By Mark Blackwell
I’ve been asked this question more this year than in my past twenty five years in the financial services industry. Presumably, the question arises because of Michael Lewis’ book Flash Boys, in which he makes the claim that the stock market is, in fact, rigged. His premise is that trading technology has “advanced” to the point that unscrupulous flash traders can now see your trade and get ahead of it, forcing you to buy higher or sell lower than you would have otherwise, thus allowing the flash trader to pocket the difference. Numerous commentators have argued against Lewis’ premise, rightly pointing out that the differences in transaction prices are not significant in terms of the overall returns of the markets. With that said, though, I’d like to take a contrary opinion and point out that stock markets are rigged — just not in the way that Mr. Lewis presents.
We understand that casinos are “rigged,” in the sense that the averages are stacked in favor of the house. One gambler may hit the jackpot, causing the house to lose in the short-term, but as more gamblers play and more time passes, the averages and the economic “law of large numbers” eventually take over and the casino makes money. A system in which the time-tested averages assure a gain for the house is obviously rigged against gamblers as a group, although individually each has a chance of coming out ahead. If that system assured the reverse outcome, that the average participant would be more likely to make money the longer he or she played, we would have to conclude that system is rigged, as well. And that is my point, as that is exactly how the averages have worked out for the stock market.
J.P. Morgan maintains a rolling quarterly study in which they evaluate the best and worst returns of various holding periods for stocks since 1950 and the likelihood of a profit or loss. In their most recent publication of this data, they found that a one-year holding period resulted in a loss almost one third of the time, but 10-year holding periods made money about 97 percent of the time (only 2008 and 2009 ended 10-year holding periods with losses) and every 20-year holding period resulted in a gain. And to further develop the point, the worst loss in a 10-year holding period was less than 1 percent annually and the worst 20-year holding period didn’t just make money, it provided a 6 percent annual rate of return! Granted, the next 64 years could look a lot different than the past sixty four, but the study period had its share of crises, too (multiple wars, financial disruption, political conflict, etc.). Within the context of the markets’ historical returns over a very long time period, the greater likelihood of a reasonable gain versus the slight risk of loss for long holding periods is a compelling argument for a diversified portfolio of equities for investors with reasonably extended time horizons.
One further note of caution in the study, however, relates to the actual returns of investors versus the returns of hypothetical portfolios. Looking at the twenty years from 1993 to 2012, J.P. Morgan found that, although the S&P 500 returned 8.2 percent annually, the average investor made only 2.3 percent. To put that in perspective, $100,000 grows to $483,665 in 20 years at 8.2 percent, but only $157,584 at 2.3 percent, so the first investor made almost seven times the return on her investment than the second investor. Again, we can’t be sure that those returns are what we’ll experience in the next twenty years, but this study, like others, confirms the relative benefit of getting in and staying in equity markets.
There are numerous reasons that the average investor has failed to achieve the higher returns of the stock markets, but a major contributor to the poor performance was making emotional decisions based upon short-term economic or market conditions. History, on the other hand, suggests the markets are “rigged” to reward the diversified, long-term equity investor.
» Mark Blackwell is the Mississippi Area Executive for Regions Private Wealth Management.
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