The Risks Of Being Out Of The Game

Includes: CVX, GPC, KO, PG, SPY, T
by: Eli Inkrot


I have previously demonstrated the idea that “all time highs” necessitate neither high valuations nor immediate price declines.

In the prior commentaries I used specific examples to illustrate this concept.

This article takes a more generalized approach to reach a similar conclusion.

In the end, regardless of what you “believe” might happen, the risks of being out of the investing game are far greater than the risks of being in it.

In a recent article I detailed how selling or waiting to buy could expose you to the risk of "losing out on the ultimate bonanza." Within this commentary, I used three specific forward looking examples - Coca-Cola (NYSE:KO), Genuine Parts (NYSE:GPC) and the S&P 500 index (NYSEARCA:SPY) - to demonstrate the logic. The underlying reasoning is quite straightforward: you have no way to determine what the price of a given company or the market will do tomorrow, next week or next year. As such, the best that you can do is realize that equity partnerships tend to be quite profitable in the long-term and keep this dependable mindset throughout your investing career.

The takeaway was that time, consistency and compounding can make up for many "valuation missteps" while simultaneously providing reasonable results. In general the article was well received, yet a few suggested something along these lines: "the market is too high right now, just wait." In other words: "don't buy high, wait to buy low." In theory it seems perfectly sensible. Yet in practice, nothing could be further from the truth. In fact, as we'll see, this could actually be a lot riskier than it seems.

Consider the average investor dating back to 1991. Over the next 20 years equity investors earned a yearly average of 3.83% as compared to the S&P 500 index's return of 9.14% per annum. Think about that. You could have picked an index fund, ignored anything finance related for 2 decades and concurrently crushed the returns of your fellow average investor.

The Forbes 400 list was created in 1982. Since naming the original 400, just 7% of those remained on the list through 2009. Any guess what compound annual growth rate of wealth was required to remain on the list? About 8.7%. Any guess what the S&P 500 index returned over that period? Roughly 10.6% with dividends reinvested. Now certainly it's true that wealth generation isn't the focus of everyone - philanthropy, business control, other projects and family planning certainly play a role. Yet it holds that the majority fell off the list because their wealth either did not grow fast enough or eroded. And to think, all they had to do is grab an index fund and tick "reinvest dividends."

Any way you present it, it's clear that your biggest investing obstacle can often be yourself. Investor psychology, fees, constant media streams and transaction costs can really affect returns.

Not it should be underscored that I'm not advocating a pure John Bogle indexing strategy. Everyone is different with regard to his or her investing objectives and temperament. Some might focus on total wealth accumulation, regardless of dividends or domicile. Other investors may want to ignore the market and consider the higher yielding world of preferred equity. Or perhaps some shareholders focus on a dividend growth strategy; focusing on a growing stream of income supplied by what they perceive to be "wonderful partnerships."

There are many strategies that will work just fine for the individual. All I'm suggesting is that quibbling over whether not to buy Chevron (NYSE:CVX) at $130 or $120, AT&T (NYSE:T) at $36 or $33, or Procter & Gamble (NYSE:PG) at $81 or $76 likely won't mean much 30 years from now.

I'll finish with a comparison to the current market, using the historical returns of the S&P 500 as a guide.

On a pure return basis, 1995 looked quite a bit like 2013. From 1991 through 1995 the S&P 500 index returned about 115%, or a 16.6% annual rate. From 2009 through 2013, the index returned 128%, or a yearly rate of 17.95%. Both were strong 5-year positive streaks and the value of every dollar invested would have doubled to $2 and change.

Obviously, and this almost goes without saying, but obviously history is not a forecaster for the future and this certainly isn't a prediction of any kind. Yet consider the investor at the end of 1995. It would have been seemingly rational to take a stance along these lines: "you know, the market has more than doubled in the last 5 years, it's gone up much faster than its historical average, I think I'll just wait for a big correction to occur then invest."

Of course the problem with that ideology is that you might then see something like this:

1996 - 23%

1997 - 33.4%

1998 - 28.6%

1999 - 21%

All told the next 4 years would bring the total increase to 155% more than it was at the end of 1995. The counterpoint is straightforward: "but it was the tech bubble! The period of irrational exuberance." True, but the investor of 1995 didn't know that. In the same way that today we have no idea what will happen in the next 4 or 5 years.

Eventually, the "hammer comes down" and provides a period of negative returns.

2000 - negative 9.1%

2001 - negative 11.9%

2002 - negative 22.1%

Yet reflect on the idea that the index still would have been up by about 59% since the end of 1995, despite the "crash." Now if you had told the investor back at the end of 1995 that the annual returns including dividends for the market over the next 7 years would be about 6.9% annually, that would have seemed reasonable. They might have thought: "the market has gone up quite a bit, the returns "need" to come back to a reasonable level, so slightly lower returns over the intermediate-term could be expected."

What couldn't be predicted is the order of returns. You have no way of telling if next year is a negative 20% year or a positive 30% one. Moreover, if you had decided to sell or hold on to cash in 1995, when do you choose to put it "back to work?" Prices never get lower than they were then, despite future negative years to come.

This is in no way a prediction, but it's possible that the same could hold true today. Yes returns have been above average for a while and yes valuations are higher than they were 5 years ago. Yet consider that these facts are not mutually exclusive from solid returns in the future. Much like the investor of 1995, you could have made the same argument at the end of 2012: "we've had a good run, prices are higher, perhaps I'll sit 2013 out and wait" - simultaneously missing out on a 30%+ year.

The thing of it all is that we simply don't know. Nobody likes to buy today and see prices decline 10% next month; that's always a risk to keep in mind. In the short-term there's no great insight. However, what's worse is not buying today in fear of a decline that never comes. You can live with buying and seeing the market temporarily bid prices lower than your cost; not buying and seeing prices forever higher is a bit harder to deal with. If we know that a long-term time horizon can sensibly expect positive results, the risk of waiting is far greater than the risk keeping a levelheaded temperament.

Warren Buffett expresses the sentiment better than I:

"Since the basic game is so favorable, I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity… The risks of being out of the game are huge compared to the risks of being in it."

Disclosure: The author is long CVX, T, KO, PG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.