A 2-Minute History Lesson to Make You a Better Investor
November 11, 2019
By Michael List, CFP®
Last week, Michelle highlighted the investment biases wired in our brains that act against us, and principles we can use to improve our chances of achieving our financial goals. We will continue that theme this week, by highlighting our most important investment principle: being diversified.
History Lesson #1: Invest after midterms
Last year, Krista pointed out that the stock market has posted a positive 12-month return after every midterm election since 1942. For the next several months I thought she was crazy — especially considering how ugly things looked last December. But last week marked 12 months since the midterms, and wouldn't you know it? The S&P 500 was up around 15 percent.
This is a reminder that when it comes to investing, history is a good guide for the future. “History doesn’t repeat itself but, it often rhymes,” as Mark Twain would say.
History Lesson #2: Stock prices and earnings are closely related
So what is history showing us today? The stock market recently hit new all-time highs, so is now a good time to invest? Another relevant (though unattributed) quote provides an answer: “The best timing to invest remains yesterday, the second best is today, and the worst is tomorrow.”
Stock prices are at an all-time high because earnings are at an all-time high. Over the past 70 years, stock prices and earnings have had a very close relationship with a 0.94 correlation (1.00 is perfectly correlated).
History Lesson #3: Over the long term, valuation matters
One final history lesson tells us that the price paid for an asset has a major influence on future returns — but only in the long-run. The chart below looks at the relationship between valuation (price/earnings per share or P/E) and future returns over the next one to 12 years.
In the short term, there is almost no relationship between valuation and future returns. But longer term, 10 years or more, the P/E (valuation) at the time of purchase determined 80 percent of the total return. Just remember, since our target is 10 years in the future, we have to go through years one to nine to get there.
What have we learned? Diversification is most important
With this as a guide, how should we invest? In one word, diversify. Being diversified helps spread risk by placing your eggs in many baskets. Most clients have both short and long-term goals competing in their overall financial plan. For short-term goals, the common focus is to reduce volatility and generate a return, often by investing in momentum stocks (stocks that have performed well recently). Longer term, you want to invest in low valuation. Today, a “low valuation” strategy would include prioritizing international over domestic stocks and value over growth stocks.
When we build diversified portfolios, we invest in a balance of all these opportunities, short and long, all while reducing risk. Incorporating this and other investment principles helps us to manage assets and develop a plan to reach your financial goals, while counteracting any biases that stand in the way.
Serving clients in Siouxland for over 135 years has given us a valuable perspective on sound strategy for the long term. We at Security National Wealth Management have helped thousands of families in Siouxland achieve their financial goals. If you are looking for a financial partner to go the distance with you, please contact us today. Your success matters to us.