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The Most Important Investing Risk


Published October 5th, 2015

The stock market has averaged compound total returns of about 9% a year over the last 100+ years.

This means a doubling of your money about every 8 years.

When your money doubles every 8 years on average you will eventually become very wealthy.

And that’s only if you match the market returns.  Surely, some investors should beat this ‘average’ return by a substantial amount.

So why aren’t there more rich and ultra-rich investors if it really is that easy?

The Sad Truth

The sad truth is, it is not that easy.

On paper, investing is very simple.  But we don’t live on paper.

Real-life investors (unless you are a robot, that is you) greatly underperform the market.

Case-in-point:  Over the last 20 years, the S&P 500 has averaged 9.2% annual returns.  Individual investors have averaged returns of 5.0% a year over the same time period according to the 2014 DALBAR QAIB Study.

There is no reason at all individual investors should greatly underperform the market – but they are.

The Most Important Investing Risk Is You

The reason individual investors fail to beat – or even match – the market is because we fail to follow a consistent strategy when times get tough.

Simply put, we panic.

We have been in a strong bull market for much of the last 6 years.  It’s easy to be a great investor during bull markets.  A rising tide lifts all swimmers, after all.  But…

“It’s only when the tide goes out that you discover who has been swimming naked”

– Warren Buffett

Bear markets, panics, and market crashes are what destroys individual investment returns.  When the market tide retreats, don’t get caught without your swimming suit.

It’s not the paper losses that are what destroys individual investor returns…  The S&P 500 experiences those as well, and average returns for the S&P 500 are 4.2 percentage points higher than average investor returns.

What destroys investor returns is panic selling.

You see that ‘amazing’ stock you bought go down 30%, 40%, 50%, or more, and think “this was a terrible investment!  Time to sell before it goes down to 0”.

The error in this thinking is looking at a stock as nothing more than a lottery ticket that bounces up and down in value based on the whims of some ‘invisible hand of the market’.

The good news is that investing isn’t nearly that scary.

A stock is just fractional ownership in a business.  As an example, Wal-Mart (WMT) is one of my favorite businesses to own for bear markets.  The company has about 3.2 billion shares.  If you owned 3.2 billion shares of Wal-Mart, you would own the whole company.  If you own one share, you own 1 3.2 billionth of Wal-Mart.

Wal-Mart has generated about $485 billion in revenue over the last 12 months.  If you own one share, your share of that revenue is about $151.  Wal-Mart has made $15.5 billion in profits over the last 12 months.  Owning one share means your share of that profit is around $4.80.

If you owned a business, you might not want to take all the money you made out of the business.  Instead, you might want to reinvest some of that money in growing the business.  Wal-Mart is no different.  The company pays currently pays out $1.96 of its ~$4.80 in profits to shareholders in the form of a dividend.  The rest is reinvested back into the business for future growth.

When you think about your stock holdings for what they really are – fractional ownership in a business – then you will be less likely to sell when the price goes down.

Wal-Mart’s stock price has declined 9.8% over the last quarter…  But the business is still largely the same as it was 3 months ago.

Some investors will sell because the stock price fell, but that doesn’t make sense.  The business of Wal-Mart has not changed. Only other people’s perception of Wal-Mart stock has changed.  This shouldn’t have any merit on your investing decisions.  Only the underlying health of Wal-Mart’s business should effect your investment decision in the stock.

This section of the article is titled “The Most Important Investing Risk Is You”.  That is very true.

When you invest in high quality dividend growth stocks, the risk that you will sell because of a stock price decline is far greater than the risk that a high quality business will experience a permanent decline.

Simply put, if you want to generate market beating returns you have to have the commitment and fortitude to hold your stocks and add to your positions (if possible) during market declines.

Professionals Are No Better

As a quick aside, professionals are not much better than individual investors.

It’s true, there are a few notable exceptions – Warren Buffett, Seth Klarman, Peter Lynch, Benjamin Graham, Jim Simmons, George Soros, Carl Icahn, Joel Greenblatt, and a few other investors really have trounced the market over very long periods of time.

Those investors are not who I’m talking about.  I’m talking about your ‘average’ mutual fund manager, investment advisor, financial advisor, etc.

The truth is that 86% of investment managers failed to beat the market in 2014.  I don’t like those odds, and you shouldn’t either.

2014 was not some wild aberration either.  Professional investors have a long history of failing to beat the market after accounting for their fees.

How to Match (or beat) the Market

A few paragraphs back, I used Wal-Mart as an example.  Wal-Mart is a member of a select group of 52 stocks called the Dividend Aristocrats Index.

These are stocks that have increased their dividend payments for 25 or more consecutive years.  Think about that… That’s a long time.  To pay dividends for that long, a business must have a few things:

  1. A well-defined dividend policy
  2. A strong and durable competitive advantage
  3. A slow-changing market with favorable long-term growth prospects

That is the type of business I want to invest in.  Who wouldn’t want their business investments to pay them more over time, consistently and reliably?

It is common sense to invest in strong businesses.

As it turns out, common sense is not wrong, at least in this case.  The Dividend Aristocrats Index has outperformed the market by over 3 percentage points a year over the last decade.

The Dividend Aristocrats have reached these returns with less risk.

You can see the complete list of all 52 Dividend Aristocrats at this link.

Not all high quality dividend growth stocks are Dividend Aristocrats, but all Dividend Aristocrats are high quality dividend growth stocks.

Know What You Own

When you own parts of real businesses, and know they are of a very high quality, you will have greater confidence in your investments.

The next time Coca-Cola (KO) falls 30%, look at it as an excellent opportunity to buy a high quality business at a steep discount.

This is the exact opposite of what most investors think.  If they see Coca-Cola stock price fall 30%, they will think “Time to sell!”…  All because of a price.

Imagine a world where coupons (discounts) made people buy less.  The stock market is this crazy world.  People tend to buy more, when prices rise.

If you go into a grocery store, and they say – “Great news!  Use this coupon to pay an extra 50% for your vegetables”, you would think they’ve lost their mind…  Yet when a stock goes up 50% in a short period of time, people rush in to buy more.

When you know what you own, and why you own it, stock price declines lose much of their anxiety producing effects.  Stock price declines become nothing more than sales.

Final Thoughts

The single greatest determinant of your investing success is you.

That’s great news.  But it means you must control how you think about investing.

When you own high quality businesses, you can separate the fickle stock price from the stability of the underlying business.  You will see yourself as a partial owner of a great business, rather than someone with a lottery ticket for a certain ticker symbol.

This shift in thinking has already helped many individual investors to take advantage of market corrections rather than succumb to them.  There are still a great many more investors that need to hear this message, however.

Most importantly, to match or beat market returns, you must maintain your convictions in the face of falling prices.

 


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