4 ms·

Another way of thinking about it is: on average, stock value over the long term (20+ years) is very likely to be in range of, say, 5%/year, plus or minus (actu

by hsitz 9y ago

Another way of thinking about it is: on average, stock value over the long term (20+ years) is very likely to be in range of, say, 5%/year, plus or minus (actual number is not that important for our purpose here), after adjusting for inflation. If stocks have been on a recent runup, gaining, say, 50% or 100% over a period of a few years, then they are very likely to grow more slowly than average (i.e., revert to the mean) over the coming years. If you buy during period of inflated prices you will realize a lower than average return if you're holding over the long term. Robert Shiller (Yale finance professor, of Case/Shiller housing index) likes to make the following analogy. Predicting the stock market is basically the opposite of predicting weather. With weather our short-term predictions can be fairly accurate, but our long term predictions are very poor. With the stock market it's the reverse, short-term predictions are worthless, but long term predictions are generally fairly accurate.

enoch_r 9y ago
> they are very likely to grow more slowly than average (i.e., revert to the mean) I mostly agree with you, but this is basically the gambler's fallacy. If I'm flipping a coin every second for days, and I hit a run of 10 heads in a row, "reversion to the mean" just means that the next 10 flips are likely to be less extreme than the previous 10. It does not mean that I should expect "more tails than usual" for the next flips. We revert towards the mean, not past it.
- poke111 9y ago
  No. The gambler's fallacy is when we ascribe dependency to independent events. Stock performance tomorrow is very much NOT independent of stock performance today, e.g. "market correction"
  - enoch_r 9y ago
    There is a pretty strong empirical support for the random walk hypothesis, the essence of which is that performance tomorrow is independent of performance today.
- macmccann 9y ago
  This is the definition of the gambler's fallacy. However, if you look at a chart of the stock market vs. a chart of a coin being flipped many times, they will look very different. While a coin being flipped will either asymptotically trend towards zero or a positive slope of .5 depending upon how it is charted, the stock market will have large peaks and valleys, meaning that after a period of high growth (overvaluation), the market will not continue to value these stocks at a steady growth of 10% per year. Instead, the market will correct the value of these stocks, which looks like a short term undervaluation and so we should expect "more tails than usual".
  - tarsinge 9y ago
    I recommend you look at the random walk hypothesis, the chart (not the average) of a coin flipped does not trend towards 0 and looks surprisingly similar to stock charts
- bottled_poe 9y ago
  It might appear that way but stock prices are actually tied to economic performance, not coin flips.
- konschubert 9y ago
  No, it's not like gambling. Unlike in a casino, the returns and value of stocks are loosely coupled to the real economy. If stock values grow quicker than the economy, then we should expect a correction, because of that loose coupling. Of course, markets can stay irrational longer than we can stay solvent, so I wouldn't try to time it.
- wirelessest 9y ago
  But shifts in the market aren't independent random events. You can definitely find examples of dramatic, real shifts in valuation but in the vast majority of cases business value is created over time. That rate of growth might be slightly faster or slightly slower, but you can be certain it's within reasonable bounds. So when speculation or scare drives the price higher or lower, you can be sure it will find its way back.
yodsanklai 9y ago
> on average, stock value over the long term (20+ years) is very likely to be in range of, say, 5%/year, plus or minus (actual number is not that important for our purpose here), after adjusting for inflation. Why should it be that way?
- svachalek 9y ago
  The classic explanation is that the economy is growing and thus the overall "pie" being shared is growing even if individual pieces are not as predictable. But I think broader and broader participation in the market via government policies like 401(k) has to be part of the story, and also I worry how much we try to extrapolate from modern financial history which is barely more than a single human lifetime.
  - hsitz 9y ago
    William Bernstein has argued pretty well that the growth of economies over the long term has held pretty stable over (surprisingly) the last several hundred years. See his book, "The Birth of Plenty": https://www.amazon.com/Birth-Plenty-Prosperity-Modern-Created/dp/0071747044 https://www.amazon.com/Birth-Plenty-Prosperity-Modern-Create... The keys to economic growth he identifies are (1) property rights, (2) scientific rationalism, (3) capital markets, and (4) adequate transportation/communication. All of these appeared in sufficient form for prosperous growth several hundred years ago. There is of course no guarantee of continued growth at same rate as last several hundred years. But given the conditions that have prevailed it has settled at a fairly stable rate as sort of a natural law.
    - PoachedSausage 9y ago
      He missed out (5) Abundant fossil fuels.
      - vkou 9y ago
        This is the real cause of economic growth. The Soviet Union and the People's Republic of China industrialized at only a slightly slower rate then the West, despite not having much in the way of property rights or capital markets. Without two hundred years of unsustainable consumption of fossil fuels, property rights or capital markets wouldn't have given us a fraction of the economic growth that we got. Stock exchanges don't do much for you when 97% of your population are either subsistance peasants, or make hand-crafted tools used by subsistance peasants, and you have to spend 8 hours a day banging rocks together to stay warm and to scare away mountain lions. #4 is also only possible because of #5.
mcguire 9y ago
Long term returns over the last century have been about 3%, after taxes, inflation, etc. If have to do some digging to find the chart. "Long term" is longer than 20 years.
- prepend 9y ago
  Cool. I’d like to see that chart because there will need to be some interesting assumptions about taxes. The 20th century was particularly good and I think the average return was closer to 6 than 3.
  - mcguire 9y ago
    https://www.crestmontresearch.com/stock-matrix-options/ https://www.crestmontresearch.com/stock-matrix-options/ The assumptions should be documented there.
    - prepend 9y ago
      Thanks this is really helpful. 4% for the 20th century is definitely closer to 3 than 6. However, the assumptions have only 80% in capital gains while this should be much higher for long term investors. If you’re investing in a 401k then you add about 1-3% because you won’t be taxed each year and those gains are compounded. And it’s assuming 1% admin fees from 2000+. This is way too high and is closer to .1% starting in the 80s with vanguard index funds. So if you invest in tax deferred index funds you are looking at 5-6% after taxes and inflation. But I like the way this matrix displays info and I want to find a version with assumptions for efficient 401k investors.
deleted 9y ago
[deleted]
smallgovt 9y ago
>> If stocks have been on a recent runup, gaining, say, 50% or 100% over a period of a few years, then they are very likely to grow more slowly than average (i.e., revert to the mean) over the coming years This is incorrect. Prior performance of the market over the span of years has little to no predictive power on future performance of the market. Your statement is like saying: Because I flipped a coin and got heads 10 times in a row, I'm more likely to get tails in the future. While it's true you should expect the market to revert to the mean over the coming years, there's no evidence that it will grow 'more slowly than average' in the coming years to 'make up' for the hyper growth in past years. If you were a betting man (and a non-sophisticated investor), you should bet that the future years will grow at exactly the historical mean. Edit: I did some analysis on historical S&P 500 pricing to validate my intuition. On average, the monthly growth rate of the S&P in a month following a bear month is -0.39% On average, the monthly growth rate of the S&P in a month following a bull month is 1.08% You might argue that it takes longer than 1 month for the market correction to occur, so I've included the script and data set I used here for you to play around with: https://pastebin.com/F78pLUka https://pastebin.com/F78pLUka. You can use any cadence, and will find the same relationship. Empirically, you cannot time the market, which implies future growth rate is not affected by past growth rate.
- sokoloff 9y ago
  Stock prices aren't the outcome of lotto balls or coin flips. In theory, over the long-run, the price of shares will represent an equilibrium of investors' opinions of the intrinsic value of a company (divided by the number of shares). The intrinsic value is commonly modeled as the net present value of future cash flows plus a discounted terminal enterprise value. For the same inputs (sequence of future cash flows, enterprise value, and weighted average cost of capital [discount rate]), the long-run value will be the same. If the near-term share price value rises more quickly than the long-run intrinsic value model, it is entirely reasonable to assume future growth of share price will moderate, as it must in order to converge on the same long-run value. I think it's not at all like your example with 10 coin flips in a row.
  - JoeAltmaier 9y ago

