The following is a guest post from Ben Carlson at A Wealth of Common Sense. Ben writes about personal finance, investments, investor psychology and using your common sense to build wealth.
Investing is counterintuitive. It’s one of the reasons that investors get into trouble by paying attention to the wrong factors when making decisions. In light of this, here are three stock market myths to consider.
Myth #1: The Economy Must be Strong for Stocks to Perform Well
Most investors think that forecasting economic activity is a prerequisite for achieving good stock returns. Recently we have seen slow global economic growth with high rates of unemployment in many countries. Many see this economic data and assume that stocks should be doing terribly.
But anyone who has paid attention to global stock markets for the past five years knows that this is not the case. Economic growth has been anemic yet many stocks have performed remarkably well, doubling or more in some global markets.
Multiple studies have shown that the majority of the time, stocks and economic activity have little to no correlation in the short or intermediate term. Over the long-term there is a relationship between stock earnings growth and nominal GDP but trying to make investment decisions based on economic growth projections is ineffective.
In fact, a recent article in The Economist discussed a study that looked at the 1972 to 2009 period and ranked countries by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the previous five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.
According to NBER, since the Great Depression, the US economy has been in a recession for almost 13 years or 15% of the time. Yet in that time frame, stocks are still up almost 10% per year.
Myth #2: High Unemployment is Bad for Stocks
An offshoot on the economic growth myth is the fact that investors see high rates of unemployment in most countries and think that this has to lead to poor stock performance.
The line of thinking goes because more people are out of work, spending decreases, which leads to lower revenues for companies and therefore lower stock prices. Historical data shows that this is another false assumption.
Consider first, the start of the 30-plus year bull market for stocks in the early 1980s was at a time of double digit unemployment in the US and a pretty nasty recession. Next, consider with a 25% unemployment rate during the Great Depression, stocks had their single best three-year period on record. Last, since 1951, the best twelve month returns were in periods following an 8% unemployment rate. Conversely, the worst stock returns have actually occurred following 4% unemployment.
One of the reasons for this is the fact the unemployment is largely is a lagging indicator. It tells us what happened in the past, not what is going to happen in the future.
Myth #3: Stocks are More Volatile than Bonds
In the short-term this is correct. Stocks have had multiple declines of 20% or more in fairly short periods of time. I’m sure we’ve all had large losses in our equity investments at one time or another. But when you look at the long-term data this myth doesn’t hold up. Take a look at the volatility (standard deviation) of the rolling returns for stocks and bonds since 1928:
As you can see, the longer your time horizon, the lower the volatility for stock returns. Over rolling 30 year periods, the volatility of returns for stocks is actually lower than it is for bonds. Hard to believe, but true.
You don’t necessarily need to pay attention to the economy or short-term investment results when you make your decisions. Instead, think long-term and simply focus on the factors that you can control. Investing for the long-term can break all kinds of myths.
Thanks to Ben for his contributions to My Own Advisor. Any other stock market myths to bust?