FOOL'S EYE VIEW
Fear Not A Falling Market

By James Carlisle
June 26, 2002

It is said that the stock market climbs a wall of fear and, at the moment, you can see why. There certainly seems to be a lot of fear around, although precious little sign of much climbing. For long-term investors, these are both good things.

Over the long-term, the stock market outperforms safe assets like gilts and cash, precisely because it's frightened. If you can be sure what an investment will be give you, and there's no uncertainty involved, then you'll expect it to give you a return of a particular amount. Since 1869, this amount has been, on average, 4.7% per year -- the long-term return on gilts and cash.

To be tempted to invest in something where the returns are uncertain, like shares, investors have to expect a little more -- otherwise what would be the point? So shares, over the years, get priced by investors so that they generate a higher return than the safe assets. Since 1869, the London stock market has averaged a return of 9.5% per year. The extra return over safe assets, of 4.8%, is called the 'risk premium' and it's there precisely because people find shares a bit scary.

The return that shares are priced to provide will go up and down as market prices change, but it's fair to imagine that it's offering its most attractive prices just when everyone's at their most scared. So, to get the best out of shares over the long-term, you have to stay calm, and invested, when everyone else is running away. That's easier said than done and to achieve it, you have to adopt a stoic mindset.

First of all, don't think of the stock market as something that might be about to go up, or down, because no one, whatever they might tell you, really has a clue about its short-term movements. Instead, think of it as a collection of assets which, at their current price, can be expected to deliver a particular return over the long term. Concentrate on thinking about what that return might be and keep in mind that, the longer you remain invested, the more likely it is to exceed the returns from safe assets.

Secondly, get your head around the fact that, most likely, you actually want shares to go down! Warren Buffett made this point very well in his 1997 letter to the shareholders of Berkshire Hathaway, in a section entitled 'How We Think About Market Fluctuations':

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

So, when you see the stock market going down, take a tip from the world's greatest investor -- don't be sad or frightened, but smile and look forward to all those cheap shares you'll be buying this month, and hopefully the month after that and for many months to come.

Which brings us to the final point. If you're investing in the stock market on a regular basis, it really isn't so risky anyway, because you get the benefit of something called 'pound cost averaging'. It sounds fancy, but really it's just a way of saying that, if the market falls, then your next investment will be made at the new, lower level.

Looking at the recent experience in the London market, for example, the FTSE All-Share Index peaked in December 1999 at 3,242. It's now 33% lower at 2,187. So, if you'd been very unlucky and picked just that wrong moment to invest a lump sum, then you'd now be down a total of 33% -- not so good!

If, however, you had chosen that fateful day to start making regular contributions to an index tracker, then you would have paid in a total of £3,000 and your pot would now be valued at about £2,436. That's a total loss of just over 19 per cent. Hardly ideal, but a long way from a disaster despite landing bang on top of the worst spell for the stock market since 1974. And then, of course, you'll be making your investment this month at the new lower level. If you're going to be a net saver for a while, just cross your fingers and hope that the market falls further!

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