Category: Stock Market

“In 1997,  I had just graduated from Penn State with my finance degree & was about to start law school.  I even had hair. I wasn’t into Harry Potter but I did know about Y2K, this new thing called the Internet & the Russian financial crisis. David Booth in the article below highlights what is happened since that time and what it means for stocks and investments. Hope you enjoy the article!”

-Neel

We are living in a time of extreme uncertainty and the anxiety that comes along with it. Against the backdrop of war, humanitarian crisis, and economic hardship, it’s natural to wonder what effect these world events will have on our long-term investment performance.
While these challenges certainly warrant our attention and deep concern, they don’t have to be a reason to panic about markets when you’re focused on long-term investing.

Imagine it’s 25 years ago, 1997:

• J.K. Rowling just published the first Harry Potter book.
• General Motors is releasing the EV1, an electric car with a range of 60 miles.
• The internet is in its infancy, Y2K looms, and everyone is worried about the Russian fnancial crisis.

A stranger offers to tell you what’s going to happen over the course of the next 25 years. Here’s the big question: Would you invest in the stock market knowing the following events were going to happen? And could you stay invested?

• Asian contagion
• Russian default
• Tech collapse
• 9/11
• Stocks’ “lost decade”
• Great Recession
• Global pandemic
• Second Russian defaultWith everything I just mentioned, what would you have done? Gotten into the market? Gotten out? Increased your equity holdings? Decreased them?
  Well, let’s look at what happened. From January of 1997 to December of 2021, the US stock market returned, on average, 9.8% a year. A dollar invested at the beginning of the period would be worth about $10.25 at the end of the period. These returns are very much in line with what returns have been over the history of the stock market. How can that be? The market is doing its job. It’s science.

Investing in markets is uncertain. It’s the role of markets to
price out that uncertainty.

Investing in markets is uncertain. The role of markets is to price in that uncertainty. There were a lot of negative surprises over the past 25 years, but there were a lot of positive ones as well. The net result was a stock market return that seems very reasonable, even generous. It’s a tribute to human ingenuity that when negative forces pop up, people and companies respond and mobilize to get things back on track. Human ingenuity created incredible innovations over the past 25 years. Plenty of things went wrong, but plenty of things went right. There’s always opportunity out there. Think about how different life is from the way it was in 1999: the way we work, the way we
communicate, the way we live. For example, the gross domestic product of the US in 1997 was $8.6 trillion and grew to $23 trillion in 2021. (Read more about the merits of investing in innovation.)

I am an eternal optimist, because I believe in people. I have an unshakable faith in human beings’ ability to deal with tough times. In 1997, few would have forecast a nearly 10% average return for the stock market. But that remarkable return was available to anyone who could open an investment account, buy a broad-market portfolio, and let the market do its job. Investing in the stock market is always uncertain. Uncertainty never goes away. If it did, there wouldn’t be a stock market. It’s because of uncertainty that we have a positive premium when investing in stocks vs. relatively riskless assets. In my opinion, reaping the benefts of the stock market requires being a long-term investor. By investing in a market portfolio, you’re not trying to fgure out which stocks are going to thrive, and which aren’t going to be able to recover. You’re betting on human ingenuity to solve problems.

The pandemic was a big blow to the economy. But people, companies and markets adapt. That’s my worldview. Whatever the next blow we face, I have faith that we will meet the challenge in ways we can’t forecast.
I would never try to predict what might happen in the next 25 years. But I do believe the best investment strategy going forward is to keep in mind the lesson learned from that stranger back in 1997: Don’t panic. Invest for the long term.

By: David Booth
Executive Chairman and Founder

Sources: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Investment products: • Not FDIC Insured • Not Bank Guaranteed • May Lose Value Dimensional Fund Advisors does not have any bank affliates.

On May 4, the US Federal Reserve increased the target federal funds rate1 by 50 basis points as part of what the central bank said will be a series of rate increases to combat soaring inflation in the US. Some investors may worry that rising interest rates will decrease equity valuations and therefore lead to relatively poor equity market performance. However, history offers good news: Equity returns in the US have been positive on average following hikes in the fed funds rate.

We study the relation between US equity returns, measured by the Fama/French Total US Market Research Index, and changes in the federal fund’s target rate from 1983 to 2021. Over this period of 468 months, rates increased in 70 months and decreased in 67 months. Exhibit 1 presents the average monthly returns of US equities in months when there is an increase, decrease, or no change in the target rate. On average, US equity market returns are reliably positive in months with increases in target rates.2 Moreover, the average stock market return in those months is similar to the average return in months with decreases or no changes in target rates.

What about the months after rate hikes? This question may be of particular interest when the Fed is expected to increase the federal funds target rate multiple times. Exhibit 2 presents annualized US equity market returns over the one-, three-, and fve-year periods following one or two consecutive monthly increases in the fed funds target rate, as well as following months with no increase. In reassuring news for investors concerned with the
current environment of increasing rates, the US equity market has delivered strong longer-term performance on average regardless of activity at the Fed.

