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To Invest or Not to Invest: That is NOT the Question

John Price, Ph.D.

Sorry Mr. Shakespeare. There is just no question about this one. And by invest, I mean investing for the long-term in quality companies.

Let's start by looking at some alternatives. Suppose you think that stocks are too much of a gamble and you like plain old fashioned CDs or treasury bonds. Perhaps you remember the good times from 1979 to 1981 when the average 3-month CD rate was 13.4%. Just ask yourself, why did banks back then pay such a high rate? The simple answer is that they had to because inflation at the time was at a record high. For the years just mentioned the average inflation rate was 11.58%. And don't forget the tax you would have paid on your interest.

In fact, when you include income tax and factor in the inflation rates for each year, you find that the annual return on investing in 3-month CDs is negative, around -1%. CDs may be fine as a temporary parking place for cash held for emergencies. But they are a non-starter for building long-term wealth.

How about real estate? There is no question that if you bought at the right time in the right location, you made a lot of money. But the stakes are high when you buy investment property and you really have to know what you are doing.

No matter how you do the calculations, I think that the best return for the average investor is going to be in a portfolio of stocks in great companies with proven records. Of course, there are risks. To get a handle on these, suppose we try something very simple and just invest in an index fund based on the S&P 500. But perhaps I invest at the wrong time, you might be thinking. Perhaps I will always invest when the market is at its peak. Well, let's have a look at that.

Consider two friends, Mr. High and Mrs. Low. For the past eleven years they have invested $10,000 each year in an S&P 500 index fund. Mr. High had the misfortune of investing when the index was at the highest point for the year. In contrast, Mrs. Low was much more fortunate. Each time she invested the index was at its lowest annual point.

Their wealth will increase over the years. And, of course, the average annual return of Mrs. Low is going to exceed that of Mr. High. But by how much? Before reading on, have a guess at what is going to be the difference.

Let's make a start. The high point for 1987 was 336.75 and occurred on August 25. By the end of the year it had dipped to 247.10 which means that Mr. High's $10,000 would be reduced to $7,337.79. Not an auspicious start.

In contrast, Mrs. Low would have invested on December 4 when the index 223.90. This converted her investment to $11,036.18, a much better result. The difference is even more stark when you annualize their returns. The annualized return for Mr. High is a dismal -58.63% whereas that of Mrs. Low, because it is over such a short period, is a whopping 279.18%.

In the following year Mr. High would have invested his next $10,000 on October 21 when the index was at a high of 283.65. By the end of the year it had dropped to 277.70. Using the $7,337.79 from the end of the previous year, his cumulative wealth at the end of 1988 would be $18,036.71. This gives him an annualized return of -12.5%. Similar calculations for Mrs. Low give her an annualized return of 19.0%.

Notice how the annualized returns become closer together. For example, repeating this for 1989 we would find that their returns are now 7.1% and 24.0%.

In fact, it is always the case that the difference between investing regularly at the market lows or at the market highs becomes less and less. Jumping forward to the end of 1998, the annualized return for Mr. High would be 15.77% and that for Mrs. Low would be 18.17%. You can think of these as the two extremes and you can see that there is not a lot of difference between them. Most regular investment strategies would be somewhere in the middle. But even Mr. High would have a portfolio of over $300,000 at the end of 11 years growing from his outlay of $120,000. (Please e-mail me if you would like a spreadsheet with the calculations.)

We all know that the last ten years has been a boom time in the stock market. Can we be confident of another ten years of record highs? Of course we can't. But we can be confident that the stock market will outperform CD rates. Remember the -1% mentioned above.

For a truly rosy picture I recommend the book "The Roaring 2000s" by Harry Dent. Basing his argument on the fact that the baby boomers are just reaching their peak spending years, he predicts that the Dow will continue to soar and will eventually reach at least 21,500, and possibly 35,000, by 2008.

So, with all respects to Mr. Shakespeare, the question is not whether to invest or not, but just how soon you can set up and follow through on a regular investment plan.

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