Brent Sheather: Share study needs a long-term view

What's the biggest worry when investing in shares?

For many people, it's the fear of losing the lot in some huge crash, like what happened in the 1930s.

But exactly what did happen to sharemarket investors in the Great Depression? Did everyone really lose everything and then jump out the window?

Economist J. K. Galbraith writes in The Great Crash 1929 that a suicide wave was in progress and 11 well-known speculators had already killed themselves.

Clerks in downtown hotels were said to be asking guests whether they wished the room for sleeping or jumping.

In this two-part series I want to look at what happened to two sharemarket investors, one wanting growth, the other income.

This first column tracks the performance of the portfolio of an individual, Uncle Sam, saving for retirement through that period.

Part two will examine the impact of the crash on the portfolio of Aunt Daisy, who is retired and for whom the income-producing ability of the portfolio is especially relevant. All returns are pre-tax and pre-fees.

To make the analysis simple, we will assume that both investors' portfolios were invested totally in United States stocks; pretty risky but, what the heck, it's August 1929, the sharemarket has risen by almost 80 per cent in the past two years, and everyone and everything is buzzing.

Even President Calvin Coolidge is hyped: in his December 1928 State of the Union address, he says no Congress of the US on surveying the state of the union has met with a more pleasing prospect than that which appears as the present time.

The decision to invest only in shares will also serve to amplify the impact of the crash because stocks are typically more volatile than bonds.

Let's further assume that Uncle Sam, who is saving for retirement, was 31 in August 1929 and has invested US$10,000.

We have picked August 1929 as our starting point because it was the peak of the 1920s bull market, the very worst time to invest in the US sharemarket.

The analysis uses data for the entire US stockmarket index (all the shares in the market weighted according to their size) from Ibbotson & Associates' 2004 yearbook.

The graph charts the history of Uncle Sam's portfolio in the subsequent 25 years until his retirement in 1954. It kicks off with the crash of October 29 (a fall of 20 per cent) followed by a 25 per cent drop in the 1930 calendar year, a horrifying 43 per cent plunge in 1931 and a further 8 per cent in 1932.

The year 1933, however, saw a 54 per cent gain, in 1934 the market finished about where it started, then in 1935 it rose by 47 per cent and in 1936 by 34 per cent. Now that is volatility.

It took Uncle Sam seven years to get his original US$10,000 back in real terms and it fell badly again after that but, after 25 years, in 1953 it was worth US$20,310, again in inflation-adjusted terms.

The graph also highlights another important lesson about shares: they can require a long-term commitment. Selling out after even 13 years would have seen Uncle Sam lose around half of his money.

The first thing we notice about the performance of Uncle Sam's portfolio is that he didn't lose the lot but he certainly could have had he not diversified as widely as he did or if he had become depressed and sold out, like no doubt so many did.

In fact, the most Uncle Sam could have lost had he sold at the market low was 83.4 per cent in June 1932. At that point, the US market was yielding an attractive 6.5 per cent.

Certainly, Uncle Sam's return was poor: 4.8 per cent a year for the 24 years versus 3 per cent for Government bonds and 0.7 per cent for cash, but at least it was a positive return. Remember too that annual inflation over the period was only 1.8 per cent.

So pre-tax and pre-fees, Uncle Sam made a real return over the period despite buying in just ahead of the worst bear market in 100 years.

The reasons Uncle Sam's portfolio held together were threefold:

* First and foremost he didn't panic and sell. If he had sold out at the bottom in June 1932 and stuck the money on deposit, his US$10,000 nest egg would be worth only US$1860 at retirement in 1953.

* Second, because Uncle Sam's portfolio tracked the market average, it had lots of money in blue chips such as General Electric, American Telephone & Telegraph and General Motors. He had only small weightings in the speculative, highly-geared investment trusts so popular at the time. Being widely diversified was critical to his result.

* The third reason Uncle Sam didn't feel the urge to jump was that unlike many others he hadn't borrowed money to invest in the market.

Investing on margin was popular in the late 1920s when it was possible to get into the market with a 10 per cent deposit and borrow the other 90 per cent.

Today, leverage isn't popular locally but the listed options market in New Zealand, which the NZX is encouraging, is borrowing in another guise.

While the 1929 crash must have been a terrible time, it inevitably had some humorous moments.

J. K. Galbraith writes: "Outside the exchange in Broad St a weird roar could be heard. A crowd gathered. Police Commissioner Grover Whalen became aware that something was happening and dispatched a special police detail to Wall St to ensure the peace.

"More people came and waited, although apparently no one knew for what. A workman appeared atop one of the high buildings to accomplish some repairs and the multitude assumed he was a would-be suicide and waited impatiently for him to jump."

Part two will look at how the 1929 crash affected an individual relying on the sharemarket for income and what we can learn from those times.

* Brent Sheather is a Whakatane-based financial adviser.