PREVIOUS RELEVANT POSTS
My journey to financial freedom
Financial freedom: how to get it
The math behind getting financial freedom
WHY INVEST IN STOCKS
If you read the last post referenced above then you have seen how important the percentage growth rate is to growing your nest egg. Small percentage differences over a long period of time make a very large difference in the amount of wealth that’s ultimately built. For this reason, I have focused much of my efforts on achieving high rates of return. Investors can choose from a variety of asset classes to grow their wealth. The most commonly discussed asset classes are stocks and bonds. In addition, real estate, cash (US dollar and other currencies), precious metals, and, more recently, cryptocurrencies include some of the alternative asset classes for investors. For now, we’ll just compare stocks and bonds.
STOCKS VERSUS BONDS
What are stocks and bonds
A stock is an ownership stake in a business. You can think of a share of stock as a tiny slice of the whole pie. Generally, if the whole company increases in value then your share will increase proportionally. The owner of the stock will participate in the success of the business. A bond, on the other hand, is a loan usually to a company or to a government. The bond pays interest, usually a fixed rate for a fixed period of years, and, at the end of this term, the initial capital is returned to the investor. The interest rate on bonds is dependent on the risk of default with the highest rates offered on so-called junk bonds which have a highest chance of default. Historically, stocks, as a class, have outperformed bonds.
Historical returns
| Asset | Average Annual Return (1928-2020) |
|---|---|
| Stocks | 12.06% |
| Baa Bonds | 7.50% |
| Treasury Bonds | 5.28% |
| Treasury Bills | 3.36% |
From 1825 through 2020 (a span of 195 years), the average annual stock market return was 9.64%. From 1928-2020 (a period of 93 years), the average return was 12.06%. Since WWII (the 75 years including 1946-2020), the average return was 12.70%. It’s almost common knowledge that on average stocks outperform bonds.
Let’s look at how various types of bonds performed from 1928 through 2020. U.S. Treasury Bills (short term bonds) returned an average rate of 3.36%. U.S. Treasury Bonds (long term bonds with a 30-year maturity) returned an average rate of 5.28%. Baa corporate bonds, which are considered the lowest possible investment grade bonds but still lower risk than junk bonds, returned an average rate of 7.50%.
Distribution of annual returns
If stocks perform better than bonds, then why would anyone invest in bonds? I think it’s a great question. The answer to this question may lie in the distribution of annual returns. Yes, the average return of stocks has been almost 9% higher than the safest bonds, but what can happen in any given year or series of 2-3 years can be important to either a person’s life situation and/or his psychology. We’ll get to that in a second, but let’s first look at the following table which shows the distribution of returns for stocks and various types of bonds over the 93-year period from 1928 through 2020.
| Asset | -40% to -50% | -30% to -40% | -20% to -30% | -10% to -20% | 0% to -10% | 0% to +10% | +10% to +20% | +20% to +30% | +30% to +40% | +40% to +50% | >+50% |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Stocks | 1% | 2% | 3% | 5% | 14% | 16% | 22% | 16% | 15% | 3% | 2% |
| Baa Bonds | 0% | 0% | 0% | 1% | 14% | 52% | 27% | 6% | 0% | 0% | 0% |
| T-bonds | 0% | 0% | 0% | 1% | 17% | 61% | 15% | 4% | 1% | 0% | 0% |
| T-bills | 0% | 0% | 0% | 0% | 0% | 96% | 4% | 0% | 0% | 0% | 0% |
Yes, stocks averaged 12.06% in the 93-year period, but they also had a much wider distribution of outcomes, losing money in 26% of the years and losing 20% or more in 6% of the years. People in the later years of life may not be able or willing to tolerate the chance of large losses because such a loss may mean not have enough assets to meet their future expenses; older people also have fewer years to recover from a loss. Others may have a psychological aversion to financial losses even if they’re shown the data that stocks outperform bonds over a long period. The aftermath of dotcom bubble and the great financial crisis of 2008-2009 likely has left deep scars in the psyche of some, making them more risk averse. While bonds have a higher chance of a positive return in any given year, the returns from bonds will almost certainly be insufficient to lead to financial freedom.
Inflation and real return
Inflation is the erosion of purchasing power. Inflation of 2% means that goods that cost $1 this year will cost $1.02 next year and about $1.04 in two years. Thus, when we look at the historical returns for stocks and bonds, we need to subtract inflation to get what’s called the real rate of return. The returns in the 1928-2020 period that we previously examined yielded lower returns when adjusted for inflation. From 1928-2020 inflation in the United States averaged 3.01%. Therefore, the real rate of return, adjusted for inflation, for stocks was 9.05% (12.06% less 3.01%). At this rate, the purchasing power of the funds invested in stocks doubles in eight years. And note that the time period that I selected for the calculation began at the start of the Great Depression, the worst decline in U.S. stock market history; in spite of this, stocks still increased by 9.05%, even after adjusting for inflation! By comparison, T-bills (short term bonds) which give the most “security” gained 3.36%, but after inflation the average annual gain was only 0.35%. Doubling purchasing power at this rate would take 198 years! The highest yielding investment grade bonds gained on average 4.49% per year after subtracting inflation. At this rate, money doubles in about 16 years.
