To illustrate some possibilities, we consider some real data here. The Vanguard 500 Index Fund mimics an average of stocks of 500 major companies (the S&P 500 Index). For comparison, we also consider the Vanguard Total Bond Index Fund, which averages the prices of all U.S. bonds. Instead of buying a single stock or bond, an investor can buy a share of the fund, essentially buying an average. Suppose that an investor bought $1000 worth of each fund at the end of 1995, and held them both untouched for 15 years, reinvesting any earnings that they accrued along the way. The initial value is labeled “1.00” in Figure 1. The actual historical results are shown in the figure.
To make sense of this plot, let us think back to the actual events in the years shown:
One thing to notice in Figure 1 is that the stock fund goes up and down much more than the bond fund. In fact, in the 3-year period from the end of 1995 to the end of 1998 its value doubled, and kept up that pace through 1999! The late 1900s were the “dot-com boom”, when many investors were wildly optimistic about the new possibilities made available by the construction of the internet. This boom was too good to last, and many of the optimistic forecasts turned out to be hype. In 2000 the dot-com boom became the dot-com bubble, with stock prices falling for three straight years.
During all this time the bond fund was plodding along, slowly increasing, until the values of the two investments were nearly equal again at the end of 2002.
The pattern appears to repeat in the next decade, although the economic causes were different. In 2008 the Great Recession hit. Its causes were complex; we simply note that if more people had seen it coming, it might not have occurred. The stock market plummeted but the bond market managed to keep its slow increase.
During the whole 15 years shown, the bond fund trended upward in a steady way, despite the ups and downs of the stock fund. During that period, the stock fund also rose, but in an erratic way. In fact, during the last ten or so years the stock fund showed very little change: compare the stock value in 1999 with 2009, or 2000 with 2010 — there was very little long-term change after the bumpy ride.
We might expect similar patterns every 8 or 10 years, but the markets are too unpredictable for that. Figure 2 shows the same history, with the next 13 years added.
The left side of Figure 2 really is the same as Figure 1, but it looks different because the top of the graph in Figure 2 is at 14.00 instead of at Figure 1’s 3.50. In the late twenty-teens the stock fund hit record highs, doubling in the three years from the end of 2018 through 2021. Such doubling also happened in 1995-98, but it looks much more impressive in 2018-2021 because it starts from a larger value.
In 2020 the covid pandemic hit and disrupted much of the economy. However, the stock fund did not suffer until complications from this disruption caught up with it, with the Russia-Ukraine war adding a final kick. Serious inflation arose, causing the Federal Reserve Bank to raise interest rates sharply. These new high interest rates brought drops in both the stock fund and the bond fund: stocks because high interest rates make company operations less profitable, and bonds because new high interest rates make the currently-held bonds look unattractive.
If the stock fund seems volatile in this example, you should see the individual stocks! They can be all over the place. For example, at the start of the covid pandemic, companies that enabled on-line shopping or on-line meetings, such as Amazon and Microsoft, boomed. Hospitality companies, such as hotel and restaurant chains, suffered and survived only with government help. This crisis may seem extreme, but even in less stressful times there can be great variation among companies.
Over the full 28 years shown, the bond fund rose at an average annual rate of about 4%. This is somewhat higher than the average Consumer Price Index inflation rate for those years, about 2.5% (not shown on the graph). The stock fund rose at an annual rate of almost 9%, but in a highly irregular way. The reason for the overall upward trend is that the U.S. economy as a whole has tended to grow and be successful. A diverse composite fund, as in Figures 1 and 2, is a slice of the whole economy, and therefore has grown.
Here are the main things to notice in these examples.
- Stock prices are much more volatile than bond prices; that is, they go up and down much more.
- The long-term trend is up (and has been for much longer than the years shown in Figure 2), but in some decades stock prices may not follow this trend.
- In the long run, stocks go up more than bonds, but bonds are more predictable.
- Surprises happen. Therefore, every financial prospectus says, “Past performance is no guarantee of future results.” Or as Yogi Berra is reported to have said, “It’s tough to make predictions, especially about the future.”
Here are common recommendations to deal with the above observations. They are not universal rules, just recommendations that many people make.
- Invest for the long term. Don’t try to get rich quick; be satisfied to become comfortable, gradually.
- Since no one can perfectly predict which companies will succeed, build diversity into your investments. Especially when buying stocks, this reduces the wild swings and helps your investments adhere closer to the market as a whole. One good method is to use mutual funds.
- For the same reason, put diversity into the purchase times. If possible, have a regular schedule for putting a certain amount into your investments. This will avoid the emotional temptation to buy near the top of a boom or sell near the bottom of a bust. It will also cause you to buy more shares when they are cheap and fewer when they are expensive.