by hsitz 9y ago

enoch_r 9y ago

> they are very likely to grow more slowly than average (i.e., revert to the mean) I mostly agree with you, but this is basically the gambler's fallacy. If I'm flipping a coin every second for days, and I hit a run of 10 heads in a row, "reversion to the mean" just means that the next 10 flips are likely to be less extreme than the previous 10. It does not mean that I should expect "more tails than usual" for the next flips. We revert towards the mean, not past it.

poke111 9y ago
No. The gambler's fallacy is when we ascribe dependency to independent events. Stock performance tomorrow is very much NOT independent of stock performance today, e.g. "market correction"
- enoch_r 9y ago
  There is a pretty strong empirical support for the random walk hypothesis, the essence of which is that performance tomorrow is independent of performance today.
macmccann 9y ago
This is the definition of the gambler's fallacy. However, if you look at a chart of the stock market vs. a chart of a coin being flipped many times, they will look very different. While a coin being flipped will either asymptotically trend towards zero or a positive slope of .5 depending upon how it is charted, the stock market will have large peaks and valleys, meaning that after a period of high growth (overvaluation), the market will not continue to value these stocks at a steady growth of 10% per year. Instead, the market will correct the value of these stocks, which looks like a short term undervaluation and so we should expect "more tails than usual".
- tarsinge 9y ago
  I recommend you look at the random walk hypothesis, the chart (not the average) of a coin flipped does not trend towards 0 and looks surprisingly similar to stock charts
bottled_poe 9y ago
It might appear that way but stock prices are actually tied to economic performance, not coin flips.
konschubert 9y ago
No, it's not like gambling. Unlike in a casino, the returns and value of stocks are loosely coupled to the real economy. If stock values grow quicker than the economy, then we should expect a correction, because of that loose coupling. Of course, markets can stay irrational longer than we can stay solvent, so I wouldn't try to time it.
wirelessest 9y ago
But shifts in the market aren't independent random events. You can definitely find examples of dramatic, real shifts in valuation but in the vast majority of cases business value is created over time. That rate of growth might be slightly faster or slightly slower, but you can be certain it's within reasonable bounds. So when speculation or scare drives the price higher or lower, you can be sure it will find its way back.

