History has shown that investors who stick to disciplined, fundamental-focused strategies give themselves a good chance of beating the market over the long haul. And one of the investment gurus who has compiled the most data on that topic is James O’Shaughnessy, whose book What Works on Wall Street became something of a bible for investment strategies when it was released 15 years ago.
Now, O’Shaughnessy has released an updated version of his book, with a plethora of new data on various investment strategies. Using data that stretches back to before the Great Depression in some cases, O’Shaughnessy back-tests numerous strategies, and comes to some very intriguing conclusions.
One of those conclusions is about broader investment approach. For O’Shaughnessy, one of the biggest problems investors face is the tendency to focus on recent events. In the introduction to his book, he discusses how some began calling the “abysmal” returns of the past decade the “new normal”, even though it wasn’t that long ago that commentators were declaring that the Internet had ushered in a “new era” of perpetually rising stock returns — a declaration that proved to be horribly wrong. “It seems that the one thing that doesn’t change is people’s reaction to short-term conditions and their axiomatic ability to perpetuate them far into the future,” O’Shaughnessy writes.
But while many investors are assuming that the poor performance of stocks during the 2000s is the start of a new era of poor returns, O’Shaughnessy says history shows something entirely different. He looks at the worst rolling ten-year returns for equities since 1900; the period ending in February 2009 was the second-worst over that span, with 10 other 10-year spans ending in 2008, 2009, or 2010 cracking the top 50 (his data goes through 2010).
What did he find? Well, he found that equity returns following those awful 10-year periods tended to be outstanding. In the year following the 50 worst 10-year periods, stocks averaged a real return of 20.47%. The average three-year real compound annualized return following the bad decades was 14.53%; the five-year figure was 15.78%, and the ten-year figure was 14.55%.
Since stocks bottomed in early 2009, that pattern has again played out, to an even greater degree. The S&P 500 gained 68.57% in the first year after its March 9, 2009 bottom; it averaged 39.68% gains in the first two years. (These S&P figures are before inflation is factored in, but the main idea — that bad periods are followed by strong rebounds — holds true.)
“Historically, we have always seen reversion to the mean,” O’Shaughnessy explains. “After stocks have had an unusually great 10 or 20 years, they typically turn in subpar results over the next 10 or 20, and after bad 10- to 20-year stretches, the next 10 to 20 tend to be above average.” Why is that? O’Shaughnessy astutely notes that it’s largely about valuation — stocks get overvalued after good decades, and undervalued after bad decades. And disciplined investors who are willing to invest in stocks following bad decades, like the one we’ve recently had, can take advantage of that.
Next week, we’ll take another look at O’Shaughnessy’s updated book, focusing on his latest findings on which valuation metrics have the best track records of success over the long haul, and some of his key tenets for investing success.
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