Ralph Wagner, the legendary manager of the Acorn Fund, once likened the stock market to an excitable dog on a long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle through Central Park to the Metropolitan Museum. But at any given moment, there is no predicting which way the dog will lurch, but we know that directionally, the dog is headed northeast at an average speed of three miles per hour.
Casual observers, though, trying to gauge which way both the dog and the owner are headed, will have their eye on the dog instead of on the owner. But we all know that the dog is going to end up where the owner decides to end up.
If you missed Mr. Wagner‘s analogy, the stock market is that excitable dog while the value of the underlying businesses resembles the owner. The stock market reflects the collective prices of businesses at any given moment and as we know, stock prices are volatile.
And they’ll remain volatile because the stock market is trying to decide on the right price for a business based on the profits that business generates today and is going to generate long into the future. Imagine trying to predict profits for a business many years and decades down the road. Not that easy.
And not just that, the prevailing and future interest rates also play a role because they dictate the discount rate. And the discount rate is what gets used to discount those future profits and bring them to the present.
The aggregate value of all those future profits, once brought back to the present, is what makes up the fair value for a business (stock). More reading here if interested.
And millions of market participants, knowingly or unknowingly, duke it out each day in the stock market to arrive at the fair value for a business. Every new piece of information that changes the trajectory of those profits or those of the discount rates gets immediately reflected into a stock’s price so again, volatility will remain an inherent component of a stock market’s life.
But over the long haul and as Mr. Wagner was implying, the value of a portfolio populated with a healthy serving of diversified businesses will rise. It must rise because dividends, stock buybacks (indirect form of dividends) and the reinvestment of profits back into those businesses provides that perpetual upward lift to the value of that portfolio.
Benjamin Graham, the father of value investing, once explained this by stating that in the short run, the stock market is like a voting machine, tallying up which firms are popular and unpopular. But in the long run, the stock market is like a weighing machine, assessing the true substance of a company.
A roundabout way of saying that is that in the short run, stock prices can get stupidly volatile, both on the upside and on the downside. But that doesn’t and shouldn’t change the long-run value of a ‘good’ business.
How do we know if we own a long-range ‘good’ business? We don’t. We can hypothesize and create all sorts of scenarios that reduces the odds of ending up with a lousy business but then a totally unexpected event turns a perfectly fine business upside down, a business that has weathered pandemics and World Wars, a business that has survived recessions and depressions, a business that lasted for more than a century of everything the world can throw at it, can still go belly up overnight aka Lehman Brothers.
Or Bear Stearns.
Or a blue-chip business that steadily declines over decades like Sears.
Or Xerox.
You say Xerox? I saw that coming.
Not really.
Xerox was the Google of its time. Palo Alto Research Center or PARC, a subsidiary of Xerox, was in large part responsible for breakthroughs such as laser printing, ethernet, the personal computer (imagine that), graphical user interface, the computer mouse and many other technologies that literally changed our lives.
And you had every right to be a believer in that company and continue to remain a shareholder but if that was all you owned or if that was a major chunk of what you owned, you lost a bunch.
So, we diversify.
Owning ten different businesses in the same sector is not diversification. Because entire sectors can disappear or be left in a lurch for a long, long time. We don’t want to end up owning the next generation’s buggy whip and leather industries.
And when we are building a 50-year financial plan, we have to make some assumptions, and those assumptions should revolve around investments that can survive that timespan. They sure are not going to be those few stocks we think will get the job done because concentrated portfolios seldom deliver over decades long timeframes.
Portfolio design hence needs to be intentional. We don’t want to just slap things together with a stock here and a bond there and hope things work out. An ideal first step is to start with a baseline financial plan and incorporate investments that serve the primary intent behind that plan. Every investment should have a job to do.
And each investment in a portfolio should talk to other pieces in that portfolio. In fact, the many pieces should talk across accounts. Your 401(k) should talk to your partner’s 401(k) and your partner’s 401(k) should talk to your Roth IRA and so on. Compartmentalizing by account is never efficient. Some investments work better in tax-favored accounts like a 401(k) and others work better in taxable accounts.
And we want to expose enough of our money towards the many pieces in our portfolio to make a difference. One or two percent exposure to an investment category is not going to matter even if it were to shoot the lights out.
Getting the baseline structure right hence is key. And then building a process around how we are going to maintain that structure as our plan and our lives evolve.
Lasting money is an outcome of good financial planning. Money of course is not everything, but it buys some of the best things money can buy; peace of mind, great lived experiences and above all, independence…independence to live a life on our own terms.
Thank you for your time.
Cover image credit – Dariusz Grosa, Pexels