Stocks: Risk, Return, and Expenses

Critical Stuff:  Risk management means making sure you are being compensated for risk–not avoiding it. No balls, no blue chips.

In This Chapter:  The Stale Donut Theory of Risk. Why Diversification won’t save you. The two fund portfolio.

The popular notion of stock investing is that someone very clever uses their knowledge of the market and an understanding of the potential for individual companies to be more or less valuable to buy or sell the right stock at the right time, and thereby make a killing. The first thing you should understand about that concept is that it revolves around stocks being mispriced. The idea assumes the rest of the people buying and selling stocks do not know as much about the market and the companies whose stocks comprise it to have already taken that information into account.

That’s not likely at any time–there are plenty of bright people looking at every publicly available aspect of the market and betting their money on what they know. But it’s even more unlikely on a consistent basis. People with specific knowledge about the future performance of a company are barred from trading on that knowledge. People can and do get sent to the slammer for that. Ask Martha Stuart how that works.

So let’s start with the assumption that the the markets are efficient about pricing. That doesn’t mean they aren’t irrational and emotional. The market rises and falls, and it’s not really understandable or quantifiable except in hindsight. That makes investing in stocks risky.

That volatility and risk makes the market a perfect example of Regression to the Mean. But remember that for a high-flying stock to regress to the mean it has to rip right through that average return line and get all negative for a while. No fun there, buckwheat. That reality is why individual investors generally underperform the market by 5% or more. They buy high and sell low. And they keep on doing it until they don’t have much to buy with.

In a different world the answer might be to invest in bonds instead of stocks. Unfortunately the bond market is equally efficient in that interest for bonds is as low as possible for the economic environment and risk level for the bond not being repaid.

In fact every kind of investment–even hiding silver coins in your mattress–will have a market level of risk and reward if the investment is liquid, meaning it can be sold with relative ease for the market value. Your investment in any market should assume that the assets are correctly priced because the market is competitive. This makes diversification imperative, because concentration on a narrow class of assets increases risk without increasing reward. Putting all your money in General Motors is more risky than owning a piece of all the car companies, which is more risky than owning the entire Dow-Jones index, which is more risky than owning a little bit of every US stock, which is more risky than owning a little of all the world stocks, which is more risky than owning a mix of investments that are not dependent on each other.

All this talk of risk may make you squirm. If you ask the average Joe if he’d like to make a risky investment, the answer would generally be “NO!” But risk is really the only thing the market pays for other than overall economic growth. And I’m not talking about just the stock market, I mean the everything market. If you buy a day-old pastry at a bakery you pay less because there’s a bigger risk that it will be stale when you eat it. You’ve been compensated for that risk with a lower price. If the price was the same, you’d take the fresh pastry. You are refusing to accept an uncompensated risk. Good for you. Now apply that to your investments where it’s a heck of a lot more important than a slightly stale jelly donut.

For your investments you certainly consider stocks to be riskier than treasury bonds. You expect a higher return from stocks–that’s how you are compensated for risk. And the major risk is that the compensation won’t happen, and the value of your investment might go down.

Most of the concepts of investment theory boil down to trying to be sure you are being compensated for the risk you take. If you are, then in the long term, you’ll probably be fine. Risk can’t be eliminated, though, only compensated, and as we said before there’s risk in every strategy, including stuffing your mattress.

To fully assess a risk you need to look at all the factors involved and any available mitigation. For example, there is no way to reduce the risk of owning stocks just by diversifying within the stock market. The entire world stock market could and does sometimes go down in value and you lose money despite diversification. You might hold funds for small cap, mid cap, and large cap companies. You expect the small cap companies to offer a premium return because of a higher risk, and you moderate some of that risk by holding mid and large cap funds. The diversification helps your overall holdings but doesn’t eliminate the risk of those small cap funds.

The problem is that all those stocks and all those companies are correlated in some ways. Besides the ordinary English language version of that word there’s a math-speak version of correlation that deals with the independence (or lack thereof) of two variables. For example, the electric company might plan to reduce energy generation on a mild day, or plan to increase it during extreme weather because there is a correlation between weather and energy use. It’s possible to calculate the degree of correlation of simple variables or to model the correlation of complex things like stock markets. Such modeling makes it painfully clear that there is a limit to the risk management benefit of diversification. And no, I’m not going to explain how to do the modeling.

