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When History Fails You in Investing

Investor extraordinaire Charlie Munger was once asked in the 1970s what advice he would give to aspiring young professional investors. Munger’s reply was simple: “Read History! Read History! Read History!”

This is as good as any when it comes to the importance of knowing history when investing. But as the saying goes, you can actually get too much of a good thing – this can be applied to history in the context of investing too.

The Great Depression of 1929 in the US ranks highly as a market crash to be remembered. But, there’s a less well-known yet still extremely grueling crash that happened in the country during the first decade of the 1900s that’s known as the Panic of 1907. I’m not here to expound on the reasons for both crashes, but something interesting happened prior to both crises.

Dividend Yield vs Bond Yield for US market from 1900 to 1949

Source: Robert Shiller’s data

As you can see in the chart above, the dividend yield for stocks in the US was higher than that of bonds most of the time in the first half of the 20th century. The only two occasions when dividend yields dipped below bond yields were just before the Panic of 1907 and the Great Depression.

So, imagine what investors must have felt like when dividend yields on stocks started dropping below bond yields in the 1950s.

Dividend Yield vs Bond Yield for US market from 1950 to 1960

Source: Robert Shiller’s data

But then something interesting happened. After bond yields became fatter in relation to dividend yields in the 1950s, they stayed that way until the late 2000s (see chart below).

And how did the stock market fare? The S&P 500, a widely-followed market benchmark in the US, has gone up by 55-fold from 1955 to today in price alone. Investors who had depended on the relationship between dividend yields and bond yields to invest based on the evidence gathered over the first-half of the 1900s would have missed out on 50-plus years of massive gains from the 1950s to the 2000s.

Dividend Yield vs Bond Yield for US market from 1950s

Source: Robert Shiller’s data

Knowledge of market history is crucial. It can give us context to interpret and understand what’s happening in the market today. Take this for instance: The Straits Times Index (SGX: ^STI) has suffered devastating drawdowns (defined as the maximum peak-to-trough loss) in many calendar years from 1993 to 2014; and yet, the index has nearly doubled from 1,531 points at the start of 1993 to 3,000 or so today. In other words, it can be normal for stocks in Singapore to crash from time to time; it’s not an indication of a broken system.

Maximum drawdown for Straits Times Index, 1993 - 2014

Source: S&P Capital IQ; author’s calculations

By knowing how the Straits Times Index has performed in the past, investors may have less reason to panic and fall prey to emotionally-driven investing mistakes when their stocks fall over the short-term (which they inevitably will do). That’s an advantage of knowing history.

But, it’s also important for investors to recognise the limits of history. Sometimes, something may work… until it doesn’t. The trick is for us to recognise the things that have worked that will continue to work.

I may be wrong. But the way I see it, what will continue to work in the stock market is for investors to look at stocks as a piece of a business and keep in mind billionaire investor Warren Buffett’s simple words: “if the business does well [or poorly], the stock eventually follows.”

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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.