Index fund investing or investing in ETFs that track an index is the current investment vehicle of choice for most passive investors.
The basic premise of the index investing strategy is to buy and hold, as stocks only go up over the long -term (Which is true). But what if I told you there could be periods of 10 years or more where index investing could receive no capital gains and only receive returns via dividends?
For some index investors, this might seem absurd or simply not correct, but I can tell you it’s a genuine possibility. Why’s it a possibility? Well, it’s happened in the past. And if it’s happened before what’s to stop it from happening again.
I’ll still invest in index-tracking ETF’s
I’ll start this off with a message; I am not trying to deter you from investing in index-tracking ETF’s. In fact, I do and will continue to do so even with knowing this information. I mention the average 10% returns of the market here and there. And this is true, once you start looking years out, or, into long-term past performance.
I wanted to show people the risks or the possibility of what could happen. The strategy of a broad market index investor is long-term, and I mean very long-term 10-30 years plus.
You keep adding money over time by dollar-cost averaging, reinvest the distributions and let your money slowly compound.
Australia has been relatively lucky compared to other countries. Some global stock markets have had periods where their markets have gone nowhere. Our high dividend payouts have given us the best performing stock market in the world since 1900. Well, that and we came out relatively unscathed from the 2008 GFC. https://www.bloomberg.com/news/articles/2020-02-26/australia-has-world-s-best-performing-stock-market-since-1900
Two investors types
There’re two types of investors, those who invest for capital gains and those who invest for cash flow (think, rental income and dividends).
If you invest for the dividend income, then the capital gains are a cherry on top for your returns. To receive a higher income, you need to invest more. Your goal as an income investor should be to build up your portfolio as big as it can be by consistently adding to your positions to create a growing stream of dividend income.
So, a market that stays flat and produces no capital gains is pseudo irrelevant to a dividend investor; they want the income, not so much the capital gains. Of course, a principal amount that stays flat for long periods can be mentally draining. However, if you know this information and approach it with an anything can happen mindset, then it won’t be so bad.
Stagnate Market 1
The first flat market I’ll show you is the S&P500 from 1966 to 1980.
Flat markets can also be consolidating markets, where the market consolidates and constricts for an amount of time. Over the very long-term, the market rises, which you can see below. However, during these 14 years which I’ve outlined, it bounces up and down within this range.
Beginning in 1966 after an incredible bull run the market had to blow off steam, not only this but there was a significant recession in the 1970s embedded in this timeframe. You still would have received dividends. But what about capital gains? Well, that depends where you bought and how much you averaged in.
If you managed to buy near the end of the recession in 1974 or get your average purchase price at those lows (1974 is the 3rd arrow to the right on the bottom) from dollar-cost averaging, you would have had some nice capital gains come 1975- 1976. Then you would have stayed in profit all the way through.
But what about if you bought at the top (middle arrow), didn’t average in and just held on? You wouldn’t have been clear into profit until 1983. That’s 10 years you would have had to wait.
Stagnate Market 2
This one is nowhere near as bad as the 1966 period, but none the less it still took close to 10 years to break the high and keep marching on.
Below is a chart of the Australian All Ordinaries Index. You should see a similar pattern, which is the incredible run-up, followed by a dizzying fall into consolidation.
This time, we had the first flash crash known to markets which was the panic of 1987. Our market declined a little over 50%, as did other global stock exchanges. The market bounced around the lows (where the arrows are), and while it was hanging around the lows, we had a recession in 1991, followed by the subsequent recovery.
The market finally broke its high 9-years later, so not entirely 10 years but still close enough. It’s the same story here, if you bought at the top, didn’t dollar-cost average in and let it ride from where you purchased, it would have taken you 9 years to get out of the red. You still would have received dividends, just no capital gains.
But if you kept averaging in and managed to get your average purchase price around 1400 (where the bottom arrows are) by 1993, you would have been into profit and sailing ahead.
Why do these flat markets happen?
I can keep going and find plenty of these periods of choppy flat markets. It happens from time to time throughout history, and, in a capitalist society, just as in financial markets, it’s all linked to economic boom and bust cycles. Time for a quick economics lesson 😑
It usually starts with a boom period; central banks have relaxed lending policies and makes it easier to obtain credit. This fuels growth from the investor’s standpoint as money is cheap, and people can borrow to invest and buy assets (think, a property developer in construction). Borrowing and buying assets push up those asset prices from the increased demand. This general increase in demand leads to companies growing and expanding, needing to add more employees to help their growth. Higher employment fuels consumers spending, giving businesses higher profits. And, more profits lead to higher stock prices. It’s a virtuous cycle until it gets too frothy.
Once this boom cycle peaks, the economy goes through its bust period. The cheap money and relaxed lending have led to an oversupply of money creating inflation; central banks tighten lending policies by raising interest rates and making money more expensive. Companies and investors borrow less (since money is more expensive); the stimulus from the boom period disappears. There’s no more money pushing up assets prices, so they begin to fall, as they start to fall, people and investors don’t feel confident about the future, this reduces spending even more. Businesses cut back on hiring, purchasing and investing, which begins the cycle of unemployment. High unemployment means less consumer demand; less consumer demand means falling business profits; falling profits should mean falling stocks prices. You can see how each point of causation creates the following domino effect.
Each bust cycle is different and can last for various amounts of time. Usually, governments will react with fiscal policy, and central banks respond with monetary policy trying to get the economy jump-started again. That’s the short of it anyway, as there are a lot more variables that go into it which I’m still trying to learn myself.
Flat market conclusion
Although from time to time, it takes 10 years or so to break a previous all-time high, there are a few messages that can be taken from this information for long-term investors.
The first being, we’ll never know when an all-time high will be made. But anyone who put a whole lump-sum in at the peak in 1987 would have been doing just fine come 2007. It’s a long time to wait, but that’s why it’s buy and hold forever, and you’ll want to be happy with this being a potential outcome.
The second being is stick to the plan! If you’re like most passive investors, then dollar-cost averaging into the market is the best strategy. You won’t know when it’s going to top or bottom, but if you see a sharp decline, either stick to averaging in or break your rules for the time being to take advantage of lower share prices.
During the crash of 2020, I bypassed the plan and tried to buy when the market was down. Markets rebound quickly, and I knew I could get my average purchase price lower by taking advantage of the lower index prices. As an example, with one of the ETF’s I own, VAS, my average purchase price was high, Sitting at about $88. However, because I kept buying at lower prices, my average purchase price is now at $74. I reduced my purchase price by 16%!
I’m not trying to scare off investors with this post; I think we should know what we’re getting ourselves into. Over the long-term the market rises, that’s a simple fact. It’s wise to remember there will be periods of contraction where it doesn’t move higher, and instead, it bounces around up and down and our only returns will be dividend income. That’s okay though because it’s impermanent and this too shall pass.