Let’s have a heart to heart talk about the fundamentals of investing on the farm and off the farm and, for that matter, investing in education for a career or a used car.
Every investment has character, whether it’s a tech stock and you have to bet on a new trend or product on the Internet, or a bland government bond that rises and falls with inflation and interest rate forecasts. But behind the unique characteristics of the asset you are considering are the fundamental odds of winning and losing. Investing is all about risk. Take out the words about one thing or another and there is nothing but risk!
Let’s take an example. If a trade or an investment in anything has a $10 gain to be had and a probability of working out profitably 99.9 per cent of the time, but can generate a $5,000 loss the other or 0.1 per cent of the time, then it has a positive expected value. The payoff would be $9.99 and the potential loss $5. But if the $5,000 loss has a 0.2 per cent chance of occurrence, a $10 potential loss, then the trade or investment has approximately zero value. And, if the same bet has a chance of 0.3 per cent of the time, a $30 potential loss, it has a negative expected value.
The example has two parts, both vital to the foundation of investing: what are the odds of winning and how much do you want to bet? The way the example is set up, the odds are dramatic and not really characteristic of the market. Few investments are 99.9% sure to win and most have much more than a 1/10 of 1 per cent chance of losing.
Inflation and survivor bias
Now let’s look at the reality of investments. As you will see, time is on the side of the patient investor and dramatically improves the odds of winning.
You can make stocks, well, almost, win over periods of decades based on two key observations:
1. Inflation: Inflation pushes up asset prices. The price tags on steel girders, oranges at the store, a ton of potash fertilizer and a combine all rise over time. They do not rise evenly, but if you are diversified, you will gain in the end. Corporate earnings fattened by higher prices for the things or services they sell will rise. The real value of earnings after inflation may not be higher, but the bottom line will be fatter. Inflation creates nominal gains for most businesses.
2. Survivor bias: Survivor bias kills off losers. Survivor bias, the phenomenon that any diversified index automatically drops the losers and the bankrupt and adds the winners that qualify for inclusion, means that there is an upward bias in the S&P 500, the Dow Jones Industrial Average and, for that matter, indices of German pharmaceutical makers and Japanese steel makers. The survivors are always the winners and the losers that drag down averages vanish. So any broad index has survivor bias working for it. The key word is “broad”.
Playing survivor bias to the max means ensuring that winners keep pulling up the index. But winners are winners for only so long. In the 1950s there was a list of supposedly sure thing winners called the Nifty Fifty. They were the biggest stocks on the New York Stock Exchange. The list included Eastman Kodak. The film biz fizzled in the age of digital photography. Kodak filed for bankruptcy in 2012, then emerged as an operating company in 2013. If you want an index, buy a broad one. Narrow indexes defeat the concept of having the winners rescue the averages even if some firms or sectors are flops.
Does this always work? Well, no. If the downdraft is strong enough, as it was in 1987 when the New York Stock Exchange dropped 22.6 per cent on Oct. 19 and, the same day, Hong Kong shares fell 45.8 per cent, diversification alone will not help. You had to wait for recovery, which did happen.
It also goes the other way. The bond market has ended a remarkable 33-year bull run driven by annual interest rates that fell from double digits per year for 10-year government bonds to low single digits in 2016 when some government bonds, especially in Europe, offered negative returns.
But the broad bond market, which includes high yield or junk bonds, having had lots of ups and downs in the last three decades, is still going strong. The point: the wider your diversification, the more secure your wealth both in financial markets and in the vast world of stocks and bonds and real estate and, for that matter, wheat and flax and eggs. Collectively they rise with inflation and cross stimulation.
Each index has its own distinctive responses to economic conditions, volatility and sensitivity to underlying currency changes. The complexity of the indices and their interrelationships implies that one should buy not just one but perhaps a few with relatively little covariance. The idea is that they should not dance together. Thus the Dow 30, which is heavily American (though companies do have global businesses) and the EuroStoxx 50 are less interrelated than the Dow 30 and the Russell 2000, each a sample of the U.S. market.
Asset category diversification is a basic method of putting at least some money out of harm’s way when markets plunge. The other way is the simple process of rebalancing, that is, selling stocks that have done very well and buying those that have not. The argument against this kind of asset rebalancing is that many stocks are long-term winners. Followers would have sold off much of Warren Buffet’s Berkshire Hathaway, one of the most successful conglomerates of all time, and missed out on its extraordinary internal growth from US$20 a share in 1967 to a recent value of US$246,250 per share. However, rebalancing at a fixed time of the year, say quarterly or annually, does reduce risk and maintain growth.
So we come back to the idea that all investing is just risk management. You could say it’s one idea with many flavours. If you concentrate risk in one company or one industry, you are betting that you know the winner to be. It’s a tough call. If you spread the risk to a market, as the S&P/TSX does for public companies in Canada, you reduce your risk and buy safety at the price of not being 100 per cent in winners or, of course, 100 per cent in the losers. Indices that automatically shear off losers and boost their performance with inflation almost guarantee long term gains.