Why to (still) believe in the Stock market

( Click to enlarge)

One of the most exciting things about the stock market is its unpredictability. Some liken it to casino gambling in that there is randomness in the return on investment. Moreover, the conventional thinking is that the odds are stacked against the small invester since he is competing against highly organized hedgefunds and mutual funds with talented fund managers. So the question is, can the ordinary investor make money on the stock market. I know the answer is yes, but by "ordinary investor" I mean someone who just uses a simple mechanism of buying stocks at a low price and the selling them after a certain time lag when prices are high. Nothing fancy like short selling, derivatives, etc.

I did some basic analysis on S&P historical data to debunk the first misgiving about the stock market being a casino, and events for the last couple of weeks (Oct. 2008) have debunked the myth of the know-all big fund. They are all bleeding red ink as much as small investors (no, portfolio diversity didnt save the day for them, but that is for another blog post).

Lets get back to the S&P historical data. I obtained the monthly S&P averages from the January 1900 till May 2008. I then wrote a Matlab script to invest in an S&P index "fund" during each month an amount of $100, and sell this after a pre-specified lag (1 month, 12 months, 5 years, 10 years). The figures for the different lags are given above (click to enlarge) and show sale value (Y axis) of the $100 investment that was made in the S&P index in the time specified on the X axis. These graphs are not adjusted for inflation.

For small lags (1 month, 12 months), the graphs look random and seem to support the casino effect. However, for larger lags (60 months - 5 years, and 120 months - 10 years) there is a clear trend. Some times were better investment times than other times. For example, it was smart to buy in the late 80s when the stocks were low and sell during the late 90s when the stocks were high (120 month lag).

Some conclusions from this basic analysis are

1. There is room for applying basic intelligence, and hence, this is no casino play where winning follows a certain probability distribution.
   
2. Timing is everything when considering stocks as an investment. It is as important to guess the selling time as it is the buying time. For example, folks who bought in 1920 did very well by selling in 1925 rather than 1930. Buying and then keeping stocks away like fixed-term treasury certificates is a bad idea.
   
3. Short term gains in index funds are hard to come by. Try specific stocks for this (and assume the greater risk of no diversity in this case).

I am still working on this analysis. Will keep this blog posted If you want the Matlab scripts just email me.