The fundamental reason shares increase over time has not changed over 100 years. Yet an increasing number of investors are behaving irrationally over short-term periods. This may partly be due to the frequency with which we now receive economic news, which often disturbs us.
A rational investor who believes that the share market fundamentals have not changed has various options – which is why benchmarking is valuable. You can choose an approach you think is going to work best, but it’s important not to be “married” to that approach necessarily.
By measuring and comparing how your current approach is going over time, you learn valuable information. “How are others going who may be using a different approach?” “Can I adapt something of what they are doing which may lead to a better outcome?“
An investor could decide, for example, to use an index fund, and “set and forget”, accepting the long term return of the broad share-market.
Another investor may decide to take advantage of the new volatile world – set a target asset-allocation between shares and bonds and re-balance their portfolio more frequently to keep in line with their target asset allocation, effectively taking advantage of the local highs and lows.
So what really drives share-markets?
When you buy shares, you are buying a bit of someone’s business. Let’s say the business makes a profit of $1000. If it is a well run business it may distribute half of that profit to shareholders, as dividends.
Importantly, they reinvest the other $500 back in the business. This can be used to improve systems, or used in other ways, which may lead to an increase in profits the next year. Let’s say the profit is now $2,000, and they distribute half ($1000) as a dividend and reinvest the other $1,000.
And so on… So over time you see an increasing income stream by way of dividends, but importantly… you also see an increasing amount each year being reinvested back into the business.
It is this retention and reinvestment of profit which causes the business value, and share price, to increase over time.
So in theory, the broad sharemarket movement should look like a straight line, a trend line which is equal to the business earnings (income plus growth)… before human nature is considered.
What actually happens is we go through periods of optimism and periods of pessimism along the way. Times when we tend to pay more for shares than they are really worth, and times when we aren’t prepared to pay enough for them, and that’s usually based on what’s going on in the world around us.
The roaring ’20s for example was a very optimistic period. In this decade investors paid more for shares than the businesses actually earned.
The 70s was a pessimistic decade, when we were worried about the world running out of oil. We were not prepared to fully value shares compared to the actual business earnings.
The 80s was a very optimistic decade, and we bid way too much for shares, compared to what they were earning. And so on.
The interesting thing is, if you look at the 100 year share market movement over the twentieth century, all these periods of optimism and pessimism flattened each other out, and you were left with the 100 year return on shares being equal to the earnings of the businesses.
Understanding fundamentals like this can reduce the stress with investing, and create opportunities.
Next time a disturbing event happens overseas and world share-markets fall, ask yourself how it will affect that “widget maker in Williamstown” which you invested in. Often the answer is “not at all!”