A wise woman once said that when in doubt, zoom out. So zoom out I did. This is what a 40-year chart of Dow Jones Industrial Average looks like…
Add in reinvested dividends and we are looking at an easy double of that.
Or if we want to get exotic, here is what the Indian stock market did in a typical investor’s lifetime.
There are peaks and valleys and sometimes those valleys don’t recover for years. That is the nature of the game.
We can control the depth of those valleys by adding bonds. The ride will be smoother. We won’t make as much but that is not always the goal.
But if we can afford the occasional hits to our savings and measure our time horizon in decades, a big tilt towards stocks is what we need.
Some perspectives hence are warranted the next time markets show their usual manic-depressive side…
If you’ve owned stocks since the 2000s or the nineties or the eighties and if you held on, you did well. Just peek at what your portfolio has done over the very long-term. That outsized gain you see is the very reason you were investing in the first place.
You can’t dance in and out of the markets to avoid downturns. Because you cannot predict when they will come but you do know how absolutely crushing a blow it will be to your long-term wealth if you miss just a few of the market’s best days. So think long and hard before making any hasty decisions. Best yet, follow the plan blueprint that you have been following since saner times.
Your goals don’t change that often and nothing about any short-term events changes the fundamentals of capitalism. There is a reason you own a heavy dollop of stocks. Volatile as they are, but the equity risk premium stocks deliver over other investments in the long run is what is going to get you to your goals.
Not everyone can take the heat and maybe you are one of them. But think about what else you are going to do with your savings. When you own stocks, you own cash-generating businesses. The world runs on businesses. If you still cannot take the heat, there is no harm in restructuring your investments for a less volatile portfolio, assuming you can still meet your plan goals.
Our best defense against doing anything rash with our money is to know what we own and why we own it. Once we have conviction, blissful ignorance is the best strategy.
And who would not want to own a piece of this?
My litmus test for whether the world economy will create value over time is asking the question – Did more people wake up this morning seeking to solve problems and make life better for others than do the opposite? And the answer is still firmly “yes”.
Morgan Housel, Collaborative Fund
This is a decades long game. Sticking to our plans in times of turbulence is our only option.
What am I doing with my surplus cash? I am buying. I am always buying.
My daughters are buying. And they’ll always be buying.
Rule number one – don’t lose money. Rule number two – don’t forget rule number one. That of course is classic Buffett.
So, say you have a choice between investing in the hottest tech stock around or in a basket of stocks that represent say the entire tech sector. Which one do you think offers a better risk-reward situation? A basket of tech stocks of course.
Prices of investments moving up or down, even violently at times, is not risk. The likelihood of losing purchasing power over time is the true risk. The fortunes of a single business can decline and never recover but the fortunes of an entire sector, rare but it could still happen.
Like say you invest in a fund that owns a basket of oil company stocks and you think that is safe because you are technically diversified across many businesses. But you are still making a sectoral bet. Can you predict that sector’s profits twenty years from today?
Not so easy because it is quite possible that the entire sector could be disrupted out of existence or at the very least, prominence due to advances in technology.
So, there is a non-zero probability of loss by investing for the long-term in a supposedly diversified investment.
But what about investing in all sectors of an economy through an investment that represents say 500 of the largest publicly traded businesses in these United States? That is the S&P 500 index that we are all familiar with.
So, we are now getting to a point where we have diversified away any diversifiable risk associated with a single company or a sector in a given economy.
But then there are still gaps as S&P 500 is a collection of 500 large publicly traded businesses in a single country. Then there are mid-size companies, small companies, international and emerging market companies. And then there are domestic bonds, international bonds, real estate and so on.
Talk about S&P 500, back in the Dot-com days of the late 1990s, the S&P 500 then, just like these days1, was extremely top-heavy and concentrated. The top 10 companies made up more than 30 percent of its total value.
Where is the problem? The problem is that this happens when investors come to believe that stocks of some businesses are better (and safer) because they have a great story to tell. They are the stocks everyone owns. They are the stocks everyone talks about. They are the stocks everyone loves.
But investing for the long-term isn’t a popularity contest. The investments that everyone is chasing are usually overhyped and overpriced, with prices driven higher not so much by fundamentals but because more and more investors are piling into them.
And when the valuation pendulum eventually swings, you get left holding the proverbial bag, sometimes forever, because you paid through the nose for those agreeably wonderful businesses. The businesses themselves may not be the problem. The price you pay for them is.
This below is the performance of the top ten largest stocks in the S&P 500 index back then (late 1990s) to twenty years later.
n/a = bankrupt
The only one that turned out respectably okay was Microsoft. But that was after holding on for 15 years to surpass its prior peak reached during the Dot-com times.
