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The cost of entry for stock market returns

12th April, 2021

Published in the Sunday Times on 11th April 2021

We have recently passed through an important milestone, at least as far as financial markets are concerned.

It seems extraordinary to say this given the year we have just endured, but the world’s most followed stock market index, the S&P 500, has just completed the best 12 months in its history. On the 23rd of March a year ago the S&P500 hit bottom after the onset of the Covid-19 pandemic, and in the ensuing 12 months gained 76%. 

If you were unlucky enough to have invested on the eve of the collapse on February 19th and stuck with it, you’d still be 17% in the black, albeit having had to wait until November to break even.

A stock pickers market

The S&P 500 index is a market capitalisation weighted index, meaning it ranks the companies from largest to smallest in terms of their market capitalisation. So the performance of the S&P 500 is weighted towards the larger stocks. And through much of the post-pandemic rally, the returns for the index were being driven by a small cohort of large, mostly technology-related stocks in the index. 

For the full 12-month period, the equal-weighted version of the S&P 500, effectively the performance of the average stock within the 500, actually beat the cap-weighted version and very nearly doubled. So this was a broad based rally, the returns from which were widely spread amongst the constituents of the index.

Stock markets tend to go up steadily most of the time, punctuated by occasional sharp falls. But the last 12 months really has been an extreme outlier. There hasn’t been a 12-month period like it since the 1930’s depression. So, what price did investors have to pay for a piece of this action?  

What price do stock markets demand?

Stock market returns don’t come for free. Stock markets demand a price and extract that payment in the currency of uncertainty, short-term loss, fear and regret. 

What investors in US equities needed over the last year was a fair dose of fortitude to withstand the early losses and a willingness to look foolish for a short period. For the intrepid few that committed money around the bottom they also needed conviction, stoicism and a heavy dose of luck. You may or may not view this as a hefty price to pay, but the context in which you consider this price has important consequences for your returns.  

A very helpful way to consider the price that stock markets demand, as Morgan Housel partner at Collaborative Fund describes it, is to view it as a fee. Fees being something you pay for getting something valuable in return. As opposed to considering the stock market’s price as being a fine – a punishment which is something to avoid.

The distinction between seeing the price as a fee versus seeing it as a fine

It may seem like a trivial distinction, but I think it’s critical. The acceptance of stock market gyrations and short-term losses as the price of entry creates the proper mental framework for dealing with the inevitable volatility that will accompany the journey. 

We can’t avoid fees. But we will move heaven and earth to avoid fines. And the evidence here is damning. With all the dexterity of a tanker in the Suez Canal, investors trading into and out of stock markets to evade the ‘fee’ have historically destroyed far more wealth than they have ever created.   

The mental framework that views the vagaries of capital markets through the prism of fees has the advantage of inevitability about it. If we agree to pay the fee, we expect it and don’t waste time giving it further thought. A fine carries emotional baggage. It’s not inevitable, and so we are on constant guard. Emotion has primacy over cognitive functions and this mental thought process saps your emotional reserves.

The fees versus fines analogy is nice, but there are a few wrinkles. The price of investing success is not immediately obvious. There is no sticker price. What’s more, the fee is variable and charged intermittently. When the bill falls due it may feel more like a fine. 

There’s no substitute for experience

To paraphrase Roosevelt - appreciation for this belongs to the man in the arena. Experience is genuinely the only teacher. The challenges faced by those that endured the last 12 months were largely invisible to those of us on the side lines. To get a realistic sense of the emotional toll, you have to be an active participant.

You aren’t forced to pay the fee, but you can’t get something for nothing. Guaranteed products linked to stock markets or some absolute return funds purport to offer you a free ride. More often, you are being taken for one. 

Decide if the fee is worth paying. But also be mindful that there’s a price to pay if you don’t play.

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