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1 Perplexing Thing About Investing We Have To Know

Try asking the weatherman what the weather will look like tomorrow or over the next week. There’s a good chance he can come up with a decent forecast.

Try asking him about the weather 10 years from now and what you’d get in exchange will likely be a dirty look – that’s because predicting long-term weather conditions is really tough and close to impossible.

Investing though, is a direct opposite. Try guessing how stocks will move over the next day, week, month, or even year, and you’d likely pull your hair out at the randomness of it all. But, making long-term forecasts is actually much easier.

This sounds crazy. But it works. You can see a pictorial representation of this strange phenomenon in the two charts below.

The first chart uses data for the S&P 500 (a U.S. stock market barometer) stretching from 1871 to 2013. It plots the S&P 500’s starting valuation against its returns for a one-year holding period.

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

Source: Robert Shiller; author’s calculations

I trust it’s obvious to see that there’s no discernible pattern between the S&P 500’s valuation and its returns. Cheap stocks, when held for just a year, are just as likely to deliver strong gains as to produce poor returns.

Now, take a look at the second chart. It uses the same data-set as the first, but it plots the S&P 500’s starting valuation against its 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

A relationship between a stock’s return and valuation is now much more visible. Buying stocks when they’re cheap and holding them for the long-term gives you a good chance of earning decent returns. On the other hand, buying them when they’re expensive runs you the high risk of getting stuck with a poor return.

In the stock market, the ease of making correct predictions increases with time. While this is something perplexing about investing, it is something that we can use to our advantage as investors. Instead of relying on odds that are akin to a coin-toss by trying to make short-term guesses of market movements, we can stack the odds in our favour by lengthening our investing time horizon.

Investor Jeremy Grantham has a beautiful analogy, which appeared in the book Bull: A History of the Boom and Bust, 1982-2004to describe the relative ease of making long-term predictions as compared to short-term ones in certain situations:

“Think of yourself standing on the corner of a high building in a hurricane with a bag of feathers. Throw the feathers in the air. You don’t know much about those feathers. You don’t know how high they will go. You don’t know how far they will go. Above all, you don’t know how long they will stay up…

… Yet you know one thing with absolute certainty: eventually on some unknown flight path, at an unknown time, at an unknown location, the feathers will hit the ground, absolutely guaranteed. There are situations where you absolutely know the outcome of a long-term interval, though you absolutely cannot know the short-term time periods in between. That is almost perfectly analogous to the stock market.”

Currently, the Straits Times Index (SGX: ^STI), Singapore’s stock market benchmark, is valued at around 11.3 times its trailing earnings if we use data provided by the SPDR STI ETF (SGX: ES3), an exchange-traded fund which tracks the fundamentals of the Straits Times Index.

Over the past 37 years from 1973 to 2010, the Straits Times Index has carried an average price-to-earnings (PE) ratio of 16.9. When comparing the valuation numbers, we can see how stocks in Singapore appear to be cheap at the moment.

This is no way protects investors from making losses over the short-term. But for patient investors who are willing to let time be their ally, there are reasons to be optimistic about future returns.

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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.