Beneath the Surface

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Accept reasonable, but not unreasonable risk

All investment entails risk because we can’t know the future with certainty. We try to anticipate the future, based on our experience of the past, but any expectation could be invalidated by unforeseen events. Any dollar you invest could conceivably disappear, but that’s a risk that any investor must accept. What we can do is distinguish more reasonable risks from less reasonable ones.

Being alert to risk

The first step is to be aware of what kinds of risks exist. Some risks are very obvious, such as the risk that a stock will go down, or that a company might default on its bond obligations. Other risks are more subtle. You can invest in something that’s extremely safe, such as US treasury bills, but earn such a low return that you can’t keep up with inflation, so the real value of your account is actually declining.

One type of risk that can be especially confusing is the risk of fluctuating bond prices due to changes in interest rates. Suppose you buy a 20-year bond paying 7% interest. You have the security of collecting that 7% interest every year. But suppose interest rates rise and new bond issues of the same type are now paying 9%. If for some reason you would want to sell your bond before it matures, you would have to sell it at a discount to its face value. Otherwise, who wants to buy your 7% bond, when they could buy one paying 9%? The farther your bond is from maturity, the more you will have to discount it to make it attractive. Longer-term bonds are inherently riskier than shorter-term bonds because they lock in an interest rate for a longer time. They fluctuate more in market value when interest rates change.

The volatility of an investment–how much it varies in value under different market conditions–indicates its risk. In general, stocks are even riskier than bonds, because they fluctuate even more in market value. Stock indexes such as the Dow Jones Industrials or the S&P 500 can easily lose a third of their value in a bear market. (They lost 33.8% and 38.5% respectively in 2008, their worst showing since the 1930s.) Individual stocks can lose even more when individual companies have a bad year.

Risks and rewards

Some investors find the risks of investing intimidating. They are what we call “risk averse.” They are so afraid of losing money that they confine themselves to only the safest of investments. As a result they miss out on many of the rewards of investing. Successful investing requires us to take calculated risks, risks that are justified by a reasonable expectation of reward. The extra reward that you should get from accepting more risk is what we call a risk premium.

The reason why people are willing to accept the risks of stock investing is that stocks have outperformed bonds on the average over the very long run. The reason why people are willing to accept the risks of intermediate or longer-term bonds is that they usually offer higher interest rates than short-term bonds. Companies with lower credit ratings also have to offer higher interest rates as a risk premium on their bonds. So bonds are rated according to credit-worthiness. In the Standard and Poor’s ratings, for example, the most secure bonds are AAA, followed by AA, A and BBB. Those are the ratings considered “investment grade.” Bonds with ratings below BBB are often called “high-yield” bonds because of their higher interest rates, and they are also known as “junk bonds” because they are issued by financially shakier companies. Some investments are so risky that even the possibility of high rewards shouldn’t convince you to bet very much of your money on them.

Different kinds of investments fall along a continuum, with low-risk/low-reward investments at one end and high-risk/high-reward investments at the other end. At the low end are the least volatile of investments, such as insured bank deposits, treasury bills and money market funds. They are very safe, but earn very low returns. At the high end are very speculative investments such as precious metals, collectibles, commodity futures and stock options. They can earn spectacular returns, but they are so volatile that ordinary investors should approach them with great caution. In the middle are the investments from which most investors make most of their money: stocks, bonds and real estate. Bonds lie more toward the conservative end of the continuum, with shorter-term bonds more conservative than longer-term bonds. Stocks and real estate tend to be higher than bonds on both risk and reward. Small-company stocks are riskier than large-company stocks, but on the average have generated higher returns. That is especially true for small-company stocks that are priced low relative to the book value of the company’s assets (so-called “value stocks”), probably because the low price implies uncertainty about future earnings, but also provides potential for price appreciation.

Distinguishing reasonable and unreasonable risks

Much of investing consists of taking reasonable risks and being rewarded for doing so. On the other hand, you should avoid unreasonable risks, risks that are not justified by a risk premium. You can think of unreasonable risk as basically gambling. On the average, you get no reward from playing the slot machines, since the total amount paid out in winnings is less than the total amount gamblers put into the slots, after the casino takes its cut. You could come out ahead if you are unusually lucky, but a rational calculation indicates that in the long run you will come out behind. Playing the slots is what’s called a loser’s game.

Betting on horse races is also a loser’s game for most bettors, although strictly speaking it doesn’t have to be. In theory, a bettor with extraordinary knowledge of horses might be able to beat the odds. But most bettors have to rely on what is commonly known about the horses, especially their track records. Everybody knows who the favorites are, and they’re bet so heavily that it’s hard to make much money on them. If you bet the “dark horses,” you’ll win big when you win, but you won’t win very often. The average bettor has to lose money, because the track pays out less in winnings than it takes in in bets. So for most bettors in the long run, it’s a loser’s game. Some people get a kick out of playing loser’s games. They are willing to accept the risk of losing in order to have the possibility (as opposed to the rationally calculated likelihood) of winning. But they are gamblers, not investors.

