Today, I plan to share the investment insights Benjamin Graham, Warren Buffet’s mentor, gleaned from reviewing one hundred years of stock market history, part 4 in my Intelligent Investor series, writes Steve Pomeranz Wednesday.

Let’s get started.

As Yogi Berra once said, “You’ve got to be careful if you don’t know where you’re going, ‘cause you might not get there.”

Sounds pretty obvious, doesn’t it?  But in the stock market’s context, Berra’s quote is actually quite insightful.

While we all know where we’d like our stocks to be worth 10 or 20 years from now, the truth is we are all running blind. That’s because no one really knows where the stock market will be a few days and weeks from now, let alone a few years.  So, we’ve got to be careful with our investments because we really don’t know where the market is going, and we might not reach our goals if we aren’t careful.

Moreover, as Benjamin Graham proposed: “Prudence suggests that we have an adequate idea of stock-market history, particularly when it comes to major fluctuations in price … and we need to understand the varying relationships between stock prices as a whole – and their earnings and dividends so we can know the attractiveness or dangers of the level of the stock market as it presents itself at different times.” That’s a quote and I know that’s a lot to digest but it is the meat of the whole investment process.

With that in mind, let’s go over a few key moments in recent U.S. stock market history to better hone our investing instincts.

Bull-market baloney

Graham cautions that investors must not forecast the market’s future simply by extrapolating its past performance. Unfortunately, that’s exactly what most pundits did in the late 1990s, talking up return expectations and writing books with titles such as Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market, which was published in 1999 when the internet boom was raging and the Dow (DJI) was at about 11,000.

To Graham, the book’s title words, “new strategy for the market,” would have been an immediate red flag for yet another bogus attempt at beating the market.

Not content with Dow 36,000, another author published Dow 100,000: Fact or Fiction, in August 1999.

These authors argued that because stocks had returned about 7% since 1902, they would continue to do so forever. Therefore, they questioned the logic of worrying about whether a stock was fairly valued because, in their opinion, stock valuations were a non-issue if you planned to hold them for the next 20 or 30 years.

Three key questions for investors when they are overly optimistic

As Graham writes in The Intelligent Investor: “The more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run.”

Graham reiterates that the value of any investment is a function of the price you pay for it. Think of it this way: since profits that companies can earn are finite, the price we’re willing to pay for stocks must also be finite.

Predicting future returns

So how should we predict future returns?  According to Graham, the stock market’s performance depends on three factors:

  • Growth, measured by the rise in companies’ earnings and dividends.
  • Inflation, which is the rise in prices throughout the economy.
  • The investing public’s appetite for stocks, meaning are they excited or depressed.

Historically, corporate earnings have grown at an annual pace of about 4% to 5% including inflation and dividends have added about another 2% to the return. Add it all up, and you can reasonably expect stocks to give you an average return of 6% to 7%, including inflation.

Beyond that, if investors get greedy and drive stocks up, that speculative fever will temporarily drive returns higher. On the other hand, if investors get overly fearful, returns could temporarily go lower. The key word here—temporarily—is your clue on when and how to take advantage of markets, which always bounce back from extremes.

So here are three takeaways:

  • Never forecast the stock market’s future exclusively by extrapolating the past.
  • When you hear a forecast, remember the words of Lao Tsu, the 6th century Chinese poet: “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. “
  • The only indisputable truth that the past teaches us is that the future will always surprise us and will most brutally surprise those who are most certain that their views about the future are right.

As the British novelist G. K. Chesterton put it, “Blessed is he who expecteth nothing, for he shall enjoy everything.” 

So, don’t expect too much from the market, don’t let your emotions get carried away, ignore the pundits, and stay the course with Graham’s sound investment principles.

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Learn more at StevePomeranz.com