A Trap in Conservative Investment Products

Paul Winkler: Welcome. This is “The Investor Coaching Show,” with Paul Winkler and Jim Wood talking about money and investing, as well as planning for that time when your money works for you, rather than you working for money. That is the idea behind it anyway.

People go through one stage where they work, putting aside money and hoping for that day when they don’t necessarily have to work anymore because they set aside money. Just for the fun of it, I’m going to do a little thought experiment here.

Saving for the Future

Jim, let’s say I put aside $5,000 per year and I started off with zero and we’re looking 30 years into the future and the rate of return is the worst 30-year period. Say all I invested in was large U.S. stocks.

So we went through the worst 30-year period. The worst 30-year period for large U.S. stocks started during the Great Depression and the rate of return was still 8.5%, right?

Okay. So I take that $5,000 a year over 30 years. Basically, I invest $150,000. So if I did that, what’s the portfolio worth? It is worth $621,000.

Okay. So literally, one-quarter of the money is what I put there and then three-quarters of the money was gained over 30 years.

That tells us that:

We have to make sure we save for the future, and we also have to make sure that our money is invested properly.

If we look at historic markets and see that large U.S. stocks have had a certain rate of return, what’s the likelihood that’ll be the case in the future?

You will always hear that past performance is no guarantee of future results. I look at the fact that large U.S. stocks are still selling for about the historic norm, which is 16 times earnings, and that’s where returns really come from.

But here’s a pet peeve. I just want to hit this one pet peeve I have regarding that because you always hear me say, “Past performance is no guarantee of future results.”

The markets may not do anything in the future. You may not have the same returns. And that is very true.

All of it is very true, yet somehow banks don’t have to have that same disclosure. I think what that does is give people a false sense of complacency regarding banks.

Take insurance products, for example. The only thing insurance companies have to do is say that the paying ability of the insurance company is going to be an issue.

You have to make sure that the insurance company is good and solvent, otherwise you might not get your money back. But that has nothing to do with investing in fixed assets. You don’t hear the same type of thing with fixed income assets.

Long-Term and Short-Term Risk

The reality of it is, we have examples all over the world, and I’ve talked about them before. In post-World War I Germany, the mark became worthless. If you put money in a German bank, it was worth nothing at the end of it.

But if you owned Volkswagen stock, a German company, you were fine. If you look around the world where hyperinflation exists, you can see that it’s just the devaluation of the currency.

I think that the disclosure for investing ought to be on everything regardless of what it is. Banks ought to have CDs that say past performance is no guarantee. You’ll get your physical money back, but you cannot discount the fact that there is no such thing as safety in life.

Jim Wood: Right. I mean, you don’t know necessarily when you drive across town, you’re actually going to make it, to that extent. There’s no guarantee in life, no matter what it is.

The thing about the risk too, people say, “Oh, well I want this conservative thing that never goes down.” Whether it’s CDs and annuities or even cash in the bank, there’s no risk there because the numbers never change.

But people completely ignore the long term risk of rising prices. And that is the most significant risk that virtually everybody faces.

The market might go down tomorrow. I need to be able to buy the same amount or more with money 20 years in the future.

The most significant risk everybody faces is rising prices.

PW: My parents bought their first house for $15,000.

It was located in a decent area in town and everything. The first car was less than a thousand dollars. I mean, the dollar goes down in purchasing power over time.

We hold stocks because doing so protects us against inflation, at least historically. Why? Because what is inflation exactly? It is when prices go up. Who raises prices? Companies do.

What do you own when you own stocks? You own companies. When you’re younger, the last thing that you should be worried about is volatility in stock markets. It’s actually your friend.

Purchasing Power

Because when markets are down, you’re purchasing more shares. When markets are up, you’re purchasing fewer shares and you have a long time before you’re going to use the money.

You just need to make sure that the purchasing power of the dollar lasts, if that’s the currency we’re using 30 years from now.

We’ve heard and seen things on the internet saying the dollar is going to crash and it’s going to go. Maybe it is, I don’t know, but I’m not worried about it because I own equities. I’m not saying that that’s going to happen, let me just say.

But here’s the thing. If I own stocks, I own companies. And companies produce things that people want to buy, and if the dollar isn’t worth anything then they are not going to give you their car for any amount of dollars, if dollars aren’t worth anything anymore.

They’re going to switch to the new currency, the clam, or whatever it is that we’ll end up using. So it’s a funny little thing, but everything is built on the stock market.

If earnings go away, then taxes go away. If taxes go away, then governments go away. If governments go away, the FDIC goes away.

Everything is built on the stock market.

As you get older, don’t forgo stocks, is basically what I’m saying. Make sure that you don’t forgo stocks because if you have a devaluation in the currency, you are wide open to problems.

There are a lot of crazy things that happen in the world. Who knows? I mean, it’s a crazy world.

JW: You were talking about that 8.5% was the lowest 30-year return and looking back at that for a moment, it wasn’t 8.5% every year. That percentage was through world wars, through financial crashes, a depression, and other things like that.

So not every year is going to be a positive year in the market. That’s just not how it works.

But if you look at the big picture, over the last two centuries, people are consistently getting healthier and wealthier on a global basis and more and more people are moving out of abject poverty than there ever has been in history.

That means there are new products, there are new markets, there are new consumers. That means there are new companies.