Stock investors vs. stock gamblers

What kind of game is stock investing? Investing in the stock market in general is not a loser’s game, because the companies whose stock is publicly traded usually make money (at least in the aggregate, with the gains of some more than offsetting the losses of others). Their shareholders get the benefits either in the form of dividends or share appreciation, or both. Nevertheless, many market observers have come to the conclusion that betting one’s money on particular stocks is a loser’s game for most investors, especially if the number of stocks selected is very small. To understand the reasoning behind that conclusion, we have to make a distinction between the risk premium that investors usually get from investing in stock in general, and the risk premium they may or may not get from investing in a particular stock.

Consider two groups of investors. Group A consists of all the investors who own shares in the Vanguard Total Stock Market Index Fund, a mutual fund that owns stock in virtually every publicly traded company. Group B consists of all the investors who own shares in any one publicly traded company, but only one company. Let’s assume that stocks have a reasonably good year, and the index fund generates a 10% return. Every investor in Group A took on the same risk (that the market as a whole might go down) and got the same reward for doing so. But every investor in Group B took on the additional risk that their particular company would underperform the market as a whole. They could easily lose money by betting on the wrong company. Were they rewarded for their additional risk? On the average they couldn’t be, since their average return remains around 10%. (Group B does have the advantage of not having to pay the mutual fund’s annual expenses, but we will ignore that since the expense ratio of this index fund is well under 1%.) For every investor who was smart enough–or just lucky enough–to pick a stock that returned more than 10%, there must be another whose stock returned less than 10%. Wall Street is not Lake Wobegon, where “all the children are above average.”

The fact that the average investor gets no risk premium for trying to pick individual stocks does not prove that no investor gets a risk premium for doing so. In theory, a stock-picking expert should be able to beat the market, just as a horse expert should be able to beat the odds in horse racing. But both logic and evidence suggest that this is much harder than most people think. It’s not enough to “bet the favorites,” that is, just invest in companies that are well known for their strong financial track records. Those companies may have the best earnings prospects, but they also carry high price tags. Back in the 1960s, most people thought that IBM was a good bet, since it was the leading computer company. And over the next four decades, its earnings did grow at an above-average rate. But investors who bought the stock in the 1960s paid so much for it that their percentage return on their investment actually turned out to be below average.

What a stock-picking expert needs is an extraordinary ability to spot bargains, to identify companies that will perform surprisingly well and turn out to be worth more than the masses of investors think. What really moves stock prices are earnings surprises. But surprises are by definition hard to anticipate, and unpleasant surprises are just as common as pleasant ones. Anticipating results that are surprising to everyone else cannot be a very common ability. The evidence bears this out. Not only do most ordinary investors fail to beat the market in the long run by trying to pick individual stocks, but so do most professional stock pickers, including most mutual fund managers and publishers of newsletters giving advice on which stocks to buy! (A later post on investment fees and expenses will discuss this finding further.)

What about a legendary stock picker like Warren Buffet? He does place heavy bets on individual companies, and he has been richly rewarded. Does he think that most ordinary investors should try to do what he does? Absolutely not. Most of us lack the time and the ability to pick companies as astutely as he does. If we try, we will be taking on additional risk by gambling too much on too few securities, without a reasonable expectation of an additional return. Buffet himself thinks we would be much better off managing risk by investing in highly diversified funds and settling for an average market return. Diversification is the topic of the next section.

Get time on your side

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The time value of money (TVM)

Why do you expect to receive interest on money you lend (and to pay interest on money you borrow)? Partly it’s to compensate you for the risk that money you lend might not be repaid, or that inflation might have eroded its value before it’s repaid. But there’s an even more fundamental reason that applies even to risk-free investments. A dollar that is yours to use today is more valuable than a dollar you won’t get until some time in the future. Interest payments compensate you for giving up the use of your money today.

The future value of money is the value to which it would grow over time at a particular rate of interest. The future value of a dollar next year at 5% is $1.05. The present value of money is the value today of an amount to be received in the future. If the ratio of future value to present value is 1.05, then the present value of a future dollar is 95.2 cents (1 / 1.05 = .952).

The time value of money becomes much more obvious over longer time periods. Then the growth over time is based on compound interest. At 5% interest compounded, the future value of a dollar after 20 years is $2.65, while the present value of a dollar you won’t receive for 20 years is only 38 cents. Future value is calculated by compounding present value, and present value is calculated by discounting future value. The calculations can be done easily on a business calculator or a spreadsheet using mathematical functions.

