It is a fact of life that we need money to grease the wheels of commerce, to buy seed, machinery, trucks to move the grain, and so on. It is also a fact of life that the people wanting to do all of this stuff don’t have the money. How they get it is the opening move for investors who have to decide where to put their money.
Some investors choose business ownership with all the risks that go with it. Businesses may also borrow from banks or directly from the public through bonds that promise definite payment at specified times and eventual repayment of the loan.
If we put a magnifying glass on capital markets that trade stocks and bonds, we’d find layer after layer of information about risk. Risk, after all, is what makes stocks go up and down. Bonds with absolute certainty of payment of interest and repayment of principal offer less risk and so attract investors who want certainty of payment of interest once or twice a year and exact payment of principal when the bond matures. Both stocks and bonds have the common characteristic that the greater the risk of loss, the higher the payoff has to be.
The question ultimately is how much risk to take. Too often, investors let others make their decisions, then find they have losses greater than they expected. Says Brian Roberts, who has a mixed grain and cattle farm on a section of land near Didsbury, Alberta, “I lost $172,000 in just eight months starting in mid-2015 with a portfolio constructed by an advisor who put me into bonds, a Cuban resource operation, energy stocks, real estate investment trusts and other assets I did not understand. I trusted him, so I did not ask the right questions. I took him at his word. Looking back, I should have tried to understand the investments. We made a little in good times, but we lost more when times were bad.”
You might ask, why bother to take a chance on risky stocks, which almost inevitably plunge from time to time, when a government bond, which is a sure thing, can be had with a phone call to an investment dealer or via a mutual fund of government bonds?
The answer is in the payoff. Jeremy Siegel is professor of finance at the Wharton School of the University of Pennsylvania. His research into stock and bond returns is used worldwide. He sets the standards and measurements of risk and return. Here is what he has found:
Using U.S. data, because there is so much of it and for much longer periods than Canadian data, Professor Siegel found that from 1802 to 2012, U.S. stocks had a compound annual return of 6.6 per cent, bonds 3.6 per cent, gold 0.7 per cent and the U.S. dollar — always eroding through inflation — -1.4 per cent. One U.S. dollar put into any of these categories and kept invested by an immortal asset manager running the portfolio for two centuries would have turned into $704,897 in stocks, $1,778 in bonds, $4.52 in gold or just one nickel, that is, five cents, in currency. That is why one buys stocks. The payoff is too huge to ignore, as Siegel shows in his book, Stocks for the Long Run. But what one must ignore is the propensity of stock markets to crash.
The stock market roller coaster?
Thus the paradox: Stocks have lost more than 20 per cent in brief periods as long as I have been investing. There was a flash crash of 23 per cent in 1987, then a down spike driven by interest rate increases in 1991, another crash in 1998 spurred by the almost simultaneous collapses of Long-Term Capital Management (a hedge fund in Connecticut), the wreck of Thailand’s currency, and Russia’s default on many of its bonds. In 2000 markets were sunk by the popping of the dot com bubble, then in 2001 by the tragedy of the Twin Towers, then in 2008 by the implosion of the mortgage market and the collapse of American investment dealer Lehman Brothers. Markets crash every decade and sometimes more often than that, even though statistics predict that declines of more than 25 per cent should only happen, on average, once every few hundred years.
You could say that only a fool would put money into such a roller coaster, but that would be wrong. Let’s reconsider those crashes. It becomes a matter of scale. If you watch stock prices minute by minute, as day traders once did before losing their minds and fortunes, you see tremendous volatility. A stock may rise or fall a few per cent in a matter of minutes but at the end of each day it will be close to where it started or to the market trend. A few companies may fizzle, such Enron or Bre-X, but most companies survive and eventually see their shares rise in price. The drivers are management, which must appease investors to stay employed, technical innovation and inflation.
Let’s look at stock prices again, now in a moving 20-year weekly average. Take any stock or major average, say the biggest 60 companies listed on the Toronto Stock Exchange, and write down its price at a given day, or take the five closing prices for the week and divide by five. Do this for 52 weeks a year for 20 years and move the average ahead by one week every seven days. The line will be almost perfectly straight with hardly a wrinkle. The angle will be the long-term return of stocks, say a six-degree up angle. Stick with the average and, in spite of crashes and other blowouts, occasional bankruptcies of a few companies, foolish ideas like the dot coms, which were tech companies often with no business plans at all, you should make a lot of money. All it takes is patience.
Let’s talk about patience. Seventy per cent of all returns of stocks are dividends. If you buy shares of a company with a history of paying dividends and raising them steadily, you will be paid in good times and bad. The dividends can be reinvested in the stocks if you wish via Dividend Reinvestment Plans (DRIPs), or taken as. Almost all of the biggest stocks pay dividends. Chartered banks pay in a historical range of three to five per cent of the stock price. Telecom companies like BCE Inc. pay four to five per cent. Add a conservative two per cent for annual increase in price of the stock and you have a probably rate of growth of, say, four per cent dividend and two per cent price or six per cent. A six per cent annual return, which is not even taxed if it is inside a Registered Retirement Savings Plan or in Canadian stocks inside a Tax-Free Savings Account, will make $1,000 grow to $2,191 in 20 years. If you add $100 a year for 20 years, the investment will become $5,288 in 20 years. Such is the reward of patience and commitment.
To diversify, do it yourself. There are many DIY lessons to be found the vast array of investment books and just by reading the financial press, or by watching financial news on television. Study and read and the odds are that, even with a few flops, patience and use of dividend paying stocks will let you build up a tidy sum. Add some growth companies that pay small or even no dividends, do your research yourself so that you have a feel for the assets you shop for and buy. That way, you’ll have a good shot at diversifying into profitable off-farm investments.