5 Things Every Investor Needs To Know

The stock market can be a great place to build lasting long-term wealth. But, that can only happen if investors have access to information which can help them better understand what investing and the stock market is really like.

Such information may at times be hard to come by. So, here’s me trying to help with the following list of five things (in no particular order) that every investor needs to know:

1. The stock market is very volatile over the short-term, but tends to move up over the long-term.

In the 27 full calendar years between the start of 1988 and the end of 2014, Singapore’s market barometer the Straits Times Index (SGX: ^STI) had made annual losses of 10% or more in seven separate years. That’s rough.

But, the index has also more than quadrupled from 834 points to 3,365 over the same time period. With the stock market, you’d have to suffer some short-term pain for solid long-term gains.

2. A cheap valuation offers no protection whatsoever against losses over the short-term.

For those with a little more experience in the stock market, it may be common to hear the refrain that we it’s better to invest when stocks are cheap. That’s sound advice – but it’s only half-true.

Chart 1 - Average annual returns of S&P 500 for 1 year holding period

Source: Robert Shiller; author’s calculations

The chart above plots the annual returns of the S&P 500 (a broad U.S. market index) against its starting valuation for a one year holding period using data that stretches from 1871 to 2013. As you can see, the chart’s essentially a scatter-plot – a low valuation can just as easily result in a great return as a poor one. This brings me to the whole-truth in the next important thing investors must know.

3. Buying stocks when they’re cheap helps you stack the odds of success in your favour over the long-term.

Chart 2 below is similar to Chart 1, except that it’s showing the S&P 500’s annual returns for a 10-year holding period.

Chart 2 - Average annual returns of S&P 500 for 10 year holding period

Source: Robert Shiller; author’s calculations

When the investing time horizon’s stretched out from 1 year to 10 years, there’s now a much clearer relationship between a share’s valuation and its return – if you invest when stocks carry a low valuation, your chances of earning a good return become much higher. This is certainly not a water-tight conclusion, but it’s still very useful knowledge to have.

4. What the economy does and how stocks perform can have very little correlation over both the long- and short-term.

The fourth thing here that investors must know is counter-intuitive but true. I trust it’s easy to observe in Chart 3 that there’s essentially no correlation (much less any causation) between Singapore’s annual gross domestic product (GDP) growth and the yearly returns of the Straits Times Index.

Chart 3, Singapore's annual GDP growth rate and the Straits Times Index's yearly return

Source: World Bank (for GDP figures); S&P Capital IQ (for Straits Times Index)

The striking dichotomy that can exist between a country’s long-term stock market returns and economic growth is perhaps best exemplified by the following tweet from investment manager Ben Carlson:

The state of a country’s economy is an important thing to consider when it comes to investing, but it’s not the only thing that matters. Investors who invest largely based on how much a country’s economy can grow may be setting themselves up for a rude shock.

5. The performance of a company’s business is a crucial driver of its share price over the long-term.

Peter Lynch, the legendary manager of the Fidelity Magellan Fund in the U.S. from 1977 to 1990, shared the following classic in a 1994 speech:

“I’m trying to convince people there is a method. There are reasons for stocks to go up. This is very magic: it’s a very magic number, easy to remember. Coca-cola is earning 30 times per share what they did 32 years ago; the stock has gone up 30 fold. Bethlehem Steel is earning less than they did 30 years ago – the stock is half its price 30 years ago.

Stocks are not lottery tickets. There’s a company behind every stock – if the company does well, the stock does well. It’s not that complicated.”

I couldn’t have put it any better.

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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 company mentioned.