Posted by: Bruce Allen | February 3, 2013

The “Long Stock” Effect = -2.25% of 15% Return

This February 2013 post should have read that long positions work against you, even when markets are stable.  The 2.25% quote here assumes a 15% rate of return.  The effective rates will be determined by assumed or actual rates of return.

Nick Murray, formerly a Big Deal at Bear Stearns, when there WAS a Bear Stearns, used to teach that the way to get rich in the stock market was by doing what most people don’t, because most people aren’t rich.  He used to serenade us with visions of an S&P at 10,000 and a 30,000 Dow, and he was telling us to expect this by 2005.  In addition to a myriad of other things, Nick was apparently unaware of what I choose to call The Long Stock Effect.

Here’s the problem.

Let’s say I’m an investor with $100,000 to invest and no strong feelings about the market, other than it’s hard to beat the indexes.  Let’s say I decide to put my money in a no-load, low expense S&P 500 index fund.  I’m going to buy the large cap market, and stick with it for the next 20 years or so.  No commissions, no research, no advice, just a $100,00 bet on the S&P.

s-and-p-500-history-chart

History of the S&P 500 since 1960.

Let’s also say I’m a freelance writer, and am relying on my instincts more than my intellect when it comes to investing.  (The joke here, of course, is that there is a freelance writer somewhere with $100,00 to invest.  But I digresss.)  My instinct tells me that some years the market will be up, and some down, but over a long period of time there will be more upside than downside.  Until the 21st century, that had been true for a hundred years.  Buy and hold for a long time and make money.

The paradigm seems to have shifted around 2001 with the busting of the tech bubble.  Since then, the S&P has been flat, and the variance in annual returns far higher.  Major swings up and down, with the index in early February 2013 at about the same point it was in 2001.  Undaunted, our freelance writer figures to buy today, rather than wait for the next dip.  After all, he’s a long term investor.  With good common sense, and fairly high risk tolerance.

To illustrate the problem facing our freelancer/investor, and the millions of long investors like him, let’s take a simple scenario and do the math:    The market goes down 15% this year and up 15% next year.  Will you be better off, even, or worse off in two years? (Less commissions, and in nominal dollars, in which case inflation is working against you.  If you have $100,000 in two years, you’re worse off than you are having it today to the extent that inflation has eroded its buying power.  Time value of money and all that.  But inflation has been mild, and you don’t care about that either.)

So, here’s the math.  You start with $100,000 and lose 15% coming out of the gate.  Nice going.  Now you have $85,000.  Luckily for you, the following year the S&P goes up 15%, and you’re thinking, “YES, I’m back to even again.”  Except that, um, you’re not.

Your $85,000 has indeed risen by 15%, but that leaves you with only $97,750.  So, while you felt you were breaking even, you lost 2.25% of your investment, plus commissions, plus any taxes on the gains, plus being on the wrong side of inflation.

You’re hosed.  Keep doing this for 20 years and you’ll make a small fortune the hard way–start with a LARGE fortune and follow your instincts.

Now you’re thinking, fine.  So I lost some of my capital.  The problem is that the market went down the first year, and up the second.  Surely, if you reverse the assumptions, I’ll come out ahead by that pesky 2.25%.

Let’s do the math.  Year one is a winner, and your $100,000 grows to $115,000.  Alas, year two is a bummer, and the S&P gives up 15%.  15% of $115,000 is $17,250 which, subtracted from your $115,000, leaves you with the same stinking $97,500.  STILL down 2.5%.  Plus the blah blah blah.

Up&down chart-MainYou’re hosed either way.  What does this mean for the long term investor?  Think of it as a cover charge.  The “price of admission” to investing in the stock market, ceteris paribus, is 2.25%.  Comparable to the expense ratios in expensive managed money funds and the charges inside variable annuities, with all of their guarantees.  (Wait.  This is becoming a commercial for annuities.)  Expensive mutual funds hit you with a lot of fees, but this does not negate the “long stock effect” described above.  It adds to it.  So, if your managed money account with your broker costs you 2% of assets for their expertise, you are down over 4% before you start.

No, wait.  This is becoming a commercial for short sellers.  If the long buyers are paying a 2.25% vig, then perhaps the short sellers have something going on.  We’ll have to think on that one and save it for a later date.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Categories

%d bloggers like this: