Chapter 7
The market always goes up
In 1987, on what was later to be called Black Monday, I called my broker at the end of a very busy day. Remember that this was when we all still had stockbrokers. When we were in the dark ages before cell phones, personal computers, the internet and online trading.
“Hi Bob,” I said cheerfully. “How’s it going.”
There was a long silent pause. “You’re kidding,” he said. “Right?” He
sounded dreadful.
“Kidding about what?”
“Jim, we’ve just had the biggest meltdown in history. Customers have been screaming at me all day. It’s a panic. The market is down over 500 points. Over 22%.”
That was the point at which I joined the rest of the planet in being absolutely stunned. It is hard to describe just what this was like. Not even the Great Depression had seen a day like this one. Nor have we since. Truly, it looked like the end of the financial world.
A week or so later Time Magazine featured a cover with huge type declaring:
The Crash After a Wild Week on Wall Street, the World is Different
Of course, in this they were completely wrong. Crashes, even huge ones like this, are a normal part of the process.
As any educated investor does, I knew that the market was volatile. I knew that on its relentless march upwards there could and would be sharp drops, corrections and bear markets. I knew that the best course was to hold firm and not panic. But this? This was a whole ‘nother frame of reference.
I held tight for three or four months. Stocks continued to drift ever lower. I knew this was normal, but unfortunately I knew it only on an intellectual level. I hadn’t yet learned it deep enough in my gut. Finally, I lost my nerve and sold.
I just wasn’t tough enough. That day when I sold it was, if not the absolute bottom, close enough to it as not to matter. Then, of course and as always, the market again began its inevitable climb. The market always goes up.
It took a year or so for me to regain my nerve and get back in. By then it had passed its pre-Black Monday high. I had managed to lock in my losses and pay a premium for a seat back at the table. It was expensive. It was stupid. It was an embarrassing failure of nerve. I just wasn’t tough enough.
But I am now. My mistake of ’87 taught me exactly how to weather all the future storms that came rolling in, including the Class 5 financial hurricane of 2008. It taught me to be tough and ultimately it made me far more money than the admittedly expensive education cost.
As one of my blog readers put it: “We’ve stayed the course, with a side- dish of panic.”
It’s a great line, and staying the course is always served with a side dish of panic. That’s why ya gotta be tough.
Here’s our chart of the stock market’s history again:
The Dow Jones Industrial Average 1900 – 2012 Credit: www.stockcharts.com
Can you find my 1987 blip? It’s there and easy to spot, but not quite so scary in context. Take a moment and let this chart sink in. You should notice three things:
Through disaster after disaster the market always makes its way
higher over time.
It’s a wild ride along the way.
There is a Big, Ugly Event.
Let’s talk about the good news first. We’ll tackle those other points later.
To understand why the market always goes up we need to look a bit more closely at what the market actually is.
Publicly traded companies are companies that issue stock that can be purchased by individuals and organizations. When you buy stock in a company you own a piece of that business. The stock market is made up of all the companies that are publicly traded.
The chart above represents the DJIA (Dow Jones Industrial Average).
We are looking at the DJIA because it is the only group of stocks created as a proxy for the entire stock market going back this far. Way back in 1896 a guy named Charles Dow selected 12 stocks from leading American industries to create his Index. Today the DJIA is comprised of 30 large American companies.
But now let’s shift away from the DJIA Index, which I only introduced for its long historical perspective, to a more useful and comprehensive index: the CRSP U.S. Total Market Index.
Don’t let that technical sounding name scare you. For our purposes here, all you need to understand is that it is an index of virtually every publicly traded company in the U.S. More importantly, it is the index that Vanguard currently uses to model their Total Stock Market Index Fund, VTSAX. By design they are almost precisely the same. Since we can invest in VTSAX, going forward I’ll be using it as our proxy for the stock market overall. Last time I checked, and this will vary, VTSAX held about 3,700 companies.
This means that in owning VTSAX, you own a piece of all these businesses.
In 1976 John Bogle, the founder of The Vanguard Group, launched the world’s first index fund. It tracked the S&P 500 index, allowing investors to own the largest 500 or so companies in the U.S. in one low-cost fund. It instantly became the single best tool for taking advantage of the market’s relentless climb.
Then, in 1992, Vanguard created the Total Stock Market Index Fund and investors could own in this one fund not just the 500 largest U.S. companies, but virtually the entire U.S. stock market.
Now a quick note about something that can be confusing. Vanguard’s Total Stock Market Index Fund comes in multiple varieties: VTSAX, VTSMX, VTI and a couple of others. We’ll talk about why and how these vary a bit later. But what is important to understand now is that they each hold exactly the same portfolio created using that CRSP index. Essentially, they are the same. VTSAX is what’s called the Admiral Shares version. It is the one I personally own and that’s why I’m using it here.
So now we know what the stock market actually is and we can see from the chart that it always goes up. Let’s take a moment to consider: how can this be? There are two basic reasons:
1. The market is self-cleansing.
Take a look at the 30 DJIA stocks. Care to guess how many of the original 12 are still in it? Just one. General Electric. In fact, most of today’s 30 companies didn’t exist when Mr. Dow originally crafted his list. Most of the originals have come and gone or morphed into something new. This is a key point: the market is not stagnant. Companies routinely fade away and are replaced with new blood.
The same is true of VTSAX. It holds almost every publicly traded company in the U.S. stock market. Now, picture all 3,700 of these companies along a classic bell curve graph that describes their annual stock performance.
Generic Bell Curve Graph
Those few at the left will be the worst performing. Those few to the right, the best. All those between are at various points of performance.
What is the worst possible performance a bad stock can deliver? It can lose 100% of its value and have its stock price drop to zero. Then, of course, it disappears never to be heard from again.
Now let’s consider the right side of the curve. What is the best performance a stock can deliver? 100% return? Certainly that’s possible.
But so is 200%, 300%, 1,000%, 10,000% or more. There is no upside limit.
The net result is a powerful upward bias.
We could model all 3,700 stocks in VTSAX this way and we’d find that as some stars fade, new companies launch, grow, prosper and go public.
This process of the new replacing the dead and dying is what makes the market (and VTSAX as its proxy) self-cleansing.
But note, this only works with broad-based index funds. Once “professional management” starts trying to beat the system, all bets are off.
They can, and most often do, make things much worse and they always charge more fees to do so. We’ll talk a bit more about this in a later chapter.
2. Owning stock is owning a part of living,
breathing, dynamic companies, each striving to
succeed.
To appreciate why the stock market relentlessly rises requires an understanding of what we actually own with VTSAX. We own—quite literally—a piece of virtually every publicly traded company in the U.S.
Stocks are not just little slips of traded paper. When you own stock you own a piece of a business. These are companies filled with people working endlessly to expand and serve their customer base. They are competing in an unforgiving environment that rewards those who can make it happen and discards those who can’t. It is this intense dynamic that makes stocks and the companies they represent the most powerful and successful investment class in history.
So, now we have this wonderful wealth-building tool that relentlessly marches upward but—and this is a major “but”—that causes many people to actually lose money in the market: boy howdy it’s a wild and unsettling ride. Plus, there’s that Big Ugly Event. We’ll talk about those next.