Top 5: Future innovations that will make a killing in the stock market

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Welcome back to my Top 10 list of industries that will create new trillion dollar companies.  On Monday we covered 10 to 6 with: marijuana, fake meat, virtual reality, curing diabetes, and sport gambling.  If you didn’t read it, you may want to check it out.

On to the show.

5. Video conferencing:  This is another one of those things we see in science fiction movies all the time, but what we have today still falls flat.  Today’s technology isn’t always reliable, the cameras aren’t that good, they don’t follow the subject (center it), you have challenges with people talking over each other, and even slight delays make it a farce.

That’s a pretty big list of complaints but the potential is there.  Even with today’s very flawed offerings, you can see the promise.  And there is no question of the need.

When I was a consultant we had meetings about once per month that had maybe 40 people come together.  Let’s say half of them had to fly in.  Flights, hotels, meals while traveling come to about $2000.  Plus you have all the lost time.  To get there and back on a plane takes two days lets say.  If each person in that room makes $150,000, those two days, less the time of the 4 hour meeting is about $1000 each.  All said, just to have that meeting with everyone there face to face costs $60,000 or more. 

Once the technology gets there, you can have those meetings at a fraction of the cost.  Plus, as it becomes more convenient, you’ll have a lot more “face-to-face” calls instead of phone calls or emails.  Obviously communication is much more effective if you can do that rather than just have audio or text.

There’s a ton of money to be made here, and I don’t think we’re really that far away.  It’s just making it as streamlined and simple as making a phone call is today.

4. Online shopping:  Many will say this is already there—Amazon, anyone?  In fact, e-commerce only represents about 10% of retail. 

The big rocks I see changing in the next couple years are groceries and prescription medicine.  I know right now they’re there, but it seems pretty limited.  The Fox household cannot get online grocery delivery from Amazon.  We can’t even get it where we order groceries online and them pick them up from the closest Walmart.  So there’s room for improvement there.

Beyond that, especially as you start leveraging other advances (drone technology maybe, and VR #8) you can imagine a lot of other markets opening up.  If I was smarter I could tell you exactly what it would be.  However, with only 10% penetration, e-commerce has already made Amazon a trillion-dollar company.  As penetration drives to 20%, 30%, and on, there’s no reason to think it won’t spawn more trillