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PETER LYNCH'S INVESTOR TEST
Does investing your money leave you feeling ignorant? As part of its Note: This is an extended version of the test that appears in the November 9, 1998, issue of Business Week. In this version, you'll find not only the answers but also Lynch's dissection of the whys and wherefores of each one.
QUESTIONS
A. Investors keep putting new money into stocks 2. How many market "corrections" (declines of 10% or more) have there been since 1970?
A. 5 3. The five headlines shown below ran in the last quarter of 1990:
"The Real Estate Bust," Newsweek What was the total return for the stock market the following year?
A. -6.8% 4. If you tried to time the market for the past 20 years and had the misfortune to be out of stocks and in cash during the "best" 15 months (when stock prices advanced the most), you would have given up 76% of the gains captured by the buy-and-hold investor in stocks.
A. True 5. The decision that will have the greatest impact on the risk and return of your investment is:
A. Deciding how to allocate your investment dollars among "asset classes" (stocks, bonds, cash) 6. Stock prices will decline in a recession, but they tend to turn up at the same time the economy recovers.
A. True 7. Which 10-year period saw the highest total return for the S&P 500 since 1926?
A. June, 1949 to May, 1959 8. The S&P 500 was down 21.5% in October, 1987, the month of the "Crash of '87." What was the total return of intermediate government bonds that month?
A. -10.8% 9. Since 1926, small-company stocks have outperformed large-company stocks.
A. True 10. A $1,000 investment in the U.S. stock market in 1982 would be worth an amazing $11,271 today. In which of the following countries would you have done better?
A. Britain ANSWERS AND EXPLANATIONS 1. The primary reason stock prices have risen over time is:
A. Investors keep putting new money into stocks Answer: B. Companies have grown their earnings per share over time. Basically, stock prices follow corporate earnings. Since World War II, earnings are up fifty-four-fold and the stock market is up sixty-three-fold. In the past six years, earnings are up almost twofold, and the S&P 500(r) (the Standard & Poor's 500-stock index is a widely recognized unmanaged index of common stocks) is up just over 2 1/2 times. There's a strong correlation. Certainly, short-term factors do affect the market, and the enormous amount of cash invested in stocks through 401(k) plans and the growth and popularity of mutual funds have made a positive impact. But if, for example, the same cash had gone into stocks in the last six years while corporate earnings had stayed flat or declined, I'm convinced stock prices would have been substantially lower in 1998 than they were. So, if you believe the economy will continue to expand and corporate America will continue to increase profits, it makes sense to own stocks.
Source: Ibbotson Encorr, Haver Analytics, Fidelity Investments, first quarter, 1998.
A. 5 Answer: C. Twelve corrections since 1970 translates into about one every two and a half years. These occurred in 1970, 1971, 1973-1974, 1977, 1979, 1980, 1981, 1984, 1987, 1989-1990, 1990, and 1997. A 10% correction might not sound like much, but consider this: As of midsummer 1998, the Dow topped 9,000. Take 10% from 9,000, and you've got an eye-opening 900-point drop. Source: DRI/McGraw-Hill, Fidelity Investments, 1998. 3. The five headlines shown below ran in the last quarter of 1990:
"The Real Estate Bust," Newsweek What was the total return for the stock market the following year?
A. -6.8% Answer: D. 30.5%. What does that tell us? Don't let the headlines scare you out of stocks, and stick with your plan through recessions, corrections, and bear markets. Nineteen-ninety was a terrible year. Saddam Hussein's tanks rolled into Kuwait. Half a million U.S. troops were sent to the Persian Gulf, along with thousands of body bags for potential fatalities.Banks and savings and loans were on the ropes, inflation and interest rates were on the rise. A recession was beginning, and people were losing their jobs. The news was spooky, and investors were spooked. On Wall Street, the Dow fell more than 21%, from 3,000 in July to 2,365 in October. (A 21% decline in the Dow as of midsummer 1998 would take it down more than 1,800 points!) Yet in spite of the gloom and doom in 1990, 1991 was a terrific year for stocks. Even more remarkable, the S&P 500 followed its 30.5% gain in 1991 by tripling in value by 1998. Market timers who got out of stocks in 1991 (or failed to get in), missed one of the greatest seven-year advances in modern U.S. history. Source: Bloomberg, Ibbotson Encorr, General Accounting Office, Fidelity Investments, 1998. 4. If you tried to time the market for the past 20 years and had the misfortune to be out of stocks and in cash during the "best" 15 months (when stock prices advanced the most), you would have given up 76% of the gains captured by the buy-and-hold investor in stocks.
A. True Answer: A. True. Don't try to time the market. You'll end up outsmarting yourself, and giving up important gains. If you had invested $1,000 in the S&P 500 in 1978, 20 years later your investment would be worth $21,750. However, if you exited stocks for the 15 best months, your $1,000 would be worth only $6,010. That's only slightly ahead of the return you would get from Treasury bills. Source: Ibbotson Encorr, Fidelity Investments, 1998. 5. The decision that will have the greatest impact on the risk and return of your investment is:
A. Deciding how to allocate your investment dollars among "asset classes" (stocks, bonds, cash) Answer: A. Deciding how to allocate your investment dollars among asset classes. Picking the right fund is a secondary consideration. An academic study of pension-plan managers shows that 91.5% of the difference between one portfolio's performance and another's is explained by asset allocation. So how you divide your portfolio between stocks, bonds, and cash is critical. Find the mix that fits your tolerance for risk and your timetable for when you'll need the money. Once you've made that crucial decision, choose your specific investments and stick to your plan. Source: Brinson, Singer, and Beebower (Financial Analysts Journal/ May-June, 1991), Fidelity Investments, 1998. 6. Stock prices will decline in a recession, but they tend to turn up at the same time the economy recovers.
