Stocks Investing — The Half Truths

When stocks move up … Great, that’s bullish, let’s load up and ride some good stocks.

And when stocks move down … Wonderful, I see great bargains everywhere, time to load up on good stocks.

I simplified things somewhat. But I am sure that does ring a bell. These are some of the most common things you hear. It is almost as if there was never a time not to buy stocks. There are underlying reasons supporting their calls. And yes, there are always good picks at any point in time. But that takes a lot of work, expertise and resource. So you got to think a bit more and don’t just take what is said at face value.

Over the course of history, there are many other statements made in support of stocks. Most look like they are true except that it is not the whole truth. So I thought I review a few of them and see what they are leaving out.

Note : All charts are sourced from Yahoo finance. They do not take into account dividends.

1. Apple, Amazon, Google, Netflix! Look at how much you could make!

Hindsight makes things look easy, but they are in fact not probable

Almost everyone knows these stocks today. Unsurprisingly, you find them picked on hindsight as examples everywhere in support of how much you can potentially make if you invested in them. Yes, you would have made tremendous amount of money if you had. But have you? If you have, when did you invest? How much did you put in? Do you still hold these stocks now? If not, when did you sell them? And did you take profits along the way? Every decision matters.

That is assuming you even had the eye to pick these counters early in their life when no one is paying them any attention. These counters lie on the extreme right of the spectrum. They are what we called outliers. There are only a handful of such companies out of the 3,000 or so listed in US today (more if we consider all those that were delisted over the decades). So from a mathematical perspective, your chance of picking one early is extremely small.

For every spectacular success, there are many more failures

Common sense also tells us that for each spectacular success, there are many more who failed, under performed, or produced average results. Every quarter, more than 20,000 businesses filed for bankruptcy in US. This includes public companies. I don’t have complete information on the latter. But even in a good year like 2017, 71 public companies filed for bankruptcies. And in 2008 and 2009, there are 138 and 211 respectively. Lehman Brothers is among them.

The danger is when someone deludes themselves into thinking that picking such stocks are easy. And he spent all his resources building a concentrated portfolio in the hope of landing on the next Netflix, Google or Amazon. What if he selected PALM (the PDA maker) which is now defunct, or Creative Technologies which delisted from NASDAQ instead (Creative Technologies is still listed on SGX)? Well, the results will look drastically different.

Even if you manage to pick say a multi bagger and hold on to it since day one, that is also not necessarily representative of your investment performance. unless you tell me all you had is that one stock. What determines your investment performance is your entire portfolio and the decisions you made over time. It is never about a single stock.

2. Stocks always rise in the long run. All crisis will eventually be nothing more than a blip in the chart.

We don’t have a 100 years

The favorite example out there is the S&P 500. Because it got one of the nicest looking chart with a long history spanning almost 100 years. The index started on 1957 and data before that was extrapolated. But how relevant is a 100 year chart to us when most of us wouldn’t live to a 100 years? What we should focus on is our own investing time frame and that is going to be much shorter.

So what is the time frame that matters? 5 years? 10 years? 20 years or more? Everyone has a different expectation that is peg to their financial goal. Some want it faster, some longer. But let’s just assume a 30 year time frame. This means if you start investing between the age of 20–30, you want to achieve your objective by 50–60. I think that is a reasonable time frame.

Recoveries can be painfully long and they are far from a being just a blip

Depending on when you run into a major stock crash, the impact it has on your objective can be huge. In any case, stock recoveries can take longer than what many people expects.

It took 13 years for S&P 500 to decisively break out of its Dot Com high after the Great Financial Crisis (GFC) in 08–09 derailed the recovery.

How about the 1929 Great Depression that does not even register on the chart now? But first of all, it doesn’t register because we are always looking at linear price charts. As an example, a $8 drop when the index is $10 in its early days would be a humongous -80%. But decades later, when the index is $1000, the same $8 move is only 0.8%. So naturally, they are not going to be visible. That, however, does not mean you can’t experience another 80% drop.

S&P 500 lost as much as 86% during the Great Depression between 1929–1932. And it took an awfully long 25 years moving through World War II to recover back to the peak.

If you want a more recent example, then look at Japan. After 1989, Japan went into a prolonged period of deflation and economic downturn. The period from 1989–1999 came to be known as the Lost Decade. But I guess no one anticipates the market to deteriorate further after that. Nikkei 225 fall as much as 80% from its peak, and even after more than 30 years, it was only half of what it once was at its peak in 1989.

And if you look outside of US since GFC 08–09, you will realize that many markets have yet to recoup its losses even after more a decade. So if what you set aside is 30 years, it may not be as long as you think it is.

3. Volatility Does Not Matter

Many avid long-term buy and hold stock investors believe that fluctuations in stock price as measured by volatility is inconsequential. All that matters to them is whether you make money at the end of the day. The second statement makes perfect sense. But the first statement is flawed.

As imperfect a measure as volatility is, it is nevertheless, linked to the potential loss an investment can incur. And the higher the volatility is, the more uncertain we are of hitting our target.

Why does such uncertainty exist? Because you can’t control the market. Neither can you foresee what it will do. If market always ends on a good note for everyone, then we can all live happily ever after. Unfortunately, that is not the case. A severe crash towards the later part of your investment journey can seriously derail you from your goal. The usual defense is just buy more during the crash and then wait it out. But the question is are you sure you are going to have the resource and the luxury of time?

As much as the market is out of our hands, so are many other things in life. Such stressful periods can test your finances. You may be out of job, your pay may be cut, or you are in danger of being retrenched anytime. Or you are already looking to retire soon and time is not on your side.

Parting Thoughts

The purpose of this post is not to discourage you from investing in stocks. But rather, to temper your expectations and think deeper about the approach you want to take towards investing. Personally, I always have an allocation to stocks. They are an indispensable asset class for me. But I prefer a more balanced and diversified strategy towards investing so I spread my portfolio out across other asset classes and strategies. That helps me weather the different crisis better than a pure stock portfolio. And if done correctly, returns are not necessarily lower. While uncertainty can never be fully eliminated, we can reduce it to sleep better at night.

Originally published at https://investmentcache.com on May 6, 2020.