One of the more damaging pieces of advice to the average investor is Warren Buffet’s famous investment rule:
“Rule No. 1: Never lose Money. Rule No. 2: Never forget Rule No. 1”
While this folksy wisdom has a great ring to it, it can be easily taken out of context. I think what Buffet is trying to say is not to gamble with your money and be prudent in your decision making. Many investors read this rule and believe that they should literally attempt to not lose money when they invest. Over the past 20 years, Buffet’s own company, Berkshire Hathaway, has had 6 losing years, with one of them erasing approximately 1/3 of his shareholder’s value. That means over the last 30 years, he has broken his own rule 30% of the time!
Investing involves risks. Those risks aren’t just theoretical. Historically, the stock market goes down around 1 out of every 3 years. For those who are trying to follow Buffet’s rule, how are they going to deal with this simple fact? Unfortunately, we tend to see it manifest itself in market timing, the act of trying to get in and out of the market at the right times. No one we know of has been able to do this consistently enough where you could attribute their performance to skill versus just plain luck. Buffet himself eschews the practice of market timing. He once wrote that his, “favorite holding period is forever”.
Those investors who want to follow Buffet’s rule have three strategies they can lean on to help them implement this idea of not losing money:
- Time period- over one year periods, the stock market has negative returns about 30% of the time. Conversely, there has never been a 20 year period in the S&P 500 where returns have been negative. The longer time you have, the lower the probability of losing money.
- Diversification- when you buy one or two companies, the risk of loss is high. In fact, we wrote about this in a prior post. Since 1983, 39% of all publicly traded stocks have lost money. You must spread out your bets to ensure you don’t pick one or two losers that can cause permanent losses.
- Discipline- there will be bad times. Probably the easiest way to violate Buffet’s rule is to sell your investments AFTER a loss. Having the discipline to stick with your investment strategy after a difficult period is a key factor in avoiding permanent losses.
I think amending Buffet’s rule would be immensely helpful. Here is how I would word it:
“Rule No. 1: Don’t lose money, permanently. Rule No. 2: Never forget Rule No. 2”
By implementing the three strategies we’ve listed above you have a much better chance of following that rule.
Do you own any individual stocks? If so, it would be beneficial to keep reading. JP Morgan is out with a very interesting piece about the difficulty of investing in individual stocks. The results are pretty astonishing and should make you think twice about committing any serious capital to this endeavor. Here are some of the results from their recent report spanning from 1980 until 2014:
Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value
The return on the median stock since its inception vs. an investment in the Russell 3000 Index was -54%.
Two-thirds of all stocks underperformed vs. the Russell 3000 Index
What does this tell us? It is really hard to pick stocks. These results show that even just picking a stock that is in the middle of the pack will most likely not get you the average returns you would experience by owning the who market. This is because a small group of stocks seem to drive the bulk of the returns of the market and a greater percentage (roughly 40%) have suffered permanent capital loss. Yes, you may get lucky and pick one of those winners, but the odds are definitely against you. It is a much better odds to diversify and own the entire market, while focusing on things that actually will generate positive results (minimizing costs, optimizing your allocation, reducing taxes, staying disciplined,etc.). It may not be as fun (or as wild of a ride) but the results will speak for themselves.
Our brains play terrible tricks on us when investing. We believe that the biggest impediment to a successful experience is not fees or poor performing funds, but our own behavior. The chart below talks about the most common behavioral biases we have:
- You do what everyone else is doing because of herd behavior- how many times have you made an investment decision because that is what everyone else is doing. If you say no, please confirm you never bought a tech stock in 1999, real estate in 2005 or sold out of your stocks in 2008.
- You confuse “cheap” with “value“- just because a stock has lost 90% of it’s value doesn’t necessarily make it a good “value”. A lot of times it is on its way to going out of business.
- You throw good money after bad- how many of you use cost basis for holding or selling a stock (outside of tax reasons)? The price you paid for an investment should have NO bearing on whether you buy, hold or sell.
- You practice loss aversion and that leads to bad choices- the psychological impact of losing a dollar is 2.5 to 7 times greater than winning a dollar.
- You think the future is more unpredictable than it is- many believe that what happens over the short-term is going to predict longer term results. For example, after the last decade of two booms and busts, many thing this will be the norm. History tells us this is uncommon and not probable.
