5 Critical Charts

Letasoft Sound Booster

Key points

• Successful investing can be really difficult in times like now with immense uncertainty around inflation, interest rates, issues in global banks and recession risks impacting the
  outlook for investment markets.
• This makes it all the more important to stay focussed on the basic principles of successful investing.
• These five charts focus on critical aspects of investing that are insightful in times of market stress: the power of compound interest; don’t get blown off by cyclical swings;
  the roller coaster of investor emotion; the wall of worry; & market timing is hard.

Introduction

Periodically, the degree of uncertainty around investment markets surges - this has been the case for more than a year now, driven by a combination of high inflation, rapid interest rate hikes, the increasing risk of recession, and problems in US and European banks. These factors have all come against the backdrop of geopolitical uncertainties. As a result, declines in the value of share markets and other investments can be particularly stressful - it's natural to want to retreat to perceived safety. However, it's important to remember that tumultuous markets are often accompanied by a great deal of prognostication, some of which is enlightening, but much is just noise. In times like these, it can be difficult to make accurate predictions - as US economist JK Galbraith once said, "there are two types of economists: those who don't know and those who don't know they don't know." Therefore, we must remain humble and acknowledge the limits of our forecasts. However, while each market cycle is unique, they also have commonalities - and the basic principles of investing still apply. In this note, we revisit five charts that offer useful perspective during economic and investment market stress.

Chart #1 The power of compound interest

This is my favourite chart. It shows the value of $1 invested in various Australian assets in 1900 allowing for the reinvestment of dividends and interest along the way. That $1 would have grown to $246 if invested in cash, to $997 if invested in bonds and to $781,048 if invested in shares up until the end of February. While the average return since 1900 is only double that in shares relative to bonds, the huge difference between the two at the end owes to the impact of compounding - or earning returns on top of returns. So, any interest or return earned in one period is added to the original investment so that it all earns a return in the next period. And so on. I only have Australian residential property data back to 1926 but out of interest it shows (on average!) similar long term compounded returns to shares.

Key message: to grow our wealth, we must have exposure to growth assets like shares and property. While shares and property have had a rough ride over the last year as interest rates surged, history shows that both will likely do well over the long-term.

Chart #2 Don’t get blown off by cyclical swings

Shares can experience frequent and sometimes severe setbacks, as evident during the periods highlighted by arrows on the previous chart. Although annual returns in the share market may be highly volatile, longer-term returns tend to be stable and relatively smooth, as shown in the next chart. Since 1900, Australian shares experienced negative returns for about two years out of every ten, yet there have been no negative returns over rolling 20-year periods.

The compensation for the periodic setbacks of shares, the higher returns they produce over time relative to cash and bonds. However, it's important to recognize that these periodic setbacks are an inevitable part of investing, making it crucial to stay the course to take advantage of the higher long-term returns provided by shares and other growth assets over time.

Key message:It's a reality that share markets can experience short-term, occasionally turbulent fluctuations. However, the longer you hold onto your investments, the higher the likelihood that they will achieve their intended objectives. Therefore, time can work in your favor when it comes to investing, and it's advisable to focus on long-term investment strategies.

Chart #3 The roller coaster of investor emotion

It's widely acknowledged that investment markets often experience fluctuations that cannot be solely justified by changes in investment fundamentals, such as profits, dividends, rents, and interest rates. This is because investor emotions play a significant role in market movements. The past year has been a clear example, with the markets exhibiting sharp swings. The accompanying chart illustrates the roller coaster of investor emotions throughout an investment cycle. As a cycle turns downward into a bear market, euphoria transforms into anxiety, denial, capitulation, and ultimately depression. At this point, the asset class is often undervalued and overlooked, as most sellers have already exited, making it susceptible to positive (or less negative) news. This represents the moment of maximum opportunity for potential investors. Conversely, as the cycle turns upward, depression transitions into hope and optimism, eventually leading to euphoria once again.

Key message: The impact of investor emotions on amplifying the swings in investment markets cannot be overstated. The crucial factor for investors is to resist getting caught up in this emotional roller coaster. However, it's easier said than done, which is why many investors end up making mistakes due to the effects of the investment cycle.

Chart #4 The wall of worry

Investors often find themselves constantly fretting about various concerns, and with the advent of social media competing with traditional media, these worries can feel even more magnified and distressing. Currently, uncertainty surrounding inflation, interest rates, and potential recession risks is particularly prominent. However, historical data reveals that despite the numerous worries that the global economy has faced over the past century, Australian shares have delivered an annual return of 11.7% since 1900, as evidenced by the rising trend in the All Ords price index depicted in the subsequent chart. Similarly, US shares have provided a return of 9.9% per annum. (Please note that this chart displays the All Ords share price index, while the previous chart reflects the value of $1 invested in the All Ords accumulation index, which accounts for changes in share prices and dividends.)

Key message: It's natural for worries to arise in relation to the economy and investments, and at times, they can become quite intense, as is the case currently. However, it's important to remember that worries, like any other emotions, are transient in nature and eventually pass.

Chart #5 Timing is hard

The allure of timing markets can be irresistible. In hindsight, it seems easy to predict swings in markets, such as the tech boom and bust or the GFC, and adjust your investments accordingly. During times of emotional stress, like the present with concerns about inflation, interest rates, and recession risks, it's natural to consider switching between cash and shares within your super fund to anticipate market movements. It may seem reasonable if you have a well-defined process and put in the effort. However, attempting to time the market without a proven strategy is challenging.

A compelling way to illustrate this is by comparing the returns of an investor who is fully invested in shares versus one who tries to time the market by avoiding the best or worst days. The data shows that if an investor had been fully invested in Australian shares from January 1995, the return would have been 9.3% per annum (with dividends, but not accounting for franking credits, tax, and fees).

If the investor had managed to avoid the 10 worst days (indicated by yellow bars), the return would have increased to 12.2% per annum. Furthermore, if they had avoided the 40 worst days, the return would have soared to an impressive 17.1% per annum! However, successfully avoiding these days is extremely difficult, as many investors tend to exit the market after the bad returns have already occurred, only to miss out on the best days. For instance, if an investor had missed the 10 best days (indicated by blue bars), the return would have dropped to 7.2% per annum. And if they had missed the 40 best days, the return would have plummeted to a meager 3% per annum.

Key message: attempting to time the market without a proven strategy can be risky and may result in missed opportunities for higher returns. It's important to approach market timing with caution and consider a well-researched and tested approach before making investment decisions.