Paul Winkler: Welcome. This is “The Investor Coaching Show.” I am Paul Winkler, along with Jim Wood talking about the world of money, investing, and financial planning.
I was thinking, you know how there are warnings about the stock market?
Stock Market Warnings and Investing Disclosures
The stock market is scary. You could lose everything. Past performance is no guarantee of future results, and all the disclosures are true and everything. But I was reading a box this morning, it was an exercise thing. It’s these dice, and the dice are big. They’re probably four inches high and four inches across.
They have phrases on them. Do so many jumping jacks. If it lands up here, you do so many burpees or whatever. It’s a fun way to motivate you to exercise. I got the biggest kick out of reading the disclosures on the dice.
Jim Wood: I’m just rolling my eyes.
PW: But you know what the disclosure is, and it’s something you always see when it comes to exercise. You’ve got to make sure you talk to your doctor and your medical staff before you engage in exercise because it can be dangerous and blah, blah, blah.
I wondered how many people decide not to exercise because it could be dangerous. We can look at how exercise affects mental health, how it affects physical health, how it affects longevity, how it affects brain health as far as cognitive abilities, and all of the good things that it does.
But then all you hear is “This could be very dangerous. You need to go talk to… and the parallel between that and the stock market is undeniable.
The market could go down, but you don’t see the same disclosures on a treasury bill account or a CD. Hey, the value of the dollar could drop to nothing and you could basically get your money back, but it doesn’t have any purchasing power whatsoever.
Why is it that we feel the need to warn people about some things but not give them, “Hey, historically, we have had inflation, inflation’s a real thing.”
Owning companies also means owning their assets.
When you own companies, you own the companies that are raising prices, but you also own their assets, and those assets will go up and down in value. The dollar is just kind of a measure of value, but the reality of it is it’s not backed by anything.
Owning Companies Means Owning Assets
But if you think about it, when I own assets, I own companies. It’s a real thing. I’ve got a hard asset, I’ve got a building, I’ve got machinery, I’ve got equipment, I’ve got land, I’ve got things that have actual value that somebody will trade me something of value for, so to speak, right?
Now, what will they trade me of value? Now, normally it’s dollars because that’s the most convenient thing that we’ve got, but the reality of it is if the dollar doesn’t hold its value, I’m not going to take dollars for my asset anymore.
I think of risk in terms of when I’m investing, I want to make sure that I cover other types of risks. And I think we ought to be warned about not taking enough risk, not taking enough stock market risk just as we ought to be warned of the dangers of not exercising. Right?
JW: Yeah, I think that’s a good analogy. All those disclosures that come out just every time there’s an advertisement for anything financial or something, they spend 20 minutes after the advertisement giving you all the disclosures and stuff like that.
There’s disclosures that we have to make all the time, every time we talk about investing, but it really does get people just to focus on market risk. People avoid that and they lose capturing the long term premium that is very, very likely going to exist over given enough time.
PW: The concept of diversifying is old, but we are talked away from diversifying when we see those types of things because all we see is the negative.
If we see only the risk that you could die doing those jumping jacks and your heart could fail, and certainly there is that risk, but recognize that so often the disclosure rules in the world of investing aren’t necessarily fair or a really helpful thing.
Keep in mind that disclosures are often a way to avoid getting involved in a lawsuit.
So it’s CYA on steroids so often in that. Jim, there was something you had popped in front of me just before we started, I thought was interesting. “Fortune Doesn’t Always Favor the Bold: The Perils of Concentrated Stock Returns,” and it has a bunch of bell curves, left aciduric bell curves and platykurtic bell curves and skewed.
Risk
I perused the article, so let’s talk a little bit about some of this. I think there were some really phenomenal statistics here that would be helpful for investors.
JW: Absolutely. Yeah. The article is on a guy named Larry Swedrow who’s very much kind of along the lines of our investment philosophy.
There is good risk and bad risk.
It talks about the perils of concentrated stock positions. We have people across our company walking in every week that have single stocks, and it’s part of what we do in terms of educating people on why that’s not a great idea.
The conversation really starts with the idea of risk. Because there is good risk, risk that you’re likely to get compensated for. And that’s what we’re talking about long term market returns.
PW: Right. Earlier in the week, something that came up was a conversation with a friend that I had a while back about an individual stock that he thought was just going to take off. It happened to be a company that develops food products that are very, very much in vogue with the younger crowd, vegan type of food products.
And it was like, “This is going to be huge.” And it’s interesting because this stock did indeed go up. Beyond Meat, by the way, I might as well just say what it was. Beyond Meat was the company.
An article recently talked about how challenged the company was when it came to stock market performance. But you would’ve never dreamt that back when this friend of mine said that, because everything about the company and their prospects was absolutely glowing. Yeah, it is. It’s a huge risk.