yodsanklai 9y ago

> on average, stock value over the long term (20+ years) is very likely to be in range of, say, 5%/year, plus or minus (actual number is not that important for our purpose here), after adjusting for inflation. Why should it be that way?

svachalek 9y ago
The classic explanation is that the economy is growing and thus the overall "pie" being shared is growing even if individual pieces are not as predictable. But I think broader and broader participation in the market via government policies like 401(k) has to be part of the story, and also I worry how much we try to extrapolate from modern financial history which is barely more than a single human lifetime.
- hsitz 9y ago
  William Bernstein has argued pretty well that the growth of economies over the long term has held pretty stable over (surprisingly) the last several hundred years. See his book, "The Birth of Plenty": https://www.amazon.com/Birth-Plenty-Prosperity-Modern-Created/dp/0071747044 https://www.amazon.com/Birth-Plenty-Prosperity-Modern-Create... The keys to economic growth he identifies are (1) property rights, (2) scientific rationalism, (3) capital markets, and (4) adequate transportation/communication. All of these appeared in sufficient form for prosperous growth several hundred years ago. There is of course no guarantee of continued growth at same rate as last several hundred years. But given the conditions that have prevailed it has settled at a fairly stable rate as sort of a natural law.
  - PoachedSausage 9y ago
    He missed out (5) Abundant fossil fuels.
    - vkou 9y ago
      This is the real cause of economic growth. The Soviet Union and the People's Republic of China industrialized at only a slightly slower rate then the West, despite not having much in the way of property rights or capital markets. Without two hundred years of unsustainable consumption of fossil fuels, property rights or capital markets wouldn't have given us a fraction of the economic growth that we got. Stock exchanges don't do much for you when 97% of your population are either subsistance peasants, or make hand-crafted tools used by subsistance peasants, and you have to spend 8 hours a day banging rocks together to stay warm and to scare away mountain lions. #4 is also only possible because of #5.

mcguire 9y ago

Long term returns over the last century have been about 3%, after taxes, inflation, etc. If have to do some digging to find the chart. "Long term" is longer than 20 years.

prepend 9y ago
Cool. I’d like to see that chart because there will need to be some interesting assumptions about taxes. The 20th century was particularly good and I think the average return was closer to 6 than 3.
- mcguire 9y ago
  https://www.crestmontresearch.com/stock-matrix-options/ https://www.crestmontresearch.com/stock-matrix-options/ The assumptions should be documented there.
  - prepend 9y ago
    Thanks this is really helpful. 4% for the 20th century is definitely closer to 3 than 6. However, the assumptions have only 80% in capital gains while this should be much higher for long term investors. If you’re investing in a 401k then you add about 1-3% because you won’t be taxed each year and those gains are compounded. And it’s assuming 1% admin fees from 2000+. This is way too high and is closer to .1% starting in the 80s with vanguard index funds. So if you invest in tax deferred index funds you are looking at 5-6% after taxes and inflation. But I like the way this matrix displays info and I want to find a version with assumptions for efficient 401k investors.

deleted 9y ago

[deleted]

smallgovt 9y ago

>> If stocks have been on a recent runup, gaining, say, 50% or 100% over a period of a few years, then they are very likely to grow more slowly than average (i.e., revert to the mean) over the coming years This is incorrect. Prior performance of the market over the span of years has little to no predictive power on future performance of the market. Your statement is like saying: Because I flipped a coin and got heads 10 times in a row, I'm more likely to get tails in the future. While it's true you should expect the market to revert to the mean over the coming years, there's no evidence that it will grow 'more slowly than average' in the coming years to 'make up' for the hyper growth in past years. If you were a betting man (and a non-sophisticated investor), you should bet that the future years will grow at exactly the historical mean. Edit: I did some analysis on historical S&P 500 pricing to validate my intuition. On average, the monthly growth rate of the S&P in a month following a bear month is -0.39% On average, the monthly growth rate of the S&P in a month following a bull month is 1.08% You might argue that it takes longer than 1 month for the market correction to occur, so I've included the script and data set I used here for you to play around with: https://pastebin.com/F78pLUka https://pastebin.com/F78pLUka. You can use any cadence, and will find the same relationship. Empirically, you cannot time the market, which implies future growth rate is not affected by past growth rate.

sokoloff 9y ago
Stock prices aren't the outcome of lotto balls or coin flips. In theory, over the long-run, the price of shares will represent an equilibrium of investors' opinions of the intrinsic value of a company (divided by the number of shares). The intrinsic value is commonly modeled as the net present value of future cash flows plus a discounted terminal enterprise value. For the same inputs (sequence of future cash flows, enterprise value, and weighted average cost of capital [discount rate]), the long-run value will be the same. If the near-term share price value rises more quickly than the long-run intrinsic value model, it is entirely reasonable to assume future growth of share price will moderate, as it must in order to converge on the same long-run value. I think it's not at all like your example with 10 coin flips in a row.
- JoeAltmaier 9y ago