Philosophical Economics has an interesting post that posed the question, "Would you be better off if stocks melted up 200% or plunged 67%?" For investors with 30 year time horizons, the counter-intuitive answer is the 66% plunge in stock prices.
As equity investors, we tend to focus more on capital gains, but as fixed income investors are keenly aware, there are two other sources of returns for investors. The first source is capital gains, the second is income (interest for bonds and dividends for stocks) and, lastly, re-investment return, or interest on interest.
As the analysis from Philosophical Economics shows, if stock prices were to plunge 66%, the investor would be able to compound his returns at much lower prices than if the market melted up. Thus, for investors with sufficiently long time horizons, periodic corrections and bear markets are helpful to terminal wealth value as that dividend income can be re-invested at lower prices.
I once had a taxable investor client with an extremely long time horizon. The client was formed as a trust and most of the positions acquired decades ago, e.g. GE with a cost base in pennies. The low cost base of the positions made selling nearly impossible because of the capital gains liability, so the client adopted an investment policy of focusing on companies with a history of good dividend growth. That way, the current beneficiaries could enjoy a steady and predictable rising income stream. Bear markets were especially welcome, as we could "harvest" capital losses to offset the capital gains from the sale of positions with low costs.
I had a fruitful relationship with that client, but it was a disconcerting feeling when I called to report our quarterly results when stock prices were rising. I almost felt like I had to apologize, "Sorry, we made you money this quarter. Your portfolio went up by X%." Nevertheless, the strategy of focusing on dividend growth made sense as it should provide better overall returns in the long run for investors with sufficiently long time horizons.
It was a good lesson for me in formulating an investment policy statement. Know what you really want. Know your time horizon.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”
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