While eating lunch in the cafeteria of Unum’s headquarters, two scholar interns were discussing investments. More specifically, they were talking about how cool it would be to work in Unum’s investments division, even though they (for the most part) deal with bonds. I believe they thought bonds were boring financial products, which is far from the truth. This took the two aspiring financiers into a discussion about stocks and how day trading would be a sweet gig; then, another scholar across the table asked a question: isn’t it a risky time to invest in stocks? One of the soon to be JPMorgan analyst chimed in and the only thing I can remember him saying was, “and that’s how compound interest works.” The thing is, that was a great question. Why should anyone invest in stocks when they fluctuate so much?
There are two sources of potential income for a common shareholder of a corporation, dividend income and capital gains. Dividends are just payments to shareholders, and capital gains are acquired when one sells their stock at a price higher than their initial purchasing price. A corporation usually pays dividends on a quarterly basis, but they are not contractually required to pay dividends, unlike bondholders. If a corporation doesn’t pay dividends, what’s the point in investing in the stock? Well, first off the corporation has a choice to make; they can either pay dividends or reinvest the earnings. If they decide to reinvest all of their earnings back into the company, the hope for the shareholder is that those earnings will help generate more earnings and the stock will in turn appreciate in value. Usually, the corporations that don’t pay regular dividends are small to mid-size. The witty intern (read with a hint of sarcasm) would have called these small to mid-cap stocks, meaning that their market capitalization (share price x number of shares in the market) is relatively small compared to others. These corporations usually need the capital in order to grow. Secondly, the corporation may think that other methods will provide shareholders a better return, such as a repurchase program, stock dividends, or other means. Furthermore, shareholders can save in taxes if dividends aren’t paid. Shareholders pay taxes on both dividends and capital gains, but if an investor holds a stock for longer than a year, the capital gains tax is lower than dividends that are treated as ordinary income. So, a stock doesn’t have value just because of cash dividends. Capital gains and its evil brother we sometimes forget, capital losses, are where investing in stocks becomes interesting.
Stocks are traded on the open markets and their price fluctuates based on the laws of supply and demand; the supply and demand changes are a function of the opinions of millions of people. The big risk with investing in stocks is that you may be strapped for cash when the price is much lower than when initially purchased. If you’re into finance, you’ve probably heard or read, “investing is as much of an art as it is a science.” For me, trading is an art, because the day to day fluctuations in the stock market are random. An artist doesn’t know that his current work will make him millions. Who knows what people’s opinions will be or what price they will pay. Just as the artist doesn’t know how much an individual will pay for his art, so too does a trader have no idea how much the price of a stock will be worth in a month. As an investor (not a day trader) hedging these fluctuations is simple. Don’t buy just one stock, buy the market.
The easiest way to hedge against the individual, seemingly random, fluctuations in the stock market is through diversification. The phrase, “Don’t put all your eggs in one basket”, is describing the basic premise of diversification. If you own one stock, you are helpless to the ups and downs of that one stock, but when you add more stocks your risk decreases. Oddly, when you add two very risky stocks together, their aggregate risk can be less than either one alone. This is possible because each stock doesn’t always move in the same direction, and in this case, both stocks can move in opposite directions relative to each other. Some stocks do move in the same direction, for the most part, if they’re in the same industry. When Exxon’s stock decreases, Shell’s stock most likely will too. But, McDonald’s stock is in a completely different business than Shell and Exxon. It doesn’t move in the same direction usually. The relationship between two stocks (or any two variables) is measured by their correlation, and it’s the driver in diversification. Holding multiple stocks together or any combination of assets forms what is called a portfolio. Below is a graph showing the standard deviation of a portfolio when you hold a certain number of stocks.
The risk drops dramatically when you increase the number of stocks, then levels off. This individual stock risk is called unsystematic risk. When you own a product that replicates an index (a large collection of stocks), such as the S&P 500, the individual fluctuations cancel each other out (their behavior is uncorrelated). Unsystematic risks are risks that are specific to individual stocks. The residual risk left over is called systematic risk. An example of systematic risk is the recent Fed rate increases. Treasury interest rates are the benchmark for other corporate debt. To keep the spread between corporate debt and treasuries the same, corporate borrowing rates must also rise. This event affects all corporations and can lower overall stock market levels. The tool to combat systematic risk is time. In the world of investing, diversification and time are your friends. If you don’t need to sell, fluctuations in prices don’t matter. A bondholder (without an embedded call option) can hold a bond to maturity and care less about the current market price. He’ll only have to worry about the reinvestment risk of his coupons. The same is true with shareholders; except, with stocks there isn’t a maturity date to wait for your principal to be returned. The thing is, the scholar intern who asked the question was thinking about the short-term riskiness of stocks, while diversification basically eliminates unsystematic risk. We will shortly see that, in the long run, even systematic risk can be minimized.
Below is a graph showing the monthly log returns of the S&P 500 from 1930-2018 annualized (you get the monthly return for 12 months). These returns only include price fluctuations and don’t include dividends. As you can see, the returns are all over the place. The average monthly return is 5.4% and the standard deviation is a whopping 52.59%, meaning the price fluctuates a lot.
The next few graphs show that when your holding period (or your investment horizon) increases the volatility of the market (systematic risk) decreases. Said another way, the longer you hold the position the less the risk.
The graphs calculate the holding period return annualized for each month. For example, the 5 year holding period starts at the first month and then sums the log monthly returns for 60 months into the future. This is the first bar in the chart. Then, for the next month (second month in the data set) the same thing is done and this is repeated. For each graph, you see that the pattern starts to change into something different. You see chunks of positive returns and negative returns, and these periods of ups and downs are called economic cycles. Finally, once we get to the 30 year holding period graph, we don’t see any negative returns. This means you could have invested your money any month from 1930-1988 for 30 years and have a positive return. These returns also have little volatility, exactly 1.233%, and the average return has increased to 6.89% (not including inflation).
The main takeaway is this: the longer you stay invested in the stock market the less risky it actually becomes and the closer you get to the average return for the S&P 500 from 1930-2018. So, now we can answer the question the scholar intern asked: isn’t it a risky time to invest in stocks? The answer is no, it’s not a bad time to invest in stocks if you choose a passive, diversified, long term investment strategy. A strategy like this will allow the intern, whom asked the question, to sleep easy at night. As for Mr. Day Trader, he’ll take on the extra risk, to try and beat the market. He may succeed, but on average he’ll fail and more likely than not won’t sleep as easy.
Sam
Trader Joe