Owning an individual stock is particularly risky and the risk is mostly uncompensated. The market doesn’t offer any kind of premium for buying an individual stock, the price for the stock as part of a fund is the same as it is when purchased individually, so you bear the risk with no reward for it. All the unique risk of the company (the brilliant CEO gets hit by a bus, a competitor pursues a successful lawsuit, etc) is uncompensated, and it can be substantially reduced by diversification.

This isn’t a theoretical situation, there’s proof of it everywhere you look in financial history. Yes, people who bought Apple in 1999 did very well, but in the same period of time, a huge number of companies disappeared entirely. Big ones, small ones, solid ones, shaky ones. Apple could certainly have disappeared–there were times when that looked inevitable. The crystal clear path to success is only visible looking back. Steve Jobs as the visionary savior? When he got the boot he was considered nothing more than a liability.

The bottom line here is that investing is not speculating, and speculating is not investment. We’re talking about your retirement, not a little stock bet you made when you’re 22 that you hoped will yield enough money so you can buy a motorcycle (not that I’d know about that, and no, it didn’t work out). Your interest should be in investment, and you should make certain that the risk and reward are balanced and appropriate. That’s the aim of asset allocation.

Diversification reduces the potential for loss, but it also reduces the potential for gain. Striking some kind of balance for just risk and reward would seem kind of straightforward, but different assets show substantially different historic risk/reward profiles. If you took a basket of assets and plotted each type of asset’s risk vs. reward you’d find a somewhat lumpy line with reward trending upwards as risk increases. If you wanted to establish a specific level of risk and reward that suited your available funds and intestinal fortitude you could mix those lumpy lines together and come up with a recipe that feels good to you. Presto–you just invented asset allocation and Modern Portfolio Theory. We’ll cover that in more detail later, but for now, let’s simply recognize that stocks are going to be a part of your strategy if for no other purpose than that equities permit you to arrange your asset holdings to have more compensation for an equal amount of risk. It’s probably the only mispricing that is consistently available in the investment world. We’ll cover how that might work in the chapters on asset allocation, but for now, we’re just going to concentrate on what form your stock portfolio should take.

Let’s just flat out eliminate buying individual stocks. It’s gambling. If you want to do that, then have at it, I don’t have any advice for you. Maybe you’ll find some value in the fitness section of this book.

Let’s also eliminate buying a selection of mutual funds through your fee-based financial advisor. They won’t be able to deliver higher performance on a long-term basis. If performance is all the same in the long run, then the big things that matter are cost, diversification, and taxes. We’ve talked about fee-based advisors enough. If you need major league handholding then it might be your only option, but you’d better learn to live on a very small percentage of your retirement savings because there won’t be much left for you.

Fortunately, there are a number of superior approaches to owning stocks that offer diversification, low cost, no conflict of interest, tax advantages, and low churn. Here are some of the choices:

1. You can take the information in the asset allocation chapter of this book, do a little research on Bogleheads.org or any of the many books and/or online resources listed in the Sources section, and design a portfolio for yourself. Then set up an account on Vanguard or one of the competing companies that offer low-cost ETFs and index funds and build out your portfolio. We’ll talk about bonds, cash, and other investments later. But your stock portfolio on Vanguard might be:

  • 60 percent in the Vanguard Total Stock Market Index Fund (VTSMX)
  • 40 percent in the Vanguard Total International Stock Index Fund (VGTSX)

That’s it. Those two funds have no load, no transaction costs, and expense ratios of  .017% and ,022% respectively. Contrast that to the 2% expense ratio, loads, transaction costs and other costs that your financial advisor sticks you with because he’s getting a commission. Yes, your math is right, you’re paying a hundred times more for your portolio, and that’s before you pay the assets under management fee.

2. You can use a low cost, fee-only advisor and research any other services you need on the web. Some low-cost advisors offer either hourly or flat fee services in addition to investment management. Paying a high yearly commission for services you only use once seems nuts, but I’ve done it. Changing that is what this book is really all about.

3. You can use Robo advisors. I think those really benefit younger people who are saving for retirement.

 

 

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The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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