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A brief history of stock investing

By David Luhman on Sun, 05/10/2009 - 00:49

A brief history of stock investing

Long-term returns of stocks

Hi I'm David Luhman and welcome to "Stock Investing for Everyone". In this tape I'd like to introduce you to the opportunities and risks afforded by investing in common stocks.

Let's begin by taking a look at why someone would want to invest in stocks. The obvious answer is to make money.

Stocks have been the best long-term investment of this century. Over the past 70 years, stocks have given an average annual return of about 10 percent, long-term bonds about 5 percent, and short-term debt about 4 percent. Inflation during that period averaged about 3 percent per year, so only stocks have beaten inflation and taxes by a good margin.

And because of the power of compound growth which I discuss in my tape on retirement planning, this slight difference in returns translates into much more wealth over a long period of time.

If you had invested $10,000 in bonds returning 5 percent 30 years ago, your investment would have grown to about $43,000. However if you had invested $10,000 in stocks returning 10 percent 30 years ago, you would have $170,000 or four times as much.

Investing in an asset with a slightly higher rate of return compounds into a large difference over time.

Volatility of stock markets

But this higher return comes at a price. Investing in stocks involves more short-term risk than investing in bonds. Bonds face risks in the long run because they don't keep up with inflation, but stocks can be risky in the short run.

Over the past 100 years the Dow Jones Industrial Average has seen 24 turbulent cycles, so the average market cycle lasts about four years.

In each cycle the Dow Industrials lost an average of 35 percent. These bear market losses tend to be short, and sharp, with each downturn lasting about a year.

However the market usually makes up these losses and more in the upleg of each cycle. The average upside move typically lasts about three years, with an average gain of about 100 percent.

Stock returns in the 1920s

Now let's take a look at the recent history of stock investing.

The 1920s were a great time for stocks. The inflation that came to America after World War I disappeared during the 1920s. As long-term interest rates dropped in the US during the 1920s, stocks became increasingly attractive.

The Great Depression

This lead to the bull market of the 1920s, which of course culminated with the stock market crash of October, 1929. The crash of October 28th was steep, with the Dow falling 13 percent, and then falling another 12 percent the next day.

The market recovered in 1930, but then experienced a free fall from 1930 to 1932. In this period the Dow Jones Industrial Average went way down. From the high of 380 points in 1929 to the low of 42 in 1932, the Dow Jones Industrial Average lost nearly 90 percent of its value.

This is an unparalleled loss in the modern history of stock investing. The only other modern crash which even comes close to the Great Depression was the bear market of 1974 when the market fell 45 percent.

However, the 1929 crash was unique in that it affected almost all stocks. In today's market, it's not uncommon to see a small stock lose 90 percent of it's value over a few months, but today's large blue chip stocks rarely drop more than 50 percent in a bear market. However, in the Depression, even blue chips like AT&T and General Electric lost 75 to 98 percent of their value.

The 1930s was a turbulent time for stocks -- on both the down side and the up side. Between 1932 and 1937 stocks rose over 370 percent - an unprecented rise. By contrast, the second greatest upward move in stocks was the 250 percent move between 1982 and 1987.

So if you think stock investing is wild today, it's nothing compared with the early 1930s!

Although the 1930s yielded some of the worst years for stock investors, it also gave us some of the best legislation. As a result of the crash the Securities Exchange Act of 1934 was passed.

This law helped to protect investors by forcing securities issuers to make key disclosures regarding the risks of investing in their securities.

Stocks in the 1950s

With the tremendous crash and volatility of the 1930s, it's no wonder that many investors steered clear of stocks for most of the 1940s and 1950s. In fact, during this time, most stocks had a higher dividend yield than corporate bonds paid in interest.

This seemed natural, many thought. Since stocks were riskier than bonds, the dividend yield on stocks should be higher than the interest rate on bonds.

But investors forgot one thing. Stocks offer a chance for growth, while bonds only offer the simple return of your principal, plus a fixed amount of interest.

Growth in stock earnings

During the 1950s and 1960s investors once again realized that although stocks are more risky, they also offer the opportunity for real growth, something that bonds don't offer.

So 1950 to the late 1960s was a great time to invest in stocks as the American economy grew at an enviable rate.

Stocks in the 1970s

Stocks were doing well until 1966 when the Dow almost reached 1,000 points. However, stocks were about to face serious problems during the inflationary 1970s.

But from 1966 to the early 1970s the Dow Jones Industrial Average couldn't break out past 1,000 points. With the overall market going nowhere, investors focused on several stocks with supposed magical properties.

Nifty Fifty stocks

These stocks were called the "Nifty Fifty" or the so-called "one decision stocks". These were companies like Xerox and Avon that had good management and excellent growth prospects.

According to the conventional wisdom, the only decision you had to make with these stocks was to buy them. These stocks, which at one time sold at price to earnings ratios of 80 or more, supposedly would grow forever, so you never had the make the decision to sell them.

But many investors soon decided otherwise. Although the Nifty Fifty may have been a list of 50 good stocks, they were overpriced. After the Arab oil embargo and the 1973-74 recession, it seems like many investors made another decision and sold the so-called "one decision" stocks.

Avon, Xerox and the rest of the Nifty Fifty soon collapsed. The rest of the market wasn't spared either with the Dow losing 45 percent to bottom out at 577 points in 1974.

1970s stagflation

And the high inflation that ended the 1960s bull market in stocks plagued the market throughout the 1970s.

High inflation made other investments like real estate, gold, and money market mutual funds look more attractive than stocks, at least in the short run. And with inflation devaluing your dollar 10 percent each year, investors were interested in the short run.

Even though stocks didn't offer much in the way of capital gains during the 1970s, stocks did pay increasing dividends because company earnings increased throughout most of the 1970s. And it was this increase in earnings that helped set the stage for the great bull market of the 1980s and 1990s.

During the 1960s and early 1970s, the price to earnings ratio for stocks was high, around 18, but by the late 1970s it had fallen dramatically to around seven. This drop reflected the drop in the popularity of stocks.

But as inflation and interest rates dropped in the 1980s, the good earnings of stocks began to look more attractive. Now prices have risen so high that in the mid-1990s, stocks once again are beginning to look expensive.

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