A. True Answer: B. False. History tells us that stock prices decline going into a recession, then recover before the economy at large has recovered. The reason stock prices recover early is that some investors anticipate an upturn in corporate earnings and start buying more shares. The potential for higher earnings in the future makes stocks more valuable, as investors are willing to pay higher prices for those earnings. During such a period, the background noise can be disturbing, and the lower stocks fall, the higher the volume of negative news that comes from the media and from friends and associates. They're all reminding you of how bad the recession really is. Don't panic. Stick with your stock investments. Ride it out. Source: Ibbotson Encorr, National Bureau of Economic Research, Fidelity Investments, 1998. 7. Which 10-year period saw the highest total return for the S&P 500 since 1926?
A. June, 1949 to May, 1959 Answer: A. June, 1949 to May, 1959. Investors in stocks were well-rewarded during this decade as the S&P 500 returned an average annual total return of 21.4% from June, 1949 to May, 1959. The economy grew fast in the 1950s, while inflation and interest rates both stayed low. Stocks were cheap. At the start of this decade, the S&P 500 sold for an amazingly low p-e ratio of six. (Fearing a repeat of 1929-1939, many investors distrusted stocks and avoided them. As a result, shares of great companies sold for six times earnings, less than half the normal price.) This was a dreamy combination for stock-pickers: a healthy economy, low inflation and interest rates, and bargain prices for stocks. $1,000 invested in the market in June, 1949, grew to about $6,970 by May, 1959! This was far better in comparison to the last 10 years, where the average annual return of 18.9% would turn $1,000 into approximately $5,670. Signposts of the decade June, 1949 to May, 1959: postwar construction boom, higher prices for commodities, work starts on the interstate highway system, the Korean War, the onset of the cold war. Inflation averaged a low 2% per year, while industrial production grew at nearly 6%. Source: Ibbotson Encorr, Haver Analytics, DRI, Fidelity Investments, 1998. 8. The S&P 500 was down 21.5% in October, 1987, the month of the "Crash of '87." What was the total return of intermediate government bonds that month? A. -10.8% Answer: D. 3.0%. Bonds have performed well during stock market crashes -- another reason to own them. October, 1987, was a textbook example of "flight to quality," where skittish investors seek refuge in any and all bonds and bills issued by the U.S. Treasury. Bonds became more valuable after the Fed lowered interest rates to provide "liquidity" (cheaper money) to the banking system. The total return of long-term government bonds was 6.2% that month. Source: Ibbotson Encorr, Fidelity Investments, 1998. 9. Since 1926, small-company stocks have outperformed large-company stocks.
A. True Answer: A. True. Small-company stocks returned 12.7% per year from 1926 to 1997, while larger stocks returned 11%. Why have small stocks done better? Financial powerhouses such as Wal-Mart, Home Depot, Intel, and Microsoft started out as small companies, then grew their earnings relentlessly until they became big companies. Investors who got in early were rewarded with ten-, twenty-, even hundredfold gains. Investing in small companies is riskier than investing in larger companies, because small companies are more vulnerable to economic setbacks and their stock prices move up and down more erratically. Source: Ibbotson Encorr, Fidelity Investments, 1998. References to specific companies are used only as examples and should not be construed as offers or recommendations. 10. A $1,000 investment in the U.S. stock market in 1982 would be worth an amazing $11,271 today. In which of the following countries would you have done better?
A. Britain Answer: E. All of the above. Each of these foreign markets performed better, in dollars, than the U.S. market from Dec. 31, 1982 to Dec. 31, 1997. The big winner was the Netherlands: $1,000invested there in 1982 grew into a huge $23,346 by 1997. Some decades are better than others for international stocks, but long-term investors should consider shipping a portion of their assets abroad. By allocating 15% of your portfolio to international stocks from 1970-1997, you lowered your volatility without reducing your return. Keep in mind that international stocks don't always go up. They have corrections and bear markets as readily as domestic stocks. From the peak in 1989 to April, 1998, the Japanese market fell more than 50%. If you invested there, whether you were Japanese or American, you lost money. Italy lost almost 50% from 1990 to 1992. Within the past year, Singapore and Hong Kong are down 50%, and Malaysia is down nearly 75%. The smaller, so-called emerging markets pose greater risk to investors than the larger, more established markets. Picking the best countries is no easy task, which is why it may be best to diversify into an international stock fund. Foreign investments involve greater risks than U.S. investments, including increased political and economic risks, as well as exposure to currency fluctuations. Source: Morgan Stanley Capital International, Fidelity Investments, 1998. If you want a copy of this test in booklet form, you can call Fidelity at (800) 343-3448. RELATED ITEMS
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Updated Oct. 29, 1998 by bwwebmaster
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