Transcription: Segment 5
Paul Winkler: This is the Investor Coaching Show and I am Paul Winkler, your host. We talk about the world of money and investing right here on the Investor Coaching Show. Anne Sawasky here with me as well. Having been working for a major investment provider on the legal end and it kind of a year, you’re kind of different from the rest of us, where you came from that side of things and then became a financial planner. You bypassed really messing people over selling these products that we, we just go, Oh, I can’t believe people sold this kind of garbage.
Individual stocks
So you did see it, but you weren’t a perpetrator. There was a question that came in. I want to hit this question that somebody sent me and you can surely jump in on this as well. But somebody had sent me this message. “I was thinking of buying a stock, Paul, that is about to split. The verbiage in the investment company that was trying to get them to buy this stock. The verbiage in whatever paperwork that was sent their way had them questioning a couple of things. What are my thoughts regarding that? So a couple things that I would right off the bat, no individual stocks.
I always tell people to stay away from individual stocks because there’s just a tremendous risk. I mean, there was one piece of research that—it’s been a while since I talked about this one—but I think it was something like, “Oh, 50 years ago that the average company stayed in the S&P 500 for over 60 years. So if we look at the 500 biggest companies, it used to be, the company stayed around a lot longer than they do these days.
Now we are down to companies sticking around and staying in the S&P 500 and being part of that index of the 500 biggest companies for only about 17 years. That’s the last data I saw. So companies come and go much more rapidly. And it’s because we’re in this very competitive atmosphere all around the world. And you look at a company’s competitive advantage, it only lasts so long. You know, maybe you produce a product or a service, but the problem is, that your product is service.
Think of interest rates
We can find out all about it by just going on the internet and doing a lot of research and then finding ways to compete with you. You know, so companies come and go much more rapidly these days. So number one, stay away from individual stocks. The other thing you gotta think about is this, and I don’t know if you’ve done this with people, but recently I’ve had this conversation with people and it doesn’t seem to resonate the way I think it should. And that’s where I say to people, when you buy a company’s stock, you’re letting that company use your money and they want to pay you as little as they possibly can.
And you want to get paid as much as you possibly can. Have you had that same experience with people where you’ve used that and they don’t quite get it?
Anne Sawasky: You know what, when I have that conversation, I try to give the analogy and it’s not a perfect analogy, but I kind of give them the analogy of: what if you were the bank and you go get a house loan and you go to the bank and the bank asks you about your creditworthiness, and can you pay the loan back? And is the bank going to, are you, when you go to get your loan, are you going to try to get the lowest interest rate?
You know, or are you going to go to the one that’s offering the highest interest rate when you get your loan? Oh, I’m going to get the lowest one. Well, that’s how companies are, you know, and then I say to ’em and we’ll ask the bank to pay you a higher amount of interest. If you’re a risky borrower, i.e. a smaller company, maybe a value company, you know, will you get a lower interest rate? Cause you’re really stable. You have tons of money. You make a lot of money and you’re a good risk.
Oh, well, I get a better interest rate if I’m a good brick, right. That’s how the stock market is. So, I kind of try to walk them through it that way. And that’s a little more understandable to people.
Paul Winkler: Yeah. And you know, what happens is they are giving the rights up to those profits going forward. And if they can get you to pay $20 for the right to earn $1 of profits, they would much rather get that out of you than they would get $10 out of you. Right. And if you think about it, turn it over. If I get $1 of earnings for each $10, that’s a 10% return, one divided by 10, 10 versus one divided by 20, which is 5%. So they’re going to try to get as much out of you as possible, move you as close as they can to that $20 number in my example, versus the $10.
So yeah, that’s a great way of looking at it. And I don’t think people necessarily think of it this way, but this is what’s going on. When you’re buying individual stocks, you are, without thinking about it, thinking that you are getting a deal, that you are getting a really good price on a stock and you know, more than the rest of the market, what the future earnings are actually going to be better than what is being talked about right now.
And you are actually getting a diamond in the rough and your rate of return is going to be higher. And that is why people typically look around and they say, well, I really like this company. This company’s really good. And they’re really doing well. And what they don’t recognize is that the companies that are doing really well are attracting everybody’s attention, not just yours.
Do your research
Anne Sawasky: Well, and that’s what I was going to say is so often people, when you ask them, you know, like, I don’t know about you, but when I’ve had clients come in my office and I look at their 401(k)s or whatever, and I say, “Well, why did you decide to buy this?” And they go, “Oh, well, there’s some other guy in my office. And he’d said it was good. So I just get it.” Or “My friend made a lot of money on it,” so, I mean, they don’t even really necessarily have any basis that they’re deciding on other than, Oh yeah, well, I heard this is good.
Or My friend did this and made money or something like that. The bottom line is if somebody is already in there making money, you’re going on, what’s already high instead of buying low.
Stock split
Paul Winkler: The horse is out of the barn right now in this particular person’s question, she was asking about a split. Now this is a common misconception that people have the idea that stock splits mean that returns will be higher. So let me explain what a stock split is. And the way I like to do it is just say, imagine you got a piece of pie, you got a pie. Yeah. You got this pie. And it’s sitting in a pie tin and nobody has put a knife to it yet. It’s just pie sitting there whole, one huge piece.
