One of the typical scare tactics of personal finance commentators that criticize buy-and-hold investing is to point out long stretches of time when a buy-and-hold strategy seems to not work. Among other periods, these pundits may point to the 1966-1981 stretch when the S&P 500 index only "seemed" to return 1.8%. There are some important considerations to keep in mind when thinking about crafting a long-term investing plan in light of this data.
The first thing to keep in mind is that specific periods are chosen for a reason. When someone points to 1966-1981 to spell out a doom scenario, it usually means that stocks performed well pre-1966 and did well post-1981. The year 1966 represented a 10% decline in the S&P 500, but the three previous years were quite kind to investors seeking paper wealth creation. Counting dividends, the S&P 500 went up over 12% in 1965, over 16% in 1964, and over 23% in 1963. If you start your analysis in 1963 instead of 1966, you would get a much better result.
The same holds up on the tail end as well. After 1981, there was not another single down year for the S&P 500 for the rest of the 1980s. Long-term investors got to experience two years of annual returns in excess of 20%, and two years of annual returns in excess of 30% throughout the 1982-1989 stretch, and the long-term performance of buy-and-hold investing looks much better when you are not evaluating a band of time in the 20th century designed to demonstrate the long-term performance of American stocks look bad.
Additionally, unless you are dealing with lottery winnings, an inheritance, or something of such a one-time nature, it is unlikely that your approach to investing would be of the lump sum variety. Most people invest as money becomes available, as opposed to only making a lump sum investment at the "worst" point in time and never adding capital afterwards. Sixteen years of investing $1,000 on January 1st of each year from 1966-1981 would have gotten you an extra six percentage points of annual returns compared to making a $16,000 investment in 1966.
How is this possible? Well, from 1966 to 1981, the S&P 500 actually grew earnings at 7.0% annually, but the reason why the total returns appear unsatisfactory is because the P/E ratio of the S&P 500 fell from 17.8 to 8.0 over that time frame. A dollar cost averaging strategy would allow investors to come closer to capturing the growth of corporate America during that time frame because they would be buying at lower P/E ratios along the way, especially during years such as 1973 and 1974.
But even when we are speaking in terms of lump sum investments in 1966, it can be useful to keep in mind that the 1.8% annual gains you hear about over the 1966 to 1981 period only refers to price change. If you include the fact that investors received 4.1% annually in dividends along the way, the total returns experienced by investors was actually 5.9% in nominal dollars, as opposed to the 1.8% that you hear about. As long as your personal inflation rate was below 5.9% annually during that period, you increased your purchasing power.
And lastly, valuation context is important. For instance, the 1966-1972 price run-up represents the bubble days of the Nifty Fifty. Johnson & Johnson (NYSE:JNJ) traded at 57x earnings, Coca-Cola (NYSE:KO) traded at 47x earnings, Merck (NYSE:MRK) traded at 43x earnings, and so on.
Benjamin Graham was famous for saying that no matter what is going on in the world, there is always something intelligent to do in the here and now. His most famous student, Warren Buffett, proved this. From 1966 to 1981, Buffett managed to grow book value by 23% annually. Clearly, he found something intelligent to do in the 1966 to 1981 environment.
That's the joy of individual stock picking. When you look at an S&P 500 index and see large-cap companies trading at absurd valuations in the 40-50x earnings range, you do not have to buy into that. Opportunities are always out there, even in the high-quality blue chip space, and they can be found.
You could have compounded your investment at 15% annually if you bought tobacco-maker Altria (NYSE:MO), because at the time, its foreign arm Philip Morris International (NYSE:PM) was experiencing rapid-fire growth abroad. If you wanted a more traditional blue-chip holding, you could have bought Procter & Gamble (NYSE:PG). Not only was the company growing at a 14% annual clip, but on January 1st, 1969, the consumer giant had to spin off Clorox (NYSE:CLX) because of a Supreme Court ruling on anti-trust grounds. Both of those companies went on to give investors total returns of 11% and 13% (respectively) through the 1981 period (this assumes the full reinvestment of dividends).
This isn't mere armchair quarterbacking. Procter & Gamble was a perfectly obvious blue-chip holding back in 1966. I have no idea where the perfect place to begin your investment research process is, but I will say this: if agents of the United States government are issuing orders to break your business up because it is too powerful and profitable, you might be looking at fertile soil to initiate the due diligence process. That is exactly what happened in the late 1960s when the FTC won its lawsuit against Procter & Gamble, forcing it to spin off Clorox.
That is why I do not finding periods of supposed underperformance like the 1966-1981 period to be disheartening. There are several lines of defense an investor can deploy to achieve satisfactory results. First of all, if you include dividends, those 1.8% total returns just became 5.9% average total returns each year. Secondly, a strategy of investing new funds each year (i.e. like an employee taking money from his paycheck to buy stocks) would have increased your returns by 6% annually on average (assuming full dividend reinvestment). And lastly, you are free from the shackles of owning grossly overvalued stocks by engaging in individual stock picking rather than indexing. Benjamin Graham was right. There's always something intelligent to do.