Tuesday, March 24, 2015

How To Make Your Family Line Rich

Have you heard the story behind the invention of chess?

The inventor brought the chess board to the emperor of China, and the emperor was so impressed he said he would grant the inventor one wish. The inventor had the simple wish of receiving one grain of rice for the first square on the chess board, two grains for the second square, four grains for the third square, eight grains for the fourth square, and so forth. Sounding like a fair and modest proposal, the emperor agreed. However, it turns out that filling the last 10 squares on the chess board would have required 35 quintillion grains of rice – more than enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.

Who knows whether the story is true, but the point is that with compounding, grains seem small at first, modest in the middle, then suddenly overwhelming. In the investment world, what enables compounding? Time.

Let’s review the rule of 72. The rule of 72 states we can divide the number 72 by the rate of return we achieve, and the resulting number will tell you how many years it will take your money to double. For instance, if we obtain a 9% rate of return, it will take eight years (72 / 9) for our investment to double in value.

So what rate of return can we expect when we invest in the market? From 1920 thru 2014, the S&P 500 (a typical measure of the stock market) has returned an average annualized rate of return of 10.31%.* Coincidentally, 72 divided by 10.31 equals 6.9835. Thus, if we had invested in the S&P 500 in 1920, our money would have doubled every 7 years.

What would happen if on the day your child, grandchild, or great grandchild was born, you invested $1 in the S&P 500 but kept it a secret. Assuming the infant lived to age 84, the dollar would be worth:

$2 at age 7
$4 at age 14
$8 at age 21
$16 at age 28
$32 at age 35
$64 at age 42 (still not a big deal, right?)
$128 at age 49
$256 at age 56
$512 at age 63
$1,024 at age 70
$2,048 at age 77
$4,096 at age 84

Over one life span, $1 grew into $4,096. Impressive! Now let’s add three zeros to all figures mentioned. In this scenario we invest $1,000, and after 84 years of the child’s life, you would have $4,096,000 in the investment account. Of course, I suppose you could invest $10,000 rather than $1,000…

The key, of course, is time. The child will have many urges to withdraw and spend the accumulated amount throughout his life. For this reason, the chances of success for this project likely increase if you can find a way to not tell the child for as long as possible.

How fun would this be? Imagine 84 years down the road, long after you are gone, the young heirs in  your family line – who may have very ordinary finances at the time – suddenly get such a massive infusion of assets that they could then use to maintain the family’s stability for generations to come. All due to an amazing, mysterious great, great grandparent with the incredible financial foresight to take advantage of compounding. Now, imagine you stipulate that the heirs can have access to the funds only if they take a fourth of the resulting investment account and repeat the process!

Think of compound interest as a bunch of tiny personal employees that work extremely hard for you both day and night, and mate like crazy!

Tuesday, March 10, 2015

Is the Stock Market Rigged?

I recently had dinner with a friend who abruptly asked “is the stock market rigged?” As I attempted to fully understand his question and address his concern, he ultimately said “if someone makes money by conducting a trade he wins, and if someone wins, doesn’t someone have to lose?” This viewpoint was preventing my friend from investing in his employer’s 401k plan or an individual retirement account.

While I can see the logic in my friend’s viewpoint, I don’t think it is accurate. Many people are reluctant to invest because they don’t want to be on the losing side of an investment, opposite a more experienced and skilled investor. This hesitancy likely stems from the fact that investing in the market requires the purchase of an intangible asset. However, I believe the same reasons that make purchasing a more tangible asset like a home worthwhile also apply to investing in the market.

When an individual purchases a home, he does so for a reason – he needs a place to live. For most people, the need to put a roof over his head is more of a driving force to buy the home than because he believes the current price is lower than the home’s actual value. The person only sells when his needs are no longer matched by the home – perhaps because the individual has retired and wants to move to a warmer climate or have a yard that doesn’t require much maintenance. When he sells, assuming enough time has passed since the house was purchased, the individual hopes to sell the home for more than he paid for it.

Assuming the individual does sell the house for more than he paid for it, does that make him the winner and the new purchaser of the home a loser? Of course not. The new purchaser is buying the home to fill a need, just as the original purchaser did. Similarly, assuming the new purchaser owns the home for a long enough period, chances are pretty good that he too, one day, will sell the home for a profit.

When we examine the purpose of investing in the market, it is very similar to why we purchase a home. First, we invest in the market because we have a need – to not outlive our assets. Again, for most people, the need to save for retirement is the primary reason we invest, not because we believe the market is particularly undervalued. Similarly, we only sell our investment when it no longer matches our needs – perhaps because we need to convert the asset to a more liquid and tangible asset (cash to buy a car), or because the investment has become more risky than we are willing to tolerate later in life. Just as the home provides a benefit (a place to live) while it is owned and is later sold at a higher price after enough time elapses, our investment in the market provides a benefit (dividends) while it is owned and is later likely sold for a higher price after the passage of time.

