What You Don’t Know About Stock Market Performance Can Hurt YouBradford Cornell
A worrisome fact is how little many Americans know about stock market returns and historical performance. That ignorance limits the extent to which they participate in the long-run benefits that stock ownership conveys and by so doing exacerbates the inequality of wealth. An article from the current (October 18, 2018) issue of Fortune magazine, excerpted below, illustrates the problem. The article reports that 48% of respondents to a survey think that the stock market has not gone up in the decade following the bankruptcy of Lehman. In fact, the article reports, stocks are up 140% since then.
What is a bit ironic is that the article itself contributes to the mystery that surrounds the stock market. There is a tendency to speak loosely and, thereby, to add to confusion. For instance, what “stocks” are up 140%? Does that 140% include dividends? If not, the quote mixes apples and oranges because some stocks pay dividends and others do not. In our book, Conceptual Foundations of Investing, the first foundation is the ability to assess the performance of stocks (and other assets) precisely. That requires computing periodic returns. So, let’s do the Fortune calculation right using returns.
First, “stocks” are taken to be the entire U.S. market including both New York and Nasdaq stocks. These stocks are put into an index where each company receives a weight proportional to its market value. Data on this total market index are widely available if you know where to look. I recommend Prof. Ken French’s website because the information there is so well organized and easy to access. From that website, I downloaded the monthly returns on the total market index from November 1, 2008 through August 31, 2018. These returns represent the percentage increase or decrease in the total value of an investment in the market index each month, including dividends which are assumed to be reinvested. Using this series of monthly returns, it is easy to calculate how much $100 invested in the market index would be worth on November 1, 2018. The answer is $384.29 – up 284.29%, not 140%.
It turns out that the height of the financial crisis was a wonderful time for investing in common stock. A combination of ignorance and fear had driven the stock prices of even wonderful companies to record lows relative to earnings. Warren Buffet recognized this and decided in late 2008 to go “all in.” Needless to say, Mr. Buffett is aware of how to compute returns and measure performance.
The point is that you cannot assess the performance of stocks, or any competing financial assets, without understanding how to compute returns. Unfortunately, far too many Americans have no clue. And even sophisticated publications like Fortune are often no help. If you are serious about investing, sit down with a spreadsheet and stock market data such as that from Prof. French’s website and become comfortable working with returns and using them to measure historical performance. It is some work, but it is well worth the effort.
Article by Brad Cornell's Economics Blog