In Investing, Knowledge of History Is Of Paramount Importance

Yesterday night, newswire CNNMoney ran an article on a new survey in the U.S., stating that “Ninety-three percent of millennials say that both distrust of markets and lack of investing knowledge make them less confident about investing.”

In the CNNMoney piece, Garrett Silver from Capital One ShareBuilder, the firm behind the aforementioned survey, explained millennials’ mindset toward the stock market:

“Witnessing this state of the market [the meltdowns due to the dotcom bubble in the early 2000s and the 2008 financial crisis] during formative years of their lives shaped their perceptions, leaving them very skeptical about investing and the markets in general,”

So what’s happening here is that millennials are afraid to invest because they’re taking their own experiences with the stock market and projecting it to be the only reality – “if the markets have fallen hard twice in 10 years, it’s going to keep doing so and I can never make any money investing.”

This can be a dangerous and financially-painful mindset to have for the simple reason that our own experience over a narrow slice of time is a very limited glimpse of how the world really works.

Pulling back the curtains of time

Despite millennials’ fear over the stock market in the States, a long-term investment into the S&P 500 – a broad market index in the country akin to the Straits Times Index (SGX: ^STI) here in Singapore – would still have been a lucrative investment. The S&P 500 has returned more than 300% over the past twenty years and this has happened despite the occurrence of the two big crashes which have scarred millennials.

Moreover, the painful declines that the S&P 500 had endured in the dotcom bubble and the financial crisis was also not the only times that stocks in the U.S. had fallen sharply.

For instance, the S&P 500 got sliced in half from peak-to-trough from 1973 to 1974. But, investors who bought into the index at the top in 1973 would still be sitting on returns of 1,600% today.

What ain’t broke needs no fixing

American millennials’ distrust of the stock market due to the crashes is perhaps symptomatic of another issue at hand: That market crashes are a sign that something is broken.

Thing is, there are reasons to believe that a market crash is something inherent in the financial markets and not a sign that something needs fixing. To that point, the late economist Hyman Minsky had a theory that stability breeds instability in the financial system. My colleague Morgan Housel describes:

“Whether it’s stocks not crashing or the economy going a long time without a recessions, stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.

It pretty much has to be this way. If there was no volatility, and we knew stocks went up 8% every year [the long-run average annual return for the U.S. stock market], the only rational response would be to pay more for them, until they were expensive enough to return less than 8%.

It would be crazy for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned the same amount as FDIC-insured savings accounts, which is about 0%.”

Said another way, market crashes every now and then are simply what’s needed in order for investors to earn satisfying long-term returns; they’re not something to be feared.

A Fool’s take

When we’re dealing with the financial markets, it pays to take a long look at history in order to enhance our understanding of it beyond our own limited personal experiences. As Mark Twain once said, “History doesn’t repeat itself, but it does rhyme.”

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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.