Again, just because the selling market investor sold the asset for more than he paid for it doesn’t make the purchasing investor a loser. The purchasing investor will benefit from the same dividends the first investor collected, and if he holds the investment long enough, will also likely sell at a profit when the investment no longer meets his needs. When the market continues to increase in value after the first investor sells, it doesn’t make the seller a loser. He is still a winner in that he made a profit from investing in the market and was later able to exchange the intangible investment for a more tangible asset like a new car, an exotic vacation, or simply the ability to not outlive his money.

There is, however, a factor that can potentially cause a winner/loser scenario with both the purchase of a home and an investment in the market – time. After buying a home, we are much less certain that the home’s value will have increased after only a month as compared to ten years. The impact of time is the same when investing in the stock market. We can be far from certain that the market will increase in value after only a day, month, or even a year. However, you’d be hard pressed to find a ten-year period when a diversified investment portfolio didn’t increase in value to some degree. Consequently, while both buying a home or investing in the stock market to make a quick profit is far from certain, history tells us that doing either to fill a need and with a long-term investment horizon is likely to yield a win-win situation.

Tuesday, February 24, 2015

The Best Investment of the Last 50 Years

One of my favorite writers, Morgan Housel, recently pointed out the most profitable stock since 1968 in his article titled “The Extraordinary Story of America’s Most Successful Industry." Any guesses what it might be?

The company with the best performing stock must have revolutionized the world in some way. The product must have been innovative, like computers or a cure for a dreaded disease.  Perhaps it was a small shop that became an international rage. Maybe it was a company that has been on the cutting edge for the last five decades.

As sound as those assumptions are, they are all incorrect. The best performing stock since 1968 is Altria, the cigarette company. While $1 invested in the S&P 500 in 1968 would now be worth $87, $1 invested in Altria at the same time would now be worth $6,638. That is an annual return of 20.6% for a 47 year period. Not bad!

I mention Altria not to discuss the impact of buying an addictive substance or the role of ethics in investing, but as a perfect example of the benefits of diversification. 

When thinking about the process of investing, it is human nature to think of the factors mentioned in our guesses – the sexy ingredients to success like technology or the garage shop going global. These are typical descriptions of growth-style companies. Growth companies usually utilize their profits to improve their systems, reach, or products. Further developing their infrastructure and merchandise allows them to grow faster and generate more revenue, and ultimately, more profits. This benefits investors in that the price of the company’s stock increases as its ability to generate additional profits increases.

Value-style companies are different. Value companies sell products and services that no longer require significant ongoing innovation. Consequently, rather than using profits to continue to expand, value companies payout the majority of their profits in the form of dividends to shareholders. While growth companies are new and exciting, value companies are frequently old and quite boring. As you might imagine, cigarettes are essentially the same today as they were 50 years ago.  However, since the tobacco industry hasn’t required a large expense to continually upgrade their product, an unusually high proportion of revenues have been paid out to owners of the stock. 

Clearly, an exciting new product that everyone must have and quickly generates tremendous profits makes a good growth company.  A good value company, on the other hand, is a company that earns mediocre profits for an extended period of time. Remember, to be effective compound interest requires long holding periods. Thus, Altria is a perfect example of a value-style company.

So is investing in value stocks a more profitable strategy than investing in growth companies? As always when investing, the answer is “it depends.” As Fidelity points out, value stocks did in fact outperform growth stock for the 30 year period ending in 2010, with large cap value earning an average annual return of 11.66% while large cap growth earned 9.91% annually over the same time period. Further, large cap value stocks endured less volatility over this period, with a standard deviation of 15.78 as opposed to the standard deviation of 21.89 for large cap growth stocks.

However, since 1990, large cap growth has made more than 34% during a calendar year six times, while large cap value has accomplished that feat only once, and we don’t want to miss out on all those exciting growth companies that are on the cusp of changing the world, right? Fortunately, the point of diversification is to hold uncorrelated assets in our portfolio so that when one asset category goes through rough times, other asset categories might maintain or even increase in value. Investing in assets that respond differently to various market events ultimately reduces volatility in our portfolio as a whole, and thus, reduces risk. For this reason, growth stocks are a wonderful compliment to value stocks.

The Dow Jones US Large Company Growth Index has performed surprisingly different from the Dow Jones US Large Company Value Index in various market environments since 1990:

Large Growth
Large Value

Large Growth
Large Value

While investing in companies on the verge of changing the world is exciting and worthwhile, don’t forget about the dull value companies with a tried-and-true business model and established market for their products or services. Due to lower expenses and higher dividend payout ratios, these value companies can be just as lucrative as those sexy growth investments. Fortunately, the benefits of diversification make holding both of these positions together more value than owning either by itself.