“In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well.”     J. Kenfield Morley, Some Things I Believe.

Do people make millions in the stock market? Sure, but what is the percentage of those investing in the stock market? Do people make 50% in half a year, 100% in a year. Sure, but how many and what is the percentage? And how many of them manage to make 20% a year over a period of 10 years? I know there are a number following the school of value investing, especially in the US market here:

http://klse.i3investor.com/blogs/kcchongnz/50988.jsp

But I know almost none of the unit trust funds have done that investing in Bursa, not even in a short 5-year period.

http://klse.i3investor.com/blogs/kcchongnz/75466.jsp

When one invests in the stock market, it is important to have reasonable expectations about returns. If you have reasonable expectation, and stay within that expectation, you will avoid major failures, and likely come out ahead in your investment outcomes. So what is a reasonable return from investment? The best way to start estimating a reasonable future stock returns is to look at how well stock markets have done in the past, using the largest data-set available.  

Historical Long Term Return of Equity Market

The stock market in the United States has been the most well researched market in the world with return data stretching over more than two centuries from 1802. The long term total compounded annual return (CAR) for various periods and durations as obtained from the book, “Stocks for the Long Run” by Jeremy Siegel, the Fifth Edition, for the US equity market is summarized as below:

1. The long term total nominal compounded annual return (CAR) from the US equity market of 210 years from 1802 to end of 2012 is 8.1%. Total return includes changes in the capital value plus dividends and assumes that all these cash flows are automatically reinvested in the asset over time. $1 invested in 1802 would have accumulated to $13m by the end of 2012, symbolizing the power of compounding.
2. There was a “lost decade” of zero return from 2001 to 2012.
3. US stock held over a one-year period, the maximum real return was 66.6%. On the other hand, there was also a year with a maximum loss of 38.6%!
4. When the stocks were held in longer duration, say for ten years, the maximum CAR was 16.8% and the minimum -4.1%.
5. Stocks held over a 30-year period had a maximum CAR of 10.6% and a minimum of 2.6%. There wasn’t a single period of 30 years when investing in stocks incur a loss.

Investing in Bursa follows roughly the same statistics, albeit with higher volatility. My own research when I was doing my Master in Finance shows that the 32 years from 1974 to 2006, KLCI had an average annual nominal return of 12%, not far from the US statistics during the same period. But that was before the plunge in stock prices during the US subprime housing crisis. I was surprised when I downloaded the longest daily stock prices from Yahoo Finance for KLCI from 1^st January 1994 to December 4 2015 as shown in Figure 1 below, the total CAR is only about 5%. That was way below the long-term return. But this could be due to the relative high stock prices in January 1994, and the recent plunge in stock prices due to the falling Ringgit, GST, AMDB, political instability, the China slowdown, Greece, the impending rate hike etc. For the last 5 years ended 4^th August 2015, the total CAR is also at about 5%, about twice the return from bank deposits, but not much different from the dividends from EPF, during the same period.

Knowing what you can expect from investing in the stock market is critical, not only for planning your long term finances but also for understanding alternative investments such as bank deposits, bonds, ASM, ASB, etc., or whether one should withdraw his EPF money to invest in the stock market. Note that the return from the stock market has been generally higher than from bank deposits, but it comes with some risks, or volatilities as termed by the pros.

How to get higher return from market?

How good is an average investor that he can beat the market, say having a consistent annual return of above 12%? Not unless some combination of the following as mentioned by Howard Marks in his book, “The Most Important Thing Illuminated”:

1. An extreme depressed market in which to buy (hopefully to be followed by a good environment in which to sell).
2. Extraordinary investment skill
3. Extensive risk bearing
4. Heavy leverage, or
5. Good luck

What is your chance?

Does an extreme depressed market like that of early 2009 comes along often? I can vividly remember how we discussed about one of “the once-in-a-life-time” investment opportunities then among a few of us working as financial advisers then. In that environment, does he still have the guts to buy big? Few, very few investors indeed, who dare to get into the market again after the burn before that.

Extraordinary investment skill by definition is something very rare. Do you have that? Do you have better skill and information over those working for the investment banks and fund houses? There are many players in the market watching the stocks and their prices like hawks. So remember,

“If something is easy to compute and understand, it is extremely unlikely that the market will misinterpret it. Therefore, such information will not, by itself, provide evidence of mispricing.”

Taking excessive risk, following rumours, hot tips, fads and hypes, chasing cyclic stocks at high prices, following the greater fool theory etc. in order to earn higher return can also work against you when things don’t turn out well and can get you into deep trouble. You simply subject to the mercy of the one who will turn the nob to stop the music.

Borrow money to invest or using margins, or leveraging does not improve your return; it merely amplify gains as well as losses. Leverage cuts both ways. Companies borrow money for doing business is well and good and that should be the way; but for individual investors to do for investment in the stock market is definitely not a good practice.

It is hard for ordinary investors not to be allured by the great stories of how some smart investors using, and increasing margin financing and have made multi-million of profit. Those are the very rare cases. Believe me, even for those who have boasted to you that they have made it so easily, you haven’t heard of the whole story yet.

I have written a case, a real one which I personally know, about someone using excessive margin finance in i3investor here:

http://klse.i3investor.com/blogs/kcchongnz/61822.jsp

If you are an ordinary person and were the character in the above story, you have no chance to get up again from that predicament of using the heavy margin financing. Game over.

“Hello, may I speak to Mr. Marginboy?”

“Yeah, it’s me. I am putting for birdie now”

“My name is Mr. Bad Remisier and I am calling to ask you the amount of $1,000,000 to be deposited in our account by the end of the day. If you don’t we will have to sell all your (losing) positions to pay off your investment loan at whatever the price we deem fit”.

Silence on the phone…

Surely you would like your life to be better than the above.

Also read my article on how one invested in some seemingly good stocks in Bursa also would suffer great pain if he engaged in margin financing. Also read the story of the plunge in SSE there.

http://klse.i3investor.com/blogs/kcchongnz/82699.jsp

Good luck in investing to get higher return? I don’t count on that, do you?

What should you do?

With this type of return statistic of the equity market discussed above, as a long-term risk averse investor, I would have the following mind set in investing, also expounded by Howard Marks:

“I need 10%. I’d be glad to earn 12%. 15% would be great. 20% or more would be terrific. But I won’t try that as that will entail higher risk which I am not willing to bear.”

There is no free lunch in investing. Risk and return are intertwined with each other; the higher the return expectation, the higher the risk.  A nominal return of 10% would provide me with a real return of 6% which is pretty good, assuming an inflation rate of 4%.  Moreover the historical risk premium of the equity market has been around 4%, and as the long term risk free rate is about 4%, the 10% expected return would provide me with an excess return, α of 2% a year. That is great as an additional 2% compounded over the years would make a huge difference.

Return expectations must be reasonable. Anything else will get you into trouble, usually through the acceptance of greater risk than is perceived. Expecting too much is likely to lead to disappointment of loss. Trying higher returns usually requires some increase in risk taking; risky stocks, greater portfolio concentration, or increased leverage.

Investing is about building long-term wealth slowly but surely. It isn’t (or shouldn’t be) speculating or gambling. It is taking calculated, prudent risk to achieve a decent return over time. Overnight or short-term windfalls are nice, but they aren’t dependent goal.

Always remember, if something is too good to be true, it probably is.

“Take care of the downside first, and let the upside takes care of itself.”

For those who are keen to learn the art and science of investing to build long-term wealth with better return expectation and less risk, please contact me for an online investment course for a small fee at

ckc14training2@gmail.com

K C Chong (7^th December 2015)