Centre Street Cambridge Corporation

Private Investment Counsel


July 2003

Experience is most valuable when its lessons clash with the allure of current passions, and nowhere is this principle more apparent—or more ignored—than in the field of investments. How often was sound advice, rooted in knowledge of the kinds of surprises that markets can spring on unwary speculators, dismissed in 1999 – 2000? One would have thought that three years of sharp declines (unpredicted by Wall Street) would have by now instilled a little humility in those whose wits were impaired by the adrenalin rush of the bubble market. And, indeed, we have heard a lot of words of caution during the last few years—the need for “diversification” and so on. Yet, just as speculation accompanies market booms only to be sheepishly renounced as foolishness when the tide inevitably turns, caution turns out to be a bear market companion (arriving too late to be of much use to anyone)—a more prudent attitude that is soon cast aside when it in its turn becomes an embarrassment as events unfold in their usual unanticipated fashion. The markets have turned upward a little since March and, sure enough, the big players have swung their attention to more pressing concerns, such as their industry’s ever-present intermural competition. In the middle of June, our leading business journal reported: “Professional money managers, many of whom have been caught off guard by the rally’s strength, scrambled to get into stocks before they report quarterly results at month’s end.” A similar thought process led many of these same managers to buy Enron shares just a few years ago. No heed for the lessons of experience here.

The money management business was certainly facing a troubling conundrum as markets erupted during the second quarter to produce the strongest upturn over a brief period in several years. All of the major stock market averages went from showing year-to-date declines of 4 – 9% in early March, to robust 8 – 22% gains by June 30. Bond prices, too, continued upward as interest rates fell to their lowest levels in over forty years. What were money managers to do? Having convinced themselves that (1) returns on stock investments would be low for many years, and (2) that stocks remained overpriced despite three years of declines, many fund jockeys had built up significant cash reserves (useful also if fund shareholders decided to get out). As we all know, cash is a hindrance in rising markets since it reduces relative returns—a potential disaster given the virtual real-time competition in the money management trade.

At least some of that cash build-up came from a dawning enthusiasm among the investing public, anxious to participate in a new bull market. A familiar story began to unfold as the quarter advanced. Considerations of risk were again tossed aside as buyers purchased shares in the most aggressive, typically technology-oriented funds. High-yield securities (junk bonds) found favor as well, even after substantial price increases during the previous several months. Interestingly, the hedge fund craze appeared to be dying down just as institutions of various sorts were allocating more and more resources to that, the latest hot group of gunslingers. At last report, hedge fund returns were falling well behind the market. Hedge funds’ main selling point—their “market neutrality,” or ability to prosper regardless of what the overall market does—does not seem to matter as much when the market itself is going vertical.

Investing Over a Lifetime

Goethe once said, “In the realm of ideas, everything depends on enthusiasm; in the real world, all rests on perseverance.” With regard to investment—a “realm of ideas” if ever there was one—Goethe had it wrong. For enthusiasm, when it overwhelms cool calculation, is the absolute bane of successful investment. Ardor, desirable in those who found and lead business enterprises, clouds the investor’s judgement, leading to overpayment for assets, involvement in projects of dubious quality, and short-term thinking. Perseverance, on the other hand, gives an investor a great edge: the ability to profit from what the financial markets offer to citizens of a capitalist society, namely, access to business ownership. Shareholders—part owners of businesses—have a stake in the income from that society’s chosen method of organizing the production and distribution of goods and services. Great fortunes have been accumulated through perseverance in the ownership of successful businesses over long periods of time—an important source of wealth in this economic system. Enthusiasm is best left to the managers of those businesses.

We often hear Wall Street pundits talk about investing for the “long term” (especially when their recommendations are losing money). What does this mean, exactly? There is no definite answer, unfortunately. Some commentators seem to think of six or twelve months as being an appropriate investment horizon, others, maybe two or three years. Reflection on some stock market history may help readers to acquire a useful perspective on this issue.

The Dow Jones Industrial Average first touched the 1000 mark in 1966. In 1982 the DJIA again hit 1000, on its way north. During the sixteen-year period in between, the average meandered between 600 and 1000 and was at times quite volatile in its movements. After declining in the late 1960s and reaching 630 in 1970, it again rose to about 1000 in late 1972 – early 1973, only to drop to about 580 in 1974 during the worst market crisis since the 1930s. It recovered in the mid-1970s to top 1000 again, and traded in roughly the 800-1000 range for several years into the early 1980s. Over this entire period, therefore, Dow investors in the aggregate experienced exactly no appreciation in their capital and a great deal of frustration. Nevertheless, due to a healthy rate of dividends, and reinvestment, they did earn money, at a rate of 5.2% annualized between 1966 and 1982 (inclusive).

