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How You Can Gain an Investing Edge

In his book The Signal and the Noise: The Art and Science of Prediction, statistician and political forecaster Nate Silver asked:

“How could stock prices be so predictable in the long run if they are so unpredictable in the short run?”

The phenomenon embedded in his question might actually be one of the most overlooked and counter-intuitive things about investing. But, it’s born out in the numbers.

Peering into the crystal ball

Take a look at the chart below, which is reproduced from Silver’s aforementioned-book. It compares the annual returns of the S&P 500 (a U.S. share market benchmark) for a 1-year holding period against the index’s starting valuation. The data utilised actually goes back to 1871, so we have more than a century worth of figures here.

S&P 500 annualised return (1-year period)

Source: Robert Shiller’s data; author’s calculations

As you can see, a 1-year holding period is essentially a coin flip; cheap shares can easily fall and become cheaper while expensive shares can just as easily go roaring on and become even pricier. But look what happens when we stretch the holding period to 10 years:

Average annual return for S&P500 (10-year)

Source: Robert Shiller’s data; author’s calculations

The dispersion of the S&P 500’s eventual annual return versus its starting valuation now becomes way more orderly with a very clear theme: Buy stocks when they’re cheap, and you’re likely to do well over the long-term; buy them when they’re pricey, and you’d have very poor odds of a good outcome.

This is what prompted Silver to ask his question.

Peering into another crystal ball

Shares aren’t the only financial asset which displays short-term unpredictability but yet have long-run-predictability. Bonds do the same thing too as seen in the two charts below which were shown in a recent blog post by investment manager Ben Carlson.

Bond yield graphs

Source: Ben Carlson’s blog

The first chart shows how U.S. 10-year Treasury bonds’ subsequent 10-year returns have a very strong correlation with their current yield. The second chart meanwhile, gives us an idea of how volatile the same bonds’ returns can be over a 1-year period. As it is with shares, a 1-year holding period for bonds is essentially a coin flip for bond investors.

Putting on our thinking hat

Besides making it easier to gauge our future returns, long-term investing also stacks the odds of success in the investor’s favour. One of my favourite examples shows how the odds of losing money in the Straits Times Index (SGX: ^STI), Singapore’s market barometer, decreases as we lengthen our holding period in it.

If we measure returns at the start of every month from 1988 to August 2013, there’s a 41% chance of sitting on negative nominal (i.e. unadjusted for inflation) returns if the index was held for a year. Hold it for 10 years however, and the chances of making a loss drop to 19%. If we go one-up and double that holding period to 20 years, you’d find that there were no losses.

Of course, there was no practical way for an individual investor to invest in the index itself back in 1988 (the earliest index tracker we have in Singapore is the SPDR STI ETF (SGX: ES3) and it was created only in 2002), but this look back in history can still be part of the informational tool-kit we have to help form our expectations for the future.

My colleague Morgan Housel once commented in an article of his that big money managers are forced to play the short-term guessing game in the investing arena because of career-related risks. But as individual investors, we don’t have to. “You have the opportunity to focus on the long term,” Morgan said.

With the kind of long-term predictability that the financial markets have – as we’ve seen above – and the benefits of long-term investing, adopting a long time horizon when it comes to investing is how you can really gain an investing edge.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.