Inexperienced investors sometimes think of stock markets as glorified casinos, where you can win big over the short-term, and lose your shirt thereafter. But this is only the case if you follow a strategy of speculating with your money rather than investing to build long-term wealth. Stock markets are not a guaranteed route to overnight riches, but neither are they a game of chance.
In the words of Warren Buffett’s mentor, Benjamin Graham: “In the short run the stock market is a voting machine, but in the long run it is a weighing machine. “In practical terms, we’ll see a jagged line when we look at the short-term performance of a stock market index. This represents market volatility as stocks swing up and down in response to the news and sentiment of the day.
But when we zoom out and look at the graphs on a longer time scale, the trend line resembles an upwards slope with a few dips along the way. The longer the time horizon, the less noticeable the downturns tend to be. This represents the way that accumulative dividend and earnings growth drives higher market valuations over time.
Just look at the graphs below showing the S&P 500’s performance over 5,10 and 20 years for context, with particular reference to the severe Covid-induced market correction of 2020 as shown on each graph:
S&P 500 Performance for the 5-year period ended 31 March 2023
S&P 500 Performance for the 10-year period ended 31 March 2023
S&P 500 Performance for the 20-year period ended 31 March 2023
In further support of the above analysis, the British economist John Maynard Keynes defines investment as “forecasting the prospective yield of an asset over its entire life”—and, as we can see here, this kind of forecasting is a relatively sound approach. (We add the qualification that you should, of course, diversify assets and geographies in a strategy adjusted to your investment horizon and appetite for risk.)
Timing the market is impossible
Keynes described speculation as “the activity of forecasting the market”, and this is a much rockier proposition. When you speculate, you are trading stocks in the short term rather than holding them for the long term. Your aim will be to maximise your gains by trying to time the markets, in other words, buying a stock or other instrument low and selling it high.
The trouble with this, of course, is that we can’t predict day-to-day how an index might react to news about the job market, a war somewhere in the world, the oil price or consumer spending. We also can’t forecast whether a particular company’s stock will rise or fall in response to rumours about corporate action like a merger or its latest earnings update.
A day trader might get lucky in timing the market, but at some point, that luck will run out. Even seasoned, professional traders get it wrong more often than they get it right. This is why we don’t recommend investors speculate with money they can’t afford to lose. Short-term market movements are driven by emotions rather than reason, and it’s impossible to predict when irrational exuberance will turn into panic, or vice versa.
By contrast, investing in equities for the long-term is about understanding that superior businesses and healthy economies will grow over the years. There may be some road bumps and setbacks, but over time, quality stocks will tend to grow faster than inflation. This is because these businesses will gradually increase their value by competing effectively, innovating in response to change, and addressing customers’ needs.
The stock market is a distraction from the business of investing
In the shorter term, speculators (be they day traders or professional fund managers) have the power to distort markets. The result is that we can see market sentiment swing from ebullience and optimism to gloominess and pessimism in the blink of an eye. But wise investors will ignore the commotion. As John Bogel says, the stock market is a distraction from the business of investing.
In the longer term, stock returns depend entirely on the reality of the relatively predictable investment returns earned by well-managed companies. Investors drive stock market returns because they are the owners of the productive capital invested in successful enterprises. They focus on the economics of businesses and their power to earn solid returns on capital.
As observed in the charts above, the unpredictable perceptions of market participants, reflected in momentary stock prices and in the changing multiples that drive returns, register as a mere blip in the course of years and decades. The winning game is investing in real numbers and real returns, and buying indices/stocks for the long haul. Buying stocks to flip them, or speculating, is not a successful strategy in the longer term.
Fundsmith, one of our preferred fund managers, sums it succinctly: “Buy good businesses; don’t overpay; and do nothing”. We believe that the tough and demanding task of building corporate value in a competitive world is a long-term proposition. Speculation, we feel, is a loser’s game where the outcome cannot be predicted with any confidence.