With a number of Federal Open Market Committee meetings remaining in 2022, the Fed’s signals and actions will continue to be closely watched by the market. As the Fed often signals its agenda in advance, we believe market participants are already incorporating this information into market prices. While it’s natural to wonder what the Fed’s actions mean for equity performance, our research indicates that US equity markets offer positive returns on average following rate hikes. Thus, reducing equity allocations in anticipation of, or in reaction to, fed funds rate increases is unlikely to lead to better investment outcomes. Instead, investors who maintain a broadly diversifed portfolio and use information in market prices to systematically focus on higher expected returns may be better positioned for long-term investment success.

By: Kaitlin Simpson Hendrix
Senior Researcher and Vice President

Sources: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Investment products: • Not FDIC Insured • Not Bank Guaranteed • May Lose Value Dimensional Fund Advisors does not have any bank affliates.

Many investors end up holding large concentrated positions in single stocks, whether as the result of employee compensation or a handsomely rewarded stock selection. Familiarity with these stocks or a successful track record while holding them may discourage investors from diversifying. Unfortunately, this can lead to one of the most well-known cautionary tales in finance: tragic declines in wealth from losses in single securities. And data on the behavior of individual stocks suggests it’s hardly rare for firms to underperform—or even go under—regardless of past performance.

SHIFTING LANDSCAPE
Industry development and innovation are signs of a healthy economy. Financial markets reflect this dynamic through the birth and death of public companies. As shown in Exhibit 1, this translates to meaningful turnover among individual stocks. The average survivorship statistics over rolling periods imply a little over one in five US stocks available in the market at a given time delist within five years. The survival rate goes down over longer periods, with just under half of stocks on average still trading 20 years later.

Not all delistings produce the same experience for investors. We categorize these delisting events as “good” or “bad” based on the circumstances for each stock. For example, a stock delisting due to a merger would be a good delist, as the shareholders of that stock would be compensated during the acquisition. On the other hand, a frm that delists due to its deteriorating fnancial condition would be a bad delist since it is an adverse outcome for investors. Over 20 years, about 18% of stocks went the bad-delist route on average. Most of us yearn not just to survive but also to thrive. Looking at the last row of Exhibit 1, only a minority of stocks have achieved that. A little over a third of stocks on average survived and outperformed the broad US market over fve years; this rate dwindled to a little more than one in fve over 20 years

The range of returns for single stocks is vast, even among those surviving a long time. Exhibit 2 shows distributions of excess returns for surviving stocks over rolling periods of five, 10, and 20 years formed using the average cumulative return in excess of the market at each percentile. The median stock underperforms the market across all three horizons. Not until we reach the 57th, 57th, and 56th percentiles at the 5-, 10-, and 20-year horizons, respectively, do we see positive excess returns relative to the market. Although the percentage of underperformers is similar across time horizons, the magnitudes of excess returns at the extremes are smaller at longer horizons.

WHY DIVERSIFICATION PAYS
For investors holding stocks with a long history of beating the market, diversifcation might seem like “worsifcation,” reducing expected returns relative to a more concentrated approach. In many cases, these stocks represent successful companies that investors believe will continue to prosper and buck the broad trend of adverse outcomes for single stocks. Unfortunately, a long-term track record of outperformance generally
has not been an indicator of future outperformance. Take, for example, stocks that have outperformed the market over the previous 20 years. Exhibit 3 shows that, on average, about 30% of these stocks continue to survive and outperform over the following 10 years. Of the stocks that have underperformed over the previous 20 years, the average
subsequent outperformance rate is also 30%. In other words, winners have been no more likely than losers to beat the market in the future.

Outperformers do tend to experience a lower bad delist frequency than
underperformers, which likely refects the impact of strong performance on firm size. For example, looking at the same data set of US stocks from CRSP and Compustat, the median market cap of past winners was $4.2 billion as of December 2020—compared to $800 million for past losers. However, the bad delist rate is still 3.0% even for past outperformers; the bankruptcies of companies like Enron, Chesapeake Energy, and Circuit City remain fresh memories for many investors and former employees of those

A well-diversifed portfolio can help investors reliably capture market returns, limit individual stock risk, and improve the ability to tilt toward segments of the market with higher expected returns. Even when accounting for capital gains taxes, transitioning from a concentrated portfolio to a broadly diversifed one can deliver higher growth of wealth. The long-term benefts of diversifcation can outweigh the short-term costs associated with liquidating outsize positions. Personalized vehicles can be used to further tailor
investments, manage taxes, and suit individual considerations

By: Bryan Ting, PhD
Researcher

Sources: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Investment products: • Not FDIC Insured • Not Bank Guaranteed • May Lose Value Dimensional Fund Advisors does not have any bank affliates.