Cisco Systems has yet to reach the highs set 25 years ago. Same or worse stories with the rest.
And it is not like these businesses don’t make money. Cisco, for example, is a cash generating machine. It dominates its markets. It is just that investors paid too dear a price for a very popular investment of the time and the profits have yet to catch up to that price.
But back to S&P 500 and since that index was so concentrated, it quite naturally took a beating when the Dot-com bubble burst. And that showed up in that index’s subsequent 10-year performance…
So, if you just owned the S&P 500, you had a problem. Not a big problem if you had the wherewithal to stay invested but that is easier said than done.
And most investors won’t because to persevere through a decade long underperformance, you’d have to approach portfolio construction from a much deeper perspective than many do.
But back to overconcentrating in a single stock or a sector risk, you better be super lucky and choose right. Because choosing wrong, which is more likely, can upend your life.
There is this WSJ story that I often cite when explaining concentration risk. It talks about how workers at General Electric loaded up on their employer stock during their tenure to a point where many had pretty much their entire life savings tied up in this one stock.
Now imagine telling someone to diversify out of GE, the bluest of the blue chips that has been around for more than a century, a business that has survived Worlds Wars, recessions and depressions, a business that is the only surviving member of the original Dow Jones Industrial Average.
And who could have predicted that a diversified conglomerate like GE with market leadership in industries ranging from jet engines to medical equipment to financial services could fall on hard times. The consequences for the employee-stockholders though were brutal…
You had a job for life if you had gotten in there,” said Mr. Zabroski, 61 years old. He rose to punch-press operator and retired in 2016, after working 40 years at the century-old plant, which roared to life during World War II and still churns out engines for jets and helicopters. He left GE with an annual pension of $85,000 and company stock valued at more than $280,000.
Retirement looked pretty good until GE shares collapsed. His shares are now worth about $110,000, prompting a late-life job hunt. “I never planned on retiring and having to go back to work,” said Mr. Zabroski, who has monthly mortgage payments and supports a partially disabled wife. “It’s kind of scary.”
Mr. Zabroski’s situation doesn’t appear as dire considering his $85,000 a year pension but then that is at risk as well if the company continues to flounder.
Among those hard hit by GE stock losses have been company retirees, including former factory workers who took advantage of a stock-ownership plan to build their savings. For decades, the company has had a program that encourages employees to buy GE shares by offering to match 50% of worker contributions, which were taken directly from paychecks.
With 71.4% of assets needed to cover its pension liabilities, GE is one of the worst funded large corporate pension plans in the U.S., according to an April report by consulting firm Milliman Inc. GE’s pension obligations, nearly $100 billion at the end of 2017, are underfunded by almost $30 billion.
Mr. Marruffo‘s situation isn’t looking that hot either as he too loaded up on GE stock…
Mr. Marruffo, 71, started with GE as an apprentice, working in different engineering and manufacturing areas. Just like many business experts, he respected GE’s management. Mr. Marruffo accumulated GE stock through the company’s Savings and Security Plan. He figured the company was just about invincible, which made the fall in its stock price devastating. He sold some last year but still owns about 6,000 shares. He now regrets he didn’t sell more.
Employees need to think very carefully about investing their own money beyond 10% in company stock,” said Corey Rosen, founder of the National Center for Employee Ownership, a nonprofit that works with companies. “If you are looking at retirement, then diversification is a good thing.”
Getting folks to diversify out of their employer stock is never an easy discussion, especially when it relates to some of the hottest stocks around. Plus, as an employee-stockholder, you want to believe in the future of your company so much that it is hard to bring yourself to let go of your shares.
But let go you must because the business landscape is strewn with past darlings that could do no wrong that are now just a shell of their former shelves. Some don’t even exist anymore.
Take Yahoo, for example. It had a peak market value exceeding $100 billion at one point but fifteen long years later, it got sold to Verizon for a mere $5 billion. Then there are the former stalwart businesses like Sun Microsystems, AOL, JDS Uniphase, Palm, and others from the Dot-com times that have completely vanished.
Go back in time even more and you find the Xeroxes and the Kodaks and the Polaroids of the world. Those were the Googles of their times that don’t exist anymore.
So, what do you do if you find yourself in that lucky situation of holding too much of a good thing? Do you sell all at once? Because the moment you sell, you know what is going to happen next. The stock is going to shoot up like a rocket.
So instead, I say you scale out over time just like how you scaled in. Pick a date and a timeframe and sell and keep selling until you are done.
Carl Richards in his book The Behavior Gap talks about a conversation you should be having with yourself if you have a majority of your net worth tied up in a single stock or a sector.