Companies Adapt to New Conditions

PW: Companies adapt to new conditions. They sell new products. If you look at the product lineup of a company like General Electric, think about the products that they were selling almost a hundred years ago versus the products they sell now. They have adapted through the ups and downs of everything to make sure that they’re still relevant.

Now, there was something that came up, Jim. Somebody asked me something related to this, and it made me think as I was doing the little monologue at the beginning, what do you know about payday loans?

When you own stocks, you don’t own a thing called a stock. You own companies.

JW: I know that you want to stay away from them. And I know that they are typically very, very high interest.

PW: They’re for people who are desperate. I think as I started out, I talked about why this show exists and why we talk about this stuff so often and repeat it again and again. It’s like lather, rinse, and repeat.

Too often people don’t prepare for retirement until it’s too late. Like the example I gave at the beginning, where one-quarter of the money was money you put there and three-quarters of it was the growth.

The reality of it is that so much of what you’ll have in retirement, younger people listen, is not going to be money that you put there. It will be the growth of the money that you put there in the first place.

So getting this investing thing is incredibly important and making sure that you don’t make the mistakes of your forefathers where people would try to figure out which companies are going to be better. They don’t know how to diversify.

Matter of fact, you had something about that, didn’t you, Jim?

JW: Yeah, just an article. I’m in general talking about if you’re going to have something in your portfolio, what are the characteristics that it should have versus what it shouldn’t have?

PW: So the characteristics aren’t that the media just reported on how some other person got rich on this thing so now you ought to add it to your portfolio.

JW: Typically that’s a pretty big red flag that you want to go the other way.

Expected Returns and a Lesson Learned

PW: Or it’s the thing that just recently did well when stocks went down and now you need that. That’s not the criteria.

JW: Yeah. It can even be an asset class that you should own. Everybody is saying, “Well this thing’s been doing great, it’s been on fire. My buddy made lots of money, so let’s sell everything else and load up on that.”

PW: Yeah, “Let’s load up on it,” isn’t too good.

JW: What’s the expected long term return?

PW: Is there a cost of capital? Is there a return expected above inflation?

JW: Versus the cost of its inclusion.

PW: So if I actually replace something with this new asset, what am I giving up?

A perfect example comes to mind for me, Jim, is when I first started this company, the five-year return of international small companies was zero. It was one of those things that you would’ve said, “Well let’s get rid of this.”

When investing, look at what you stand to gain and what you could be giving up.

Now, if I had gotten rid of that, over the next 10 years, that asset class actually quadrupled in value. Well, that’s what I gave up. That was the cost of inclusion.

Let’s say that I loaded up more on large U.S. stocks, which over the next decade had zero returns. It wasn’t that you didn’t own large U.S. stocks in your portfolio at all, but that you didn’t take them out without sensible reason.

JW: Great lesson I learned right out of the gate when I got into this business. It was 1998 and a wholesaler, somebody who represented a mutual fund company, came out and did a great presentation on how great their funds were.

So what happened was I bought this fund and it did well for a while, because it was loaded up on tech stocks, which through late 1998 and 1999 were just on fire.

I thought I was a genius. I thought I had a great fund.

Then March of 2000 came and the fund’s top 10 holdings were things like Sun Microsystems and Cisco and everything like that that had been on a rampage and then just completely fell off the charts.

Diversification, Diversification, Diversification

The other thing I did with that is I had a small Roth IRA leftover from when I was a bartender in a hotel. What I had sold to buy that fund was my small cap value fund.

Again, I thought I was a genius. Because the small cap value for about the next year didn’t do too well or something like that. Then I sold it and I bought that fund that went down, down.

PW: Oh, yes. Small value did so well going forward.

JW: It was a great lesson for me to learn, right out of the gate. If I was supposed to be helping people, this was a low-cost slap in the face for me to actually understand how this stuff works.

Proper diversification, not chasing asset classes is what you want.

Don’t believe the hype.

PW: I’m a big OPM kind of guy. Not opium, but OPM, which stands for “Other people’s mistakes.” Learn from others.

Listen to Jim. Don’t do what he did. Now I was trying to remember the saying that the parents used to say, “Don’t do what I do. Do what I say.”

Don’t do what I did. Do what I say now.

JW: Yeah. Well it’s experience that I can share now.

History Repeats Itself If We Don’t Learn

PW: Well, we have seen this over and over again, most recently with Bitcoin cryptocurrency and all of that. I think back to gold. In the 1980s, there was so much talk about gold, and it ended up being the worst thing going forward.

Then fast forward another generation and people forgot what a bad experience gold was in the 1980s, and they got attracted to it again in 2008.

All of a sudden, commodities did well when the stock market didn’t do well in 2008 and early 2009. Then people started loading up on those because they heard success stories of people who did really well with it.

Next, you heard of people getting rich on real estate and people dove right into that. Then the tax law changed and those investors couldn’t give the stuff away.

I remember learning about oil and gas, when we were told to sell oil and gas limited partnerships. That was a big thing.

Limited partnership, if you don’t know what that is, is where you have a general partner who has a lot of knowledge, and you’ve got a client with a lot of money, and they exchange places.

Learning lessons from these patterns can really help people make better investment decisions in the future.

Certainly during market stresses and especially in different sectors of real estate, it can get really ugly. Not only might you not be able to get your money out quickly, like you’d be able to cash it out and such, but maybe the dividends will have quit flowing altogether by then.

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