In summary, stocks have outperformed bonds over the long run. Stocks have more down years, and, occasionally, they’ve had multiple down years in a row. In fact, since 1928, there have been four instances of more than one down year in a row: 1929-1932, 1939-1941, 1973-1974, and 2000-2002.
OTHER BENEFITS OF STOCKS
In addition to providing higher average returns, stocks have several other benefits.
- Ease of trading: Opening a brokerage account to trade stocks is easy. Online trading enables stocks to be bought and sold within seconds from anywhere that has an internet connection. I’ve even traded from the jungles of Papua New Guinea.
- Liquidity: Aside from some stocks that are very thinly traded (i.e. a low number of shares bought and sold daily), getting in and out of a stock investment can be almost instant. I can sell a stock and in less than a minute have bought a different stock. By contrast, liquidating a real estate investment can take many months.
- Readily available information: Stocks that are listed on the public stock exchanges are required to provide quarterly financial statements to the public. This publicly available information is essential for properly evaluating a company for investment. Again, this information can be accessed from anywhere with an internet connection.
I particularly like the flexibility that stock investing provides. I can research stocks at any hour of the day or night that I choose while being completely untethered geographically!
AVERAGE: USUALLY BETTER THAN NOTHING
A person can do zero work and invest in the stock market. The stock market historical returns referenced above were for the S&P 500 (1957-2020) and the S&P 90 (1928-1956). If someone wants to do no work and get the S&P 500 return, he can just buy an S&P 500 index fund and pay almost no fees (imbedded or otherwise). In this case, he’s buying a proxy for the U.S. stock market as the S&P 500 captures about 80% of the tradable U.S. market capitalization. There’s no need to pay a financial advisor if the objective is to meet the market returns. With stock market investing, being average requires no effort and no fees.
BEATING THE MARKET
Achieving better than average returns will require effort. I’ve chosen to seek better than average stock market returns. To beat the average, one must only eliminate one company in the S&P 500 index that will perform poorly and replace it with (or increase the allocation of) one that will perform better. While this may sound simple, most money managers fail to beat the market average! In a 2019 report, 85% of large cap fund managers failed to beat the S&P 500 after 10 years, and 92% of them failed to beat the index after 15 years. And these guys (and gals) are taking a cut for underperforming. Wow! Perhaps this is the reason why many (perhaps most) people believe that it’s not possible to beat the market. But it’s a myth. Beating the market is possible. Saul Rosenthal, an ordinary guy with no MBA and no finance background, has averaged in excess of 25% stock investing returns over a 30-year span. Saul’s now 84, and he’s still at it, investing the vast majority of his assets in a handful of stocks. He’s shared his knowledge. I’ve been investing exclusively in growth stocks since I found Saul in 2014. Since I started diligently tracking my investment returns at the start of 2017, my portfolio has increased by 1290% (CAGR: 90.1%) compared to the S&P 500’s 86% (CAGR: 16.4%). Four years of tracking is not that long so perhaps my returns will revert to the mean. Based on Saul’s 30+ year track record, I don’t believe that will be the case, and I plan to continue investing in growth stocks as long as it keeps working for me.
GROWTH STOCKS
Growth and Value Stocks
Most people have heard of growth stocks and value stocks. Growth stocks are rapidly growing their revenues; some growth stocks may also be profitable and may also have fast growing earnings/profits. Value stocks are typically more mature companies that, by conventional valuation methods, trade at a discount of their intrinsic value. Warren Buffett, using the teachings of his mentor, Benjamin Graham, invested for decades by finding companies with stock prices discounted 20% or more compared to their intrinsic value. Some people prefer value to growth because growth stocks are often considered by many to be overvalued and difficult to assign a value. Rapidly growing companies are indeed more difficult to value, and if they don’t continue their rapid growth, then their stock prices can plummet.
Investing in Growth Stocks
The key to successful growth stock investing is to find companies that are already growing fast and will continue to grow fast. The former is easy as one can just look at the past performance to see what the growth was. Predicting or forecasting which fast growers will continue to grow into the future is the challenging aspect. This is especially the case because a fast grower that slows down will often see its valuation multiple of sales compress leading to a steep stock price drop that’s very unpleasant.
Predicting a company’s future success involves examining and tracking the company’s financial performance and other key performance indicators. However, this is not enough. A successful growth stock investor must also study the competitors and all other aspects the company’s end markets. The details and process of growth stock investing will be covered in subsequent posts.
Growth stock investing can lead to large outperformance of the S&P 500. However, even the best, most successful growth stocks are typically quite volatile and can sell off by 30% or more at times before eventually reaching new highs. Therefore, investing large allocations in growth stocks is not appropriate for everyone, especially not for risk averse people or those not willing to put in the necessary work.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.