The changes in “investor psychology” over these sixteen years illustrate our point about enthusiasm. As prices rose in the early 1970s, the public readily plowed money into the stock market. Pension fund managers were eager to buy shares and did so with gusto, bringing the portion of such funds invested in equities to almost 75%, a record, just prior to a market rout. The 1973 – 74 collapse caused a general pulling-in of horns and interest in stocks declined. Following the 1975 – 76 recovery, stocks and stock investors remained rather depressed into 1982. Despite some excitement here and there (in the energy sector, for example), by 1980 Wall Street was at a low ebb and pension fund commitments to equities had dropped substantially. Some observers even began to question the continuing viability of stocks as investment vehicles. On the very eve of the great 1980s bull market, in July, 1982, the DJIA was listless at about the 775 level, and was widely expected to go lower. Clearly, enthusiasm had not served investors very well over this period, at least during those brief seasons when it arose.

Yet suppose our investor in 1966 had altogether dispensed with emotional responses to the market’s ups and downs and persevered in investing the modest sum of $500 per year in the Dow stocks from 1966 to 1982 (inclusive). Earning the DJIA rate of return of 5.2% (probably a conservative assumption, since this “dollar cost averaging” program would have resulted in the purchase of more shares at lower prices in 1969 – 1970, and especially in 1973 – 1974, thereby enhancing results), this policy would have resulted in an account worth $13,148 by the end of 1982. Assuming no further cash additions, that sum would have grown to $249,430 during the next seventeen years of a bull market in which the Dow Industrials advanced at an annualized rate of 18.9%. Had our investor been about thirty years of age in 1966, he or she would have accumulated a tidy sum for themselves as they approached retirement age in about 1999.

By no means do we suggest that investors should expect similar results at all times—market history seldom repeats so consistently, and the 1980s and 1990s were an extraordinary era for stock gains. However, a few interesting conclusions seem warranted. First, investors would probably be better off by simply buying and holding their stocks for long spans of time—perhaps indefinitely—and letting economics, market capitalism, and compound interest work their magic. Growing businesses create wealth, and owning pieces of them is the way the average investor can get a piece of the action. The notion that one can trade in and out of stocks, avoiding declines and profiting from rises, gains an unfortunate veneer of plausibility during difficult market periods. Such trading schemes belong more appropriately to the realm of speculation, as they are virtually impossible to execute well enough to bring the desired results. Even granting clever execution, and ignoring transaction costs and taxes, such in and out trading defeats the economics of another aspect of business ownership: dividends. Companies with increasing dividends can provide a growing stream of income over time—if their stocks are held.

Secondly, investors would find themselves wealthier and wiser by ignoring market volatility. With declines such as those accumulating to -33.8% in 1973 – 1974, this can sometimes be difficult to deal with psychologically, but essential to long-term success. Even the most severe of market crashes has never led to the end of life as we know it (in this country, at least). Individual businesses have been stressed, but careful investment and the avoidance of speculation should minimize the odds of wipe-out risk. For individuals in the accumulation phase of their financial lives, or long-lived institutions such as pension funds, market troubles actually represent an opportunity to build value. For our hypothetical thirty-year-old investor in 1966, the depressed markets of much of the 1970s and early 1980s were a godsend, enabling the accumulation of securities very inexpensively. When the good times arrived in 1982, our investor was prepared and earned the rewards of patience and perseverance.

These reflections, we believe, support our view that investing is best thought of as a lifetime endeavor. Stock price gyrations and the emotional reactions of less sophisticated market participants have little significance when viewed over a span of decades. Wall Street’s obsession with the latest chit chat is revealed as nothing more than speculative silliness. But this long-term view also bespeaks the importance of getting a proper investment program in place early on. Just as success in one’s career is more easily accomplished if one gets off on a good footing at the outset, having the reassurance of a long-term objective, and guidance provided by the lessons of experience, assures that one’s responses to market events are appropriate, rather than self-defeating.


Dennis Butler, MBA, CFA