Saturday, August 7, 2010

The Stock Market is NOT Like Vegas

From time to time, I hear people saying that putting your money in the stock market is akin to gambling it away in Vegas.  I must admit that the cocktail waitresses are prettier in Vegas than they are at the NYSE; however, investing your money in the stock market is nothing like gambling in Vegas.  In fact, the numbers show that they are polar opposites!

Most of the games in the casions are designed so that the "house" makes money.  You might get a streak of luck and win over the short term, but the house eventually wins over the long term.  If you sat down at a blackjack table and played for an hour, there is a chance that you will come out ahead.  If you stay there for ten hours, the chances of you coming out ahead gets smaller.  Stay there for a day, a week, or a year and you will find that the chances of you coming out ahead diminishes to almost zero.  The moral of the story is that the longer you spend gambling in a casino, the less of a chance you have at leaving with more money than you came with.

The stock market is just the opposite.  Over the short term, there is a very real chance that you will lose money.  You only have to look back a couple of years to know that!  However, the numbers show that the longer you keep your money in stocks, the more likely you are to come out ahead.

In order to prove this, I looked at the price of the S&P 500 stock index going back to 1950.  (The S&P 500 represents the stock price of the 500 biggest U.S. companies.)  Specifically, I looked at the annual return of the S&P 500 stocks for every 1 year, 5 year, 10 year, 20 year, and 30 year period from 1950 until 2010.  Then I took the average, standard deviation, min, and max of all of these periods.

As an example, for the 30 year period analysis I looked at the returns if you had invested over the following time periods:

1950 through 1980
1951 through 1981
1952 through 1982
...
1980 through 2010

In total, there were 31 thirty year periods.  After I calculated the returns for these 31 thirty year periods, I found the average, standard deviation, min, and max of all of these returns.

(For those who aren't stat heads, the standard deviation is a measure of variability.  The higher the standard deviation, the bigger the swings are from period to period.)

The results were quite interesting:


1 Year5 Years10 Years20 Years30 Years
Annual Return - Average8.39%7.51%7.40%7.25%7.17%
Annual Return - Std Deviation15.86%6.83%4.88%3.06%1.42%
Annual Return - Min-40.09%-6.10%-4.28%2.83%5.39%
Annual Return - Max40.45%24.28%15.71%13.60%9.77%


(Note that I annualized the returns, so that the 7.51% average return for the 5 year periods means that over the average 5 year period, you would make 7.51% on your money per year.)

Over the course of a single year, your return will average 8.39%, but there is a lot of variation from year to year.  You could potentially lose over 40%, or you could gain over 40%.  If you are saving for a short term goal, like a vacation or a car, you probably can't afford to have all of your money in the stock market.  You could come out way ahead, or you could lose almost half of your money!

However, note how the standard deviation decreases as the amount of time you leave your money in the stock market increases.  Over the average 20 year period, the least amount that you would make is 2.83% per year.  In other words, if you had invested your money in the stock market and left it there for 20 years, you would always come out ahead.  The 30 year numbers are even more consistent.

The lesson here is that the longer you had been able to keep your money in the stock market, the more likely you were to come out ahead.  For long term investors, the stock market certainly merits consideration.

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