How To Gain Historical Perspective – Part 1
Over the past year, we have seen numerous economic and investment articles use the adjective, historical. It has been applied to “new records,” similar to sports reporting; and it has taken on a meaning similar to amazing, unbelievable and incredible.
But there is another, more valuable, use for the word. To understand recent events and trends, we need historical data, historical analysis and, most important, historical perspective. Perspective is the key to using yesterday to help us today. It is very hard to get perspective from media reports. Knowledge, understanding and experience are often lacking, so reports are filled with simplistic data comparisons and comments from “experts,” whose business interests often support a particular view. Remember the “new economy” concept and beliefs ten years ago? We’re getting similar propositions now, like “jobless recovery.”
Therefore, we have to do our own work to gain a true perspective. A good place to start is with data analysis…
Below is a graph of the Dow Jones Industrial Average (DJIA) for almost 100 years.
Many marketing pitches have had such exhibits to prove the importance of owning stocks or stock funds. The gains appear obvious and compelling (at least through 2007). The problem is that a numeric scale misleads because investing deals with percentage returns. Over time, a series of positive returns produces ever-larger dollar values. Below is a simple example of $100 gaining 10% a year.
The perspective we want is one that shows the underlying percentage gain. An easy change does it: Plot the graph using a logarithmic scale. Doing so removes the numeric compound effect.
Now the steady 10% gain is a straight line. Moving from $100 to $110 looks the same as moving from $1,000 to $1,100. The only reason the line would change direction is if the percentage gain changed.
Back to the DJIA. Here is the history using a logarithmic scale.
The dynamics are now clear. The boom and bust in the 1920s-1930s was much larger than what we have been experiencing. The DJIA’s long-term record has two periods of strong growth: 1942 to 1965 and 1982 to 2000. In each, the DJIA increased about ten times. The remaining years outside those two periods experienced stagnation and volatility. Some people are questioning whether a buy-and-hold strategy with common stocks is no longer valid. This graph shows there have been many periods when that question could be raised.
So, we have gained a better historical perspective by adopting a logarithmic approach for graphing stock prices. In part 2, we will tackle inflation’s effect on what we see – and what gets hidden.