JW: Good risk being to take market risk, capture market premiums, and then there’s bad risk, which you’re not likely to be compensated for.
And that is certainly prevalent when you just hold one stock because you have the expected return of all the other similar type stocks out there in the market. That’s what you’re likely to make long term, but you have all the risk of one stock.
That’s really what this article just gives statistic after statistic in terms of how individual stocks have underperformed market returns as a group. There’s always the chance of winning the lottery.
What Kind of Risk Are You Taking?
And that’s where really some of these stocks were, or lottery stocks, whether you bought Google right out of the gate or Apple or something like that and you got enormous returns above and beyond the market.
But very, very few stocks actually get those types of returns. And in fact, most stocks and the great majority of them, we’ll talk about some of these statistics actually underperform market returns.
There is such a thing as risk without return.
The example that I was always given was you’re running around a golf course in the middle of a lightning storm waving the club in the air.
PW: Are you taking a risk? Yeah, I’m raising a nine iron in a lightning storm. Are you likely to benefit from that? No, probably not.
JW: Some of this data was on if stocks outperform treasury bills. In a 2018 issue of Journal of Financial Economics, it stated that only 47% of returns of single stocks, so less than half, were greater than the one month treasury rate.
PW: And that’s not just in the short run, it’s over a longer period of time as well that they did that research.
JW: Even at the decade horizon, so 10-year periods, a minority of stocks outperformed treasury bills.
PW: And I’ve seen that data before, but I’d forgotten about it and I saw it reiterated here and I’m thinking, “Yeah, I’d forgotten that. But that is, that’s fascinating.”
You think about that. You think “I should definitely, definitely have higher returns than fixed income investments because I’m taking the risk of individual stocks, but there’s that uncompensated risk. I’m not paid to take that type of risk.”
Imagine a Sine Wave
And we often think, I remember one of the academics, I think it may have been Fama or French, I can’t remember who, but he drew a sine wave. A sine wave, it goes up and goes down, it’s back and forth.
This wave is up and down and up and down and up and down. And if you look at that thing and then you say, “Let’s take another wave and put it on top of it” and the second wave has a greater amplitude, it goes up higher and it goes down lower than the first wave.
Just kind of imagine that and it’s a little hard to picture, but the first one has a hill on it, the second one has the same hill starting at the same place, but goes to a higher level and then it goes down to a lower level when you go into the valley. Think of it that way.
He went and he went and shaded out the area on the first line, up to the second line, so where the second line was higher and then he shaded on the area on the first line where it was when it went down.
Then the area on the second line, which went lower because remember it went further down and further up. And he said, “That’s all uncompensated risk.”
Understand the concept of uncompensated risk.
He said, “This is critical because if you are taking money out toward retirement, when you have a market that goes down further than another type of an investment or investment one, let’s say, that has the lower amplitude and it goes down less than the second one that goes down further when you’re pulling money out that second one, you’re having to sell more stuff to get the same level of income.”
This is particularly true if you’re going into retirement and all of a sudden the market starts to go down and then you’re pulling money out and selling at lower and lower prices and lower and lower and lower prices and then all of a sudden you run out of money and then the market upturn happens.
It’s too late. You’ve run yourself out of money. And this is critical to understand this concept of uncompensated risk.
Herding Bias
JW: Along those same lines, it also takes better returns if you get the greater volatility. You get the downside swing of 50%, so you got a hundred dollars, now it’s $50, well then you need a 100% return to get back to where you were.
PW: Yeah, yeah. It’s daunting. The whole idea of this uncompensated risk. You do not want to take it. People are taking risk not only with individual stocks and it’s on uncompensated risk.
They’re taking risks because they’re not as well diversified. Like target date funds, I often talk about, are concentrated and people think “I’m taking less risks, these are vetted by my employer and everybody’s doing the same thing, so they must be right.”
With herding bias, people think that since everyone is doing the same thing, there must be less risk, but that’s far from true.
What you find is that they’re not as diversified. Those downturns can be not only down, but they can be long and nasty. We have decades, double decades, 1966 to 1982 is the one that I always bring up and 2000 to 2012 and 1929 to the mid 1950s, where you have returns that were lower than the inflation rate or non-existent, no return after inflation with equities.
That is a huge problem when it comes down to trying to plan for retirement and you’re not diversified enough, you’re only in the area that everybody else is in and all of a sudden you’re lost.
JW: Well, people hear that phrase probably a lot, “The dead decade” from 2000 to 2010 where you had a negative return in large U.S. stocks. But if you were properly diversified over that time, well maybe you still had a little bit below historical average returns, but you had positive, well above inflation returns at that same time. Diversification works.
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