The financial significance of time depends on whether you are in a vicious circle of debt or a virtuous circle of saving, as described in the previous post. When you borrow, time works against you because of the accumulation of finance charges. When you save and invest, time works for you because of the compounding of earnings. The future value you receive is your reward for sacrificing present value. Appreciate the power of compounding, and get it working for you instead of against you.

Doubling time

An easy way to demonstrate the power of compounding is to calculate the “doubling time,” how long it takes an investment to double at a given rate of return. Suppose you invest in the stock market and earn 10% a year (which is close to the historical norm). On the average, about 3% of that will represent inflation, so let’s say that the real return is about 7%. Anything that grows at 7% doubles in about 10 years. (You can calculate an approximate doubling time for anything by dividing the annual rate of growth into 72.) And that means it quadruples in 20 years and grows by a factor of about eight in 30 years. That’s the benefit of long-term investing, which you miss out on by not getting started as early as you can. Procrastinate for 10 years, and you can miss one whole doubling.

At 7% per year, $1000 invested at age 35 will grow to $7,612 by age 65, but the same amount invested at age 25 will grow to $14,974 by age 65. And $1000 invested every year from 35 to 65 will grow to $94,461, but the same amount invested every year from 25 to 65 will grow to $199,635.

Long-term implications of savings rates

Let’s use TVM to tackle a more difficult problem, the relationship between a household’s savings rate during the working years and its income during the retirement years.

The Census Bureau classifies households by age, based on the age of the “householder,” the adult who is listed first on the reporting form. For this simplified example, let’s assume that households with householders 25-64 are in the working years, and those with householders 65-94 are in the retirement years. So forty years of working and saving might have to support thirty years of retirement. Let’s also assume that within each five-year age group from 25-29 to 60-64, a household receives the median household income for its age group, and invests a portion of it in a diversified portfolio earning a 5% real return after inflation.

Let’s compare the average income before retirement to the average income after retirement, for households with various savings rates. For the average income before retirement, we’ll use the same figure for all households, the average income over all the age groups 25-64. To get a post-retirement income, we can calculate the nest egg a household would accumulate by age 65 with a given rate of savings. We will then make the conservative assumption that they could withdraw at least 4% of that nest egg in each year of retirement. (Withdrawal rates will be discussed in a later post.)

Now we can calculate a “replacement percentage,” the percentage of the average pre-retirement income that would be replaced by the post-retirement income. With these assumptions, the replacement rate comes out about five times the savings rate. If the household saved 5% of its income consistently during its working years, it could have a post-retirement income equal to 25% of its average pre-retirement income. If it saved 10%, it could replace 50%; and if it saved 15%, it could replace 75%. Most households needn’t plan on trying to replace all of their income with earnings on savings, because they should have additional sources of retirement income, such as Social Security, part-time earnings, or a pension. They may also have reduced expenditures, as a result of downsizing or paying off the mortgage.

More sophisticated projections

Projections like this are useful for appreciating the importance of the savings rate, but they are too general to predict the future incomes of particular households. With today’s computers, financial advisors can do far more sophisticated projections, which take into account more factors. They can take into account variations in asset allocation, such as how much of the household’s investments are in the stock market. They can take into account different rates of taxation for different investments, as well as differences in tax brackets for different taxpayers. They can take into account the ups and downs of markets and the timing of the ups and downs. You could have a very bad bear market just when your savings are at their peak. Sophisticated financial planning software can do “Monte Carlo” projections, which summarize the results of thousands of scenarios and calculate the probability of achieving a financial goal. No projection, no matter how sophisticated, can guarantee any one future, but we can identify futures that are more likely than others, based on historical experience.

Time and uncertainty

The idea of getting time on our side is not without its limitations. Once we start considering long time frames, such as the life of a human being, historical change becomes a factor. Fundamental assumptions of our financial models, such as average rate of return and normal variations in return, may turn out to have been features of a particular historical era. If you plan to live in your house for fifty years, it better be able to withstand a fifty-year storm. But what if storms that used to occur only once in a hundred years start occurring about every ten years, as a result of global climate change? Or on the financial front, what if economic globalization makes markets more volatile and economic depressions more frequent? No set of investing principles can guarantee economic security in an uncertain world. But principles that have “stood the test of time” at least up until now are better than no principles at all.

Live within your means

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The first principle of sound investing is easy to state, but harder to follow. Unless you are independently wealthy, you have to save in order to have money to invest, and that requires you to live within your means. Many households find that difficult, either because of their low incomes or their lifestyle choices. For much of the twentieth century, households carried little consumer debt and saved about 7-10% of their disposable incomes. Between the mid-1980s and the crash of 2008, consumer debt soared and the savings rate fell to near zero. (And if you consider the national debt and the international balance of payments deficit, it appears that the whole country has been trying to live beyond its means, with a lot of help from capital exporters like China.)

