Cost Segregation Study
Selwyn Gerber writes:
In order to enjoy these long-term gains from the stock market, you simply need to be in the market. That means you need to stick with stocks through good times and bad. Remember, first of all, that the return shown in the charts was posted over 80 years that included the stock market crash of 1929, the Great Depression, World War II, and the start of the Cold War. There were many other crises and crashes. The Dow Jones Industrial Average lost more than 22 percent in a single day in October 1987, and the Nasdaq Composite Index fell almost 80 percent after the Internet bubble burst.
Bear markets are nothing to fear - they have happened before and they are a normal and necessary part of the markets’ cycle. You can clearly see the 1929 crash in Figure 1-1. The oil crisis of the 70’s and the recent tech-bubble are also reflected in this graph. Yet each time the market fell back, in time it resumed its steady move forward.
The long-term results of equity investing indicate that you can ignore all the predictions of recession or depressions to rival the 1930’s or runaway inflation. Individual stocks may sizzle and then fizzle, but in the long run the major indexes always regain their lost ground and move ahead. In Table 1-1, we show every market decline of at least 10 percent that has occurred since the end of World War II. These declines have averaged ten months in duration and prices required more than thirteen months to retrace the average decline of approximately 22 percent.
“When the after-Christmas sales take place, the crowds are out the door lining up to snatch up bargains. On Wall Street when there’s a sale going on, nobody’s in sight.”
- Rip Van Winkle Wisdom
Sadly, most investors did not share in the recoveries. Again turning to research to discover facts, we learn that most of the stock market’s strong long term upward thrust occurs in surprisingly short intervals. In fact, nearly all of the total return over this 80 year period took place in just 37 months. Only those investors who had the endurance to hold tight through the declines participated in the upward moves to follow. For active investors this would have tremendous challenge, requiring nerves of steel. Rip Van Winkle, however, wouldn’t have missed a wink of sleep. Sitting tight and doing nothing as the market declines might just be the best investment strategy there is.
In order to fully comprehend the power of a buy and hold strategy, one must understand the principle of compounding returns. Simply put, compounding is when the principal for each period’s return is calculated as the previous period’s principal added to its growth. For example, if Joe invests $100 at 10% return, he will have $110 at the end of year one. In year two he will earn 10% on that $110, or $11, to make his account worth $121, and so on. The more time our money has to grow, the richer we can become from this simple tool.
A simple example shows the power of compounding. Imagine you are just starting your career. Although you may very well be, chances are that that most people reading books on conservative investing strategies have already accumulated some wealth. Just in case you are well along in your professional life, you might want to share this with somebody who is just getting started.
A twenty-one year old, working at her first job, can easily become a millionaire in retirement by contributing $250 a month to an individual retirement account (IRA) for only ten years. If she waits, and starts her contributions when she is thirty-one, she will retire with a nest egg only 60 percent as large as someone who started at age 21, even though she will have saved three and a half times more towards their retirement. We will assume that they average an annual return of 10% on their money, a little less than the stock market has delivered in the long term.
The two people in our example both want to be responsible and save for their retirement but they are achieving drastically different results. While both accumulate considerable wealth, one lets her money work harder by starting early. This is explained by the Rule of 72, which is a general rule that investors can use to figure out approximately how long it will take for their money to double at any given rate of return. Albert Einstein, better known for his contributions in quantum physics, is generally credited with discovering this rule.
The rule says you can divide the number 72 by any rate of return to find out how long it takes for money to double at that interest rate. For example if you earn 10% on your money it would double in 7.2 years (72 divided by 10 = 7.2). This rule assumes a compounded interest rate, which means that you keep all of your investment in place and earn interest on the interest gained in previous years.
To demonstrate the power of compound interest, we’ll look back at our example of two IRA investors. When both are 58 years old, with only seven years to go until retirement, the investor who started saving when she was twenty-one has almost $700,000 in her account. The investor who started ten years later has only about $400,000 in her account. Over the next seven years, both accounts will double. Obviously it is better to double a larger account. This is why it is better to start early, and let your money work for you.
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