A guy I know had his money invested in his company’s stock. He had enough money to retire comfortably, but he believed there was a good chance the value of the stock could continue to rise – maybe even double. He wanted to know if he should sell the stock upon retirement, or hang on and wait for the stock to go up further.
We had the Overconfidence Conversation.
I asked him three questions and we answered them together.
Question one: What happens if you hold the stock and you’re right – the stock doubles?
Answer: You’ll have more money.
Question two: What if you hold the stock and you’re wrong?
Answer: You’re going back to work – maybe for twenty years.
Question three: Have you been wrong before?
Answer: Yes.
He sold the stock.
It is hard enough to get rich once. Don’t force yourself to get rich twice.
If you are already rich, there is no upside to taking on a lot more risk, but there is disgrace on the downside.
How long are you going to live? Average life expectancy today for a typical American is about 80 years.
And it is somewhat distributed like this…
It is skewed left because some unlucky few will lie on the extreme left of the distribution, a major chunk will live close to the average and some to the right of that average. That is today and this distribution will shift right over time as life expectancies continue to rise.
So, if you are planning your own retirement, what life expectancy would you assume? Because that is the holy grail. You know that and the rest is easy.
But we do not know that and that is why retirement planning is so tricky.
That was not always the case though.
Most employers offered something called a defined benefit pension plan. A pension plan fundamentally is a risk-reduction setup, designed to guarantee that no one who participates in that plan goes without income during retirement.
And because life expectancy risk gets pooled in a pension plan means that we did not have to save as much. Folks dying early paid for those who lived longer. All that was required of the plan to remain solvent was to have enough assets to cover life expectancies up to just to the right of the average life expectancy to accommodate for some buffer.
And not just that, the employers we worked for hired the best number crunchers money could buy to design a plan that lasts. You didn’t have to lift a finger. You needn’t need to know what the markets or the economy were doing at any given time. You just did your life’s work and the rest fell in place.
But pensions plans have gone the way of the do-do bird. The businesses who offered these plans do not want anything to do with them. Why would or should a company in the business of making widgets take on this added burden and mostly, a liability of financial planning for their employees?
And who sticks around long enough to avail themselves of a pension these days anyway?
So, for all these reasons, you now must design your own pension plan. Not only do you have to invest right during your accumulation years, but you also must take the money out rightly from the many accounts you’ll own through your life in your distribution years.
But how long do you need to make your money last? Unlike a traditional pension plan, you now need to account for the fact that you could be a demographic outlier. That is, you might live way beyond what life expectancy tables show.
So, you have to design your own pension plan and because there is no pooling of life expectancy risk, you have to save more, much, much more than what you would have had to if you had access to traditional pensions.
But all is not lost in this game because unlike traditional pensions, your one-participant plan does not need to generate income till you retire. Your portfolio, hence, can afford more risk than what a traditional pension plan can. That then helps reduce the amount you need to save each year by some factor.
Plus, if you do happen to save more than you will ever be able to spend, the leftover assets are there to bequeath as you please.
That is not the case with traditional pensions because you depart from this planet and your pension departs with you. There are no assets to bequeath.
So that is all good but then many of us still invest by the seat of our pants. Markets sell-off and we panic. Markets ride high and we get euphoric. Most do not invest with a pension like discipline and structure. For this and many other reasons, I wish we could somehow go back to the retirement savings system of the past.
Because if you read what I read on how ill-prepared we are as a country on the retirement savings front, you’d be depressed. Because it will be a burden and the ill-prepared are going to bear the brunt of it.
Annuities are insurance products. And insurance is an expense. It is never an investment.
What do you get for that expense? Risk reduction (definition of insurance) but above all, peace of mind.
You buy life insurance to protect your loved ones from financial ruin in case you unexpectedly pass away. There is an insurable need there because you do not want your grieving family to have one more thing to deal with after you are gone.
There always must be an insurable need before you go near any insurance product. Your kids do not need life insurance as no one is financially dependent on them.
Yet they are still sold; the dumbest thing you can do with your money. It is like buying car insurance for your 5-year-old daughter.
That brings us back to annuities. We can make them as complex as complex can get but annuities quite simply are income guarantee plans.
This below is a timeline of a typical saver…
There are accumulation years and distribution years. Accumulation years are when you set aside money in a portfolio of investments to help you reach your retirement goal. You then trickle out of those investments each year to live on until you depart this planet. Trickling out of your accumulated savings is the same thing as annuitizing or pensionizing your savings.
When you reach your goal, you have a decision to make. You can pensionize your savings on your own or you can give those savings to an insurance company and purchase say a Single-Premium Immediate Annuity (SPIA).
