Happy Hour: Pause For Effect

Includes: DIA, QQQ, SPY
by: Novel Investor

Fortune has a good article on the flat market we've experienced so far this year. It gets into the possible reasons why, what history has to say about what to expect next, and why you shouldn't read too much into it.

I have a simpler answer. Markets need to pause every once in a while.

Here, I'm defining pause as a temporary break in the long term upward trend the stock market has been on since forever. Not all pauses are the same. Some are extended, awkward, uncomfortable, or dramatic. But mostly it's a short period where the market settles down, corrects, or breathes, before it finds its direction again. This happens all the time.

The market can't have high double-digit stock returns without a few flat or losing years to even things out.

Blame math.

The S&P 500 was up 27% in 2009, 15% in 2010, 16% in 2012, 32% in 2013, 14% in 2014 (check the charts).

I understand everyone wants those types of returns all the time, every year, no matter what. Who wouldn't? Except we can't.

The market can't get those returns and have a historical 10% average return without something changing. Either the average needs to rise or low returns (or losses) are needed to move back toward the average. Both are certainly possible. But the latter is more plausible.

This works both ways. A string of low returns or losses needs to be offset with higher returns or the average needs to fall. Again, I'd bet on higher returns.

Yet, this basic math seems to stump many investors. They see great returns and expect more while failing to see any potential after a fall.

I'd much rather they look for what's done poorly knowing the potential that's there.

Mentally, this is very hard to do. Few people look at something that's lost money and think, "What a great place to invest!" Yet, it's exactly what you should do if you like great returns.

If that's not possible, choose a strategy that fits you better, one that doesn't promote bad behavior, and temper your expectations.

My point is - Pauses should be expected. Maybe even taken advantage of. And if you're not expecting one at some point, then it's time to recheck your math.

Last Call

  • Thinking Strategically - S. Adams
  • Pick a Valid Strategy, Stick With It - Aleph Blog
  • Why Your Investment Strategy Should Fit on an Index Card - Morningstar
  • A Dozen Things Charlie Munger has said about Reading - 25IQ
  • Stop Thinking About Markets as if They Were Human - B. Ritholtz
  • Ignore The Dividend Hype - L. Swedroe
  • Charlie Brandes and the Orthodoxy of Value Investing - Institutional Investor
  • GMO Letter: Ten Quick Topics to Ruin Your Summer - J. Grantham
  • An Encouraging Historical Parallel to China's Stock Bubble? - FT Alphaville
  • What I Learned Talking to Stock-Market Investors in Shanghai, China -Marketwatch