Our brains are our own worst enemy. When investing it is important to try to understand when your mind could be playing tricks on you. Use an advisor or speak with a trusted friend before you make any decisions about your portfolio. Writing down an investment strategy and following it can also help you avoid this bad behavior.
With 98.5% of the companies in the S&P 500 reporting their earnings for the second quarter, we thought it would be a good idea to revisit the state of American business and what the outlook is for the future.
The lifeblood of any business sales. Sales were up 2.4% from last quarter and 3.4% from last year. We are seeing sales accelerate this quarter which is a far cry from what many commentators have been discussing. Many are saying that companies are only earning more money because they are cutting costs. While costs are being managed diligently, sales are growing and are up 17% over the past 3 years.
Earnings are one of the major drivers of stock market performance over time. These earnings were up 2.3% from last quarter and 3.7% from last year. As you can see, these match pretty closely with the sales growth numbers, meaning that companies are not only adding sales, but are also adding expenses. This is also evidenced that profit margins (or the amount of earnings you generate for each dollar of sales) remained basically unchanged at 9.5%. With margins at such elevated levels (compared to history) it is hard to believe companies will be able to continue to grow their earnings from additional cost cutting. Most earnings growth will need to come from continued expansion of the company’s sales.
Dividends are probably showing the most promise, with cash dividends up 8.3% over last quarter and 15.6% over last year. With companies seeing only minor benefits from investing in their business, and historically low payout ratios (amount of dividends paid divided by profits) this is a promising sign. The dividend rate is now at 2.15%, which is still a very attractive yield when compared to fixed income investments.
Are stocks cheap or expensive? The company’s price compared to its earnings are usually a good indicator to look at. At the end of Q2, we saw the price-to-earnings ratio around 16, which is close to its long-term average over the past 25 years. Compared to a year earlier, the P/E ratio has expanded from 13.8, meaning that stocks are still around their long-term average, but are more expensive than they were a year ago. This should be of no surprise to those of you who follow the markets. The S&P gained over 18% over the prior year while earnings grew at a much slower pace, pushing up valuations.
Analysts expect earnings to grow 2.7% next quarter and 14% in the next year. These estimates have been coming down lately so it is hard to tell exactly where these will end up, but anything close to these estimates should be welcomed news for the markets. One of the big question marks is not just earnings, but how the market will value those earnings. If the market is willing to pay the current multiple or more for earnings, this next year could see continued gains. If the market pays a lower multiple for those earnings, we could even see losses. This is why predicting the future is so hard. You not only have to know what a company will earn, but you also have to know how the market will view those earnings.
For the time being, Greenspring continues to encourage investors to maintain balance in their portfolio, with a healthy weighting still allocated to US stocks.
Source: Standard and Poors
There is a phrase I hear often in our business that makes me cringe…”this is a stock pickers market”. This phrase seems to emphasize that at this period in time there is some value in trying to select winners and losers in the stock market. It is almost always uttered by stock pickers and it is funny that it uttered no matter what type of market it is. If the market is going down stock pickers will argue that a good stock picker can avoid the big losers and focus on defensive stocks. As the market climbs, they will be able to move money into cyclical stocks and avoid the boring ones that would weigh down returns. If you’ve read our blog in the past you know that we are skeptical about these claims since there is no data to support it.
Investment News wrote an article citing Vanguard research on the topic:
Every year since 2008, more than half the stocks in the S&P 500 have finished the year with a return of 10 percentage points or more or less than the index, according to research by The Vanguard Group Inc.
That means there are at least 250 stocks in any given year that a portfolio manager could choose to overweight or underweight to boost returns versus the index.
This year has been no different. Through Aug. 19, 262 companies have returns that are more than 10 percentage points more or less than the S&P 500’s 15.4% gain, according to Lipper Inc.
This is pretty fascinating. According to the research, stock pickers have about a 50% chance to be spectacularly right, or spectacularly wrong with every stock they select. Unfortunately, all of the skill at analyzing stocks, fundamentals or technical patters doesn’t seem to give these managers an edge:
Even with the majority of stocks offering managers a way to outperform one way or another, 56% of the 287 large-cap-core mutual funds tracked by Lipper are trailing so far this year, which shouldn’t come as much of a surprise.
Could it be that outperformance is attributed more to luck than skill? That managers really have very little ability to consistently outperform the market and/or their peers? We believe that is the case, not because of some intuition or gut feeling, but because the data tells us so.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.