J.D. of Get Rich Slowly recently wrote an article about three personal finance posters that he likes. On the list was a chart typical of the kind that you’d see in a financial advisor’s office or a mutual fund’s sales literature. I’ve always called these “mountain charts” because they show a line of historical stock market returns that climbs upward like a mountain.
I have nothing against these charts themselves, but I think they’re often used to give an entirely-too-comforting view of investing in the stock market.
Mountain charts typically use a logarithmic scale, meaning that the y-axis shows exponential growth rather than arithmetic growth. So, for example, the tick marks along the y-axis might be at $10, $100, $1,000, and $10,000 rather than at $1,000, $2,000, $3,000, and $4,000.
One result of using this scale is that it makes bear markets look like no big deal. Click on the link above and look at 2008 in the poster. It’s just a tiny dip. Same goes for 2000-2002.
But for an investor who started investing in Vanguard’s Total Stock Market Index Fund 5 years before the market bottom in early 2009, this is the chart he’d be looking at if he signed into his account on 2/28/2009:
That’s not a tiny dip! For many investors, that kind of thing is terrifying. (Full disclosure: I’m inadvertently engaging in visual trickery of my own here. I don’t have control over the axes Morningstar uses for its graphs, so it’s important to note that the Y-axis doesn’t start at zero.)
Charts that give an overly-smooth appearance of market returns can trick investors into dismissing market volatility as no big deal. Result: They create portfolios with far more risk/volatility than they’re actually comfortable with, and they bail out when the market experiences its next decline.
Does History Repeat Itself?
In the long-run, stock market returns are driven by the output of a country’s economy. For the last 85 years or so — the period typically shown by stock market mountain charts — things have been (relatively) peachy for the United States.
But what would a similar chart look like for Germany? Or Brazil? Losing a world war or experiencing annual inflation in excess of 2,000% sends the value of stock investments rapidly toward zero. And those investments don’t necessarily come shooting back upward.
A chart showing U.S. stock market returns over the last 85 years is only valuable as a predictor of returns to the extent that the economies in which you’re invested experience economic growth similar to that of the U.S. economy over the last 85 years. That’s not exactly a sure thing.
How Long Is Your Investment Time Frame?
Finally, for most investors, what happens over an 8-decade time frame isn’t terribly relevant. For most investors, success is determined largely by the returns received during the period in which they have the largest amount of money in the market (i.e., the last decade or so of working years and the first decade or so of retirement).
Are Stocks a Bad Bet?
I believe wholeheartedly that a portfolio of index funds diversified across several countries is a good bet over a period of several decades. But there’s no guarantee that you’ll end up fabulously wealthy, standing atop a mountain of money. And whatever happens, it’s sure to be anything but a smooth journey.