Now, if you have a split of that pie, let’s say that you cut it in half. Now you have got two pieces. Is the pie any bigger? No, it’s still the same size. It’s just in two pieces. And the pieces are half as big as what the original was. Okay. If you manage to cut it completely in half perfectly right in the middle. Now the assumption is that the returns will be higher because the price is lower. Now, why would a company do that?
Well, let’s say that you’ve got a stock price and it’s gotten up to $200 and now the average person can’t buy it anymore because the price is too high. Now that’s actually starting to change because companies are able to do fractional shares. Now that’s the new thing out there, but you get higher costs when you do that. You know, because buying fractional shares, you’ve introduced a new expense into the whole thing. And typically what you want to do is buy in round lots, which are a hundred share units that keeps the expenses even lower.
But if you’ve got $200, it has historically been, Hey, you know what? You know, people can’t afford it as much. Let’s split it in half. Now we’ll have two shares that are a hundred, but the size of the pie hasn’t gotten any bigger, but it has always been believed that it was that the returns would be higher. And here’s where people got the misconception. There was actually a paper going back all the way to 1969 that discredited this and disproved that this is the case that stock splits are actually good.
Wall Street myths
So why does it have holding power all the way to 2020? It’s anybody’s guess. But here’s what happens many times when a stock split is announced, the company’s price, stock price, will go up in anticipation of it. And the reason it has been conjectured is because when a company is announcing a stock split, they are in essence saying we not only think that earnings have been good and the stock price, we would like to be able to make it cheaper so people can afford it.
But we think the earnings will continue into the future. Well, who knows better what the likely earnings might be, then the leadership of the company, and it has been conjectured that the reason that stock prices go up in anticipation of a split is not because of the split, but because of the announcement and the now, and that’s not a really, it’s not a physical announcement, but the tacit announcement that earnings are going to continue to go up and they’re going to continue to be good.
You know? So that is why that actually happened. Now in reality Wall Street will continue these types of myths. Why? Because think of them as a casino, they will do whatever they can to get you to start trading and trade more often and more frequently, because just like a casino, that’s where they make their money. They make money on getting products, moving a casino makes money by you pulling that slot machine, going over to the tables and doing the gambling, but realize the only people that really, really benefit greatly, regardless of what the market does, is the key, the market maker, or the investment firm, as investors, markets go up.
It’s, it’s unlike a casino. You know, where the casino, the odds are stacked against you with the stock market. The odds are stacked in your favor, but less in your favor. If you start doing more trading, the more trading you do, the more the odds get stacked in the favor of the Wall Street firms. Understand that. Now the research that I’ve read says absolutely no excess returns from splits. And there’s a tremendous amount of research out there about this.
If an announcement comes up, the stock may rise immediately and realize that it may go up. And the reason it went up has nothing to do with anything other than, than that. Management may believe that recent good history will continue for the company. So it’s very important to stay away from an individual stock. Go ahead.
Anne Sawasky: Yeah. Well, and the other thing I’d add is a lot of times, the reason they do a stock split is because the prices have gotten so high that they feel like more people would be able to afford to buy a share if they reduce the price. So it’s not, it’s really got nothing to do even with future earnings, as much as they just want to keep it more affordable for people. Yeah.
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Fractional ownership is a trend
Paul Winkler: I wrote our ownership. Absolutely. And it’s, it’s interesting. I don’t know if you caught it, I was talking about how the new trend out there is fractional ownership of shares is a big deal now. And so it’s kind of funny how Wall Street has even figured out different ways, even without splits to get broader ownership, but they figured out ways to make more money on it. It’s because they make more money if they can have the fractionalized shares. And that is a big deal right now is doing that so that smaller investors can get involved.
But realize, as an investor, you don’t want to be getting involved in individual shares, individual stocks. I want as broad diversification as I possibly can get, simply because you don’t know what might happen out there. I mean, you’re literally looking at a situation like, and back to the beginning that that statistic I gave at the very, very beginning is so, so important, that companies do not even remain around as long as they used to. They come and they go much more rapidly. And you want to make sure that you own those up and coming companies as well.
You want real diversification
When those other ones go away, you know, the very stock that you may buy a handful of them. You can own 200 stocks. I remember a workshop I taught years ago where I said, “Hey, if you own these 200 companies that are diversified” and the people that were in the workshop with me said, “Yeah, I think I’m diversified.” And the point that I made was they’re all tech stocks and they dropped 80% in value over the next couple of years. You know, you don’t realize that the level of diversification you have to have to protect yourself is in the tens of thousands of companies and, and the number of companies that you need to own in order to get broad diversification is why.
Anne Sawasky: Different asset classes too, not just number of shots, different asset classes.
Paul Winkler: Yeah. Yeah, absolutely. You don’t want to just own companies in technology, healthcare. You want to own companies there. You want to own them in retail. You want to own them in consumer durables and consumer cyclicals and all of that. Yep. Absolutely.
All right. That’s it for the Investor Coaching Show today. Hope you enjoyed it. I am Paul Winkler.
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