Years ago, the banking industry would help people live within their means by lending them only as much money as they could reasonably be expected to repay. But then a series of legal and regulatory changes greatly increased the interest rates that banks are permitted to charge. Now banks can profit from loans to customers whose ability to repay the principal is questionable, but who can be induced to pay interest for a very long time. By aggressively pushing high-interest loans, the banks have enabled millions of Americans to live beyond their means. At the same time they have successfully lobbied for more restrictive bankruptcy laws to make it harder for those who go broke to discharge their debts. If the words “pushing” and “enabling” make credit card debt sound like a form of addiction, perhaps the analogy is useful. The advice it suggests seems appropriate: Know your limit. Don’t rely on the bartender or the other drinkers to tell you when to stop. Stop spending well before you use up all your income, even if powerful voices in society tell you to keep the party going.

Vicious and virtuous circles

The balance you strike between income and expenditures is a choice between a vicious circle and a virtuous circle, or if you like, a downward financial spiral and an upward financial spiral. The more you borrow, the more you have to spend on finance charges, and so the less you can invest, and so the less you accumulate for future spending, and so the more you have to borrow . . . and so on, until you are facing a bleak financial future. But the more you save, the more you can invest, and so the more you earn on your investments, and so the more you can reinvest . . . and so on, until you have achieved financial security. Only if you can get into this virtuous financial circle can the other principles of investment be of much use to you.

Pay yourself first

A popular slogan with financial advisors is “Pay yourself first.” If you can take a percentage of your income right off the top and put it away in savings, you will greatly improve your chances of achieving your long-term financial goals. Investing through a payroll deduction plan is an excellent way to do this.

How much should you save? For retirement savings, a very general guideline is 10 to 15 percent of income. The higher the savings rate, the higher the “replacement rate,” the proportion of your working income that you can replace with investment income after you retire. The next section will discuss this in more detail. In addition, you may want to save and invest for short-term or intermediate-term goals like college education. Financial advisors also recommend an emergency fund equivalent to at least three months of income (or better, six months) that is held in cash.

As you get older, the percentage you need to save depends on how much you’ve saved already. T. Rowe Price recommends that a 40-year-old with existing savings equal to two times annual salary should save 12% a year for retirement. The recommended savings rate drops to as little as 5% with existing savings three times salary, and goes as high as 25% with no existing savings at all.

The single best thing you can do to improve your investment returns is to increase your regular contributions to your investment accounts. Research has found that this is generally more effective than changing your asset allocation or switching from one mutual fund to another. Those other kinds of decisions have their place, and they will be addressed in later posts. But be sure to put first things first.

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Over the next couple of weeks or so, I will be updating some material I’ve published previously about sound investing. I will also be posting it on my wiki, “Savvy Investor,” which is under construction.

The number of Americans who have investments of one kind or another is now very large. The number who base their investment decisions on well-thought-out principles is undoubtedly much smaller. Many people are bewildered by the whole subject of investing, and either make decisions haphazardly or let someone else make their decisions for them. Often they pay a heavy price in the form of poor returns or unnecessary fees.

The information you need to be a good investor is not as hard to acquire as you might think. Just as you don’t have to be a French chef to cook a good dinner, you don’t have to be a Wall Street analyst to make money in stocks and bonds. (And as we’ve seen recently, the most highly paid analysts can get carried away with greed and make really dumb decisions.) Yes, there are some very sophisticated technical tools for addressing certain questions, such as the likelihood of achieving a particular financial goal with a particular combination of investments. But what is more essential is a set of basic investment principles that have stood the test of time, such as regular saving, risk management, diversification, and tax sheltering. Most people have had at least a casual exposure to these notions, and yet Americans continue to save too little, put too many eggs in too few baskets, or pass up attractive tax breaks. What too many people have failed to do is consciously embrace sound principles of investing and incorporate them into a systematic investment strategy, so they become financial habits to be followed routinely. If you can do that, your chances of long-term success will be greatly improved.

The principles of sound investing I’ll be discussing sound very simple. They include things like living within your means, diversifying your investments, avoiding unnecessary fees and expenses, sheltering returns from taxes, and planning for a long retirement. To some extent, you probably already know them. What I’ll be trying to do is give you more insight into what the principles really mean and how they come together to form a solid investment strategy.

Of course, a set of general principles is not the same thing as a detailed financial plan. Your specific investment decisions–what you should actually buy, hold or sell–depend on your particular financial circumstances. Once you have a general strategy, you can decide whether you can take it from there and work out the details yourself, or whether you would like some personal financial advice. If so, you may find it most economical to pay only for a few planning sessions, while avoiding more costly management fees and commissions. Most people who have a sound investment strategy can manage their own investments most of the time, with occasional advice from a financial professional. In a later post, I’ll discuss a few different ways of obtaining that advice.