VOTING MACHINE VS. WEIGHING MACHINE
The unending stream of quotes and percentages makes it easy to think of stocks as random numbers or abstract lines on a chart - but it's important to remember that what you own in your investment portfolio are shares of operating companies. That ownership has intrinsic dollar value because it represents a claim to the assets of that operating business including the excess profits that (should) be produced by the enterprise. Although when you are purchasing a share in a public company it is typically only a small slice, the mindset should be no different than if you are purchasing the entire business - after all, your return will be determined by the same factors; How profitable is the business? What is the financial strength of the business? What is the durability of the cash flows that can be produced and distributed to owners? And finally, what is the price that you will have to pay today (cash outflow) to receive those future cash inflows. These fundamentals are the same whether you are buying the hardware store down the street, a farm, or a share of Coca-Cola.
The stock market provides essentially a massive auction-style exchange where these shares can be transacted on a daily basis with millions of buyers/sellers offering liquidity and convenience. Today with very little friction you can become the owner of your own slice of a multinational corporation like Coca-Cola - and if desired you can sell your share tomorrow just as easily. Is the true value of Coca-Cola going to change much in a day? Even in a year? Not really. So, it's a market that has short-term trading dynamics transacting long-term assets which presents both opportunities and risks. And one has to decide whether they are going to be a trader or an investor.
The fundamentals of a business in relation to its stock price works like gravity. In the short run, like we are experiencing this year, stock prices will gyrate wildly. However, in the long run stock prices are determined by how the business is operating decades into the future. Just because the market offers the ability to transact shares daily does not mean that an investor has to act on the prices quoted by the market. The risk comes from not having the discipline or plan to hold steady through these periods of volatility. The opportunities arise when an investor has the flexibility to act on others' irrationality.
This short-term vs long-term dynamic is illustrated in today's chart showing the calendar year annualized return of US large-cap stocks represented by the S&P 500 Index going back to 1995. Each row going down the chart shows the progressive annualized return that large-cap stocks produced. So, the first row going across the top is one year of returns for each starting year, as the rows move down it shows the annualized return for the rows going forward. Going back to 1995 we have 29 years of annualized returns.
During short periods of time in the late 90s stocks produced exceptional results. If you bought stocks in 1995 and held for five years your annualized return was 29%. Conversely, if you bought stocks in 2000 at the peak of the tech bubble and held for five years your annualized return was -2%, including five straight negative years. For both starting points if you held for over 15 years the annualized returns began to converge towards 7-10%. This trend is true for all years including through turbulent periods such as the Tech bubble, Global Financial Crisis, and Covid. For all periods less than 10 years there was a wide dispersion in returns, but after a decade or longer returns began to converge, which intuitively makes sense. If you hold an investment for less than a full market cycle you are dictated by sentiment, geopolitical events, and liquidity shifts. After 10 years stocks will approach the actual returns of the underlying business. In the short run the market is a voting machine, dictated by the sentiment and liquidity of the market. In the long run it's a weighing machine dictated by the underlying fundamentals and cash flows that are provided to you as an investor.
Keeping this perspective is critical for weathering volatility and achieving long term investment goals.