In the stock market as in horse racing, go with the odds

Predicting the stock market is like handicapping the horses: you can pull in and analyze lots of variables, but in the end it’s better to go with the odds. Bettors at the track look at a horse’s lineage, recent races, jockey, performance in similar weather, and hundreds of other variables. In the end, however, the results of that particular race may hinge on no more than your horse hitting a pebble on the track. Despite the unpredictability of particular races, on average the favored mounts with low odds will beat the long-shots with high odds.

So it goes with the stock market—predicting the outcome of a particular period is very difficult, but, on average, the longer the period of time, the higher the odds that things will turn out well. For example, since January 1926, the beginning of recordkeeping on the Standard & Poor’s 500 Index, there have been 605 up months and 367 down months. Although the good months outnumbered the bad months, there was a 38% chance that any particular month would see a decline in U.S. stock prices. The odds improve on longer periods. In the 81 full years from 1926 through 2006, stock prices fell in 23 years and rose in 58. Stocks rose 72% of the time. The odds of an up market rose to 80% for all two-year periods, and to 93% of the time for three-year periods.

Similar studies of stock indices for earlier periods going back another 100 years or so have found similar results—the up periods outnumber the downs and longer periods of time have better odds of positive returns. However, these trends are not determinative of the future: there is no reason why we can’t have more negative three-year periods in the market over the next 81 years than over the last. But there is also not much reason why the long-term odds will shift dramatically, just as they won’t in horse racing.

The reason is that the stock market, at least in the long run, is not totally governed by chance: it is tied to growth in the economy. Yes, random and unpredictable events push prices around day to day and month to month, and the fickleness of investor sentiment can cause irrational price bubbles and runs on the market. In the end, however, economic prospects push the market ahead. Over time the economy tends to grow, despite periodic stagnation and recession. As long as the political climate allows a dynamic capitalist economy to do its thing with reasonable restraint, stock prices will increase.

All of this may seem cold comfort during an extended market downturn. The latest evidence of this occurred when stock prices collapsed in late 2002, toward the end of a grinding three-year bear market. It appeared that some investors had given up in frustration and fled the market just as it was about to begin its recovery. Down markets like that—or even more severe—will come again.

To steel yourself against such an event, you should learn, review, and internalize what stock market and economic history has shown: That the declines in the market are temporary and the long-term gains permanent. The patient investor will win in the end.