!. This chart is the same data, just up to 1982. So what do the mid 60's and early 2000's have in common? War, specifically Vietnam and the War on Terror. If you look for the pre-Vietnam run up and the flatline afterwards on the first graph you'll notice that it doesn't even register. The ramp up in the early 80's and even more so the late 90's dwarf the "problems" in the 70's.

So is the trend that following a war flatline there are two decades of growth followed by incredible growth? I think it is more of a warning about government spending, especially war spending, and what it does to the economy.

There were three events I think led to the 80's (mild compared to the 90's) boom. The first is the baby boomers (those born between 1946 and 1964). They have changed the rules at every stage of life. In the mid 80's baby boomers started turning 40. They were past the arrogant years and starting to worry about retirement. That alone would not have had that much of an impact on the stock market if it had not been for the other two events, women entering the workforce and the invention of the 401(k).

From 1970 to 1990 the percent of women working jumped over 30%. In 1970 around 1/3 of the female potential workforce was employed. By 1990 over half of the female potential workforce was employed. This increased the household income (but was in large part needed to keep up with inflation, but that is another story entirely) and added to the 401(k) boom.

The 401(k) gave companies an incentive to help their employees invest in the stock market with pre-tax money. Given that baby boomers were starting to think about retirement and taxes and companies were given incentives to help them put their money in the stock market, this led to a large cash infusion in the stock market. This is what I think led to us leaving the post-Vietnam stock slump.

The 90's also had two events that helped accelerate the stock boom, the internet (and online trading) and more available housing. I am not referring to the dot-com bubble when  I am referring to the internet, but the availability of information about companies and the ease with which the internet afforded stock trading (eTrade went public in 1996). Like the roaring 20's when the people caught the stock bug when they saw the large returns, more individuals had access to the stock market and it became popular to trade stocks online. This provided another infusion of cash into the market.

The changes to the Community Reinvestment Act in 1995 made housing available to more people. This increased the demand for housing, thus raising the prices (more people could buy homes but the number of homes did not increase as fast). This combined with the ease of online trading increased the cash available to infuse the market.

So now we look into our crystal ball to see what the future has for us. Just like the period around the Vietnam war we have a boom in the stock market, followed by some bouncy but overall flat years. Where are we going to get the cash infusion to the market for the next ride? Here are a couple of things to think about.

  1. Baby boomers are going to start retiring (turning 65 in 2011 - 2030) and start pulling money out of the market instead of putting money in. Again, they are going to change the rules. If their investing started a minor boom, what will their withdrawals do?
  2. Is there some new mechanism (tax law like 401(k) or new invention like online trading) that will encourage more people to invest in the market? Given that our economy is hurting and people are paying more attention to immediate needs than investing I don't know how we are going to squeeze more money out of people to put in the market.

So, why do I think you should invest in the stock market? Here are my reasons:

  1. You want to support baby boomers with money you'll probably never see again (kind of like Social Security)
  2. You live in a warm climate and will not need the cash to burn to keep you warm
  3. Your Investment Advisor's children are getting ready to go through college
  4. You have more money than you know what to do with
  5. You'd rather pay 22% on your credit cards and throw your money down the stock market drain
What should you do instead of invest in the stock market? I'm not going to tell you. Go out and figure it out for yourself. Learning is your best defense against poverty.

No comments:

Post a Comment