You’d then be guaranteeing yourself a certain fixed amount of income for life. No worrying about the markets or the economy. As long as the insurance company is around, you’d get your “paycheck”.
What does the insurance company do with your savings? They pool your cash with cash from say a million other customers and invest in a portfolio of investments that outearns what they have to pay out. They must outearn what they pay out because insurance businesses are not in the business of losing money. If the markets do not deliver as expected, the insurance company gets that money from you through increased costs for their products.
But if you die the day after you buy that annuity, life’s tough. That money is gone because you are indirectly paying for someone who happens to be in the same insurance pool and lives to be one hundred years old.
So quite naturally, you’d never want to do this with all your money. You would want to annuitize, if at all, say a tiny portion of your money that guarantees a bare subsistence level of income through the end of your life. The rest should be invested like you otherwise would.
But if the job of planning is done right through your accumulation years, there is seldom a need for this product – especially if you want to leave an inheritance behind.
And if it were me and if I had to choose, this is the only kind I’d buy.
That is mostly it for annuities, but we’ll continue along to learn more about the types you should maybe consider buying and the real insidious ones that you should never go near. Because the only kind that are sold are the insidious ones so it’s good to know about them.
There is a flavor of annuity I just described and that’s Single-Premium Deferred Annuity (SPDA), also called longevity annuity. You buy this at say age 65 but defer annuitizing it (collecting income) to say age 85. This costs you less because you don’t touch the money for twenty more years, but it serves the same purpose of protecting you against running out of money in case you live much longer than planned.
But if you die at say age 84, again, that money is gone. Not necessarily a problem as it served an insurable need.
I am still not a fan of these unless a better product comes along for reasons cited below:
You are taking a big inflation risk with them because these annuities make nominal payouts (not inflation-adjusted). You buy them for longevity insurance but guess what, 30 years of inflation will turn those dollars you’ll receive into funny money so that so-called income protection benefit fades away.
That risk is even bigger with a deferred annuity because you are not getting paid for many, many years. That payout might look good today but when it does come, you might be sorely disappointed with its purchasing power.
Also, you are taking a huge credit risk. These are all commercial products and though they have state guarantees, they (guarantees) are funded by the insurance industry. Most states have much lower caps on the amount that is protected and even those guarantees can fail when the insurance company fails. Just google the collapse of Executive Life Insurance.
Yet they are still all right if you truly need them, but these are not the ones ever sold. The ones you’ll be pitched are the ones that combine the accumulation and the distribution phases of a typical saver’s timeline into a single product.
And these are the ones you should stay away from. The first of its kind is an indexed annuity.
The stock market as we know is a volatile beast. It goes up and down like a yo-yo. We all love the ups but cannot deal with the downs.
So along comes this insurance salesperson, who pitches something so amazing that you cannot believe it could possibly exist. But it does.
You are going to get the up of the stock market but if the market goes down, you won’t lose money. That is the promise, and it is pushed hard every day because there is a lot of money to be made…from you.
Fancy vacations, tickets to high-profile sporting events etc. are some of the perks insurance companies shower on their agents selling these hugely profitable products. But these are the petty things.
The real money is made in commissions and the investment expenses they cleave out of your savings by the truckload at every chance they get.
Because this thing that is supposed to be an absolute grand slam for your wallet is actually a windfall for the broker and the insurance company selling it to you.
And that promise of you reaping the benefits of the stock market when it is up is never entirely true. Because what the insurers do in the contract you sign is that you get the upside of the market, but that upside is capped at a much lower number. That is disclosed deep down in their brochure in mice-type legalese that even a Harvard-trained lawyer cannot decipher.
I get these marketing materials clients send me when they are pitched these products, and they all look great on paper. But I know that is mostly fluff and the real truth only comes out once you buy them.
So yes, you get the upside but a much smaller upside.
And if you have been a stock market investor, you know that besides the gains in the value of your investments, dividends and reinvestment of dividends is where the real magic happens.
But with these products, you do not get the dividends. Who gets those dividends? You guessed it.
The second part of the promise is that you won’t lose money if the market declines. You won’t lose money only if you use the product exactly as written and stay in it for a decade.
If you need YOUR money before then, you lose the downside protection.
And then to add salt to that horrific wound, if you find out that you made a mistake and want out, you get hit with massive, gigantic, extreme penalties known as surrender charges. It is like Hotel California that you can check out of, but your money cannot leave.
The other main kind that is sold is a variable annuity and with these, the insurance company invests your money in a portfolio of investments just like you’d do in your 401(k).
Again, same sets of problems. Lots of fees and commissions up to a point where you would be better off investing your savings in Treasury bills.
So, the right kind of annuities are conditionally all right, but the wrong ones will rob you blind. Don’t do them.
