Young Man's Caution Could be Costly

If there's one thing we know about forecasting the share market, it's that we don't know. But it's often helpful to look at history.
While it's always possible that things are "different this time", many an investor has regretted saying that.

And the numbers from the past tell a pretty compelling story. Let's look at two pieces of research – both of which exclude 2008 because we don't yet know what will follow it. They looked at:

• What happened after the ten worst calendar years for America's Dow Jones share market index since 1900.

Most of these dog years came fairly early last century. They were: 1903, 1907, 1914, 1917, 1920, 1930, 1931, 1932, 1937 and 1974, says Melville Jessup Weaver in a recent newsletter.

In eight of the five-year periods that followed these slumps, the market recovered well or really well. Four times it rose between 32 and 75 per cent over the five years. Another four times, it almost doubled or more than doubled.

What about the two other half decades? One was 1930-35, through the Great Depression, when the market fell 12 per cent. Note though, that good things were in store. In 1931–36, growth was a stunning 131 per cent. The other was 1937-42, in the run-up to and start of World War Two, when the market dipped 1 per cent. You have to admit those two situations really were "different this time."

• What happened after the six worst years for America's S&P 500 index since 1956.

The years in question ended: June 1962, June 1970, September 1974, July 1982, November 1987 and September 2002.

Research by T. Rowe Price shows that in the 12 months following those slumps, returns ranged from 19 to 52 per cent, averaging 31 per cent. Pretty impressive for single years.

Equally interesting is what happened after that. Over the three-year periods following the slumps, returns averaged 15 per cent; over five-year periods it was 13 per cent; and over ten-year periods it was 10 per cent. The big recoveries happened fast.

Both these studies look at the US, and things could be different here – although probably not hugely. In any case, it's a good idea to invest in international share funds, which tend to be dominated by US shares.

So what should our young man, who has his savings in corporate bonds and a bank, do?

Firstly, note that this research looks at recoveries from the bottom of slumps, and we may not have reached the bottom of this one yet. Our hero might feel sick if he transferred all his savings into shares and the market tumbled further.

If I were him, I would do the following:

• Decide what proportion of his savings is unlikely to be spent in the next ten years or so. Only long-term money should be in shares. Let's say that's $120,000.

• Divide that amount by, say, 12 – which comes to $10,000.

• Set up an automatic transfer of $10,000 into a share fund every month for the next year. Or, if he wants to be more cautious, transfer every two months for the next two years.

That way, he should make at least some of his purchases at the bottom of the market. And if we have a sudden boom, he will be at least partially onboard.