Let’s Play Poker: Go with the Odds!

In my last article, I discussed the importance of a long-term focus when investing and why such a focus has historically served investors well. With markets continuing to gyrate wildly, is it time for a different approach? For the answer, let’s evaluate the stock market’s odds of winning and losing over the long run.

Market Carnage Continues

Since my last article (August 8, 2022), the S&P 500 has dropped another 10%, leaving many investors more frustrated than ever. Any market rally quickly dissipates and leads to further losses. With the plethora of issues facing the market – Russia/Ukraine, supply chain snarls, Fed rate hikes, rampant inflation, etc. – investors are searching for any sign that we are near the bottom. Unfortunately, such signs are only apparent in hindsight (if they exist at all). As noted last time, getting out of the market to avoid further losses often leads to investors missing out on a good chunk of the market's subsequent recovery.

Some Perspective

With the market down roughly 20%, can it get worse? In the short term, of course. As a former colleague of mine used to note, there's always another potential 10% downside lurking around the corner. It can also get worse over the longer term – look at the Great Depression for an obvious example. The problem that investors face is that they cannot know in advance whether or not the market will go down more (or by how much) before rebounding.

Think Like a Poker Player

Making decisions in the face of uncertainty is a hallmark of poker. You make your bets with imperfect information – with cards yet to come or cards face-down and unseen by you. The best players bet big when the odds are in their favor. That does not mean they always win. So-called bad beats (when the odds are in your favor, but you lose anyway) are a fact of life for poker players. But over time, if you bet when the odds are in your favor, you win more than you lose. For an excellent discussion about making decisions in the face of uncertainty, I highly recommend Annie Duke's book "Thinking In Bets: Making Smarter Decisions When You Don't Have All the Facts."

How does that translate to investing? I pulled daily returns on the S&P 500 going back to 1950. I then looked at rolling 5-, 10-, and 20-year returns. Buying and holding for five years resulted in positive returns 83% of the time. The mean return over that time frame was around 8.5% per year. Stretching the time frame to 10 years led to positive returns 92% of the time, with average annual returns of around 8% per year. Holding for 20 years always resulted in positive returns, about 8% in returns per year.

Daily data on the MSCI EAFE (foreign developed) index only goes back to 1970, but the patterns are similar. 5-, 10-, and 20-year holding periods generate positive returns 86%, 99%, and 100% of the time.

In other words, when you are invested in the market, the long-term odds are stacked in your favor. Of course, this doesn't mean that the short-term can't or won't be painful, but it does show that sticking it out will be rewarded.

Do You Feel Lucky?

So, with the odds of positive returns stacked in your favor, do you want to risk missing out to maybe save yourself a bit of downside? Look at the previous list of risks – do you think you can accurately predict how even one of them will play out? Even if you do, are you sure you know how the market would react? If the odds of decent long-term results are already in your favor, why mess with that?

Summary

I will say it again – stick with your plan. Don't try to outguess the market because it is a losing proposition. If I ever find a better approach, I will happily adopt it, but until then, I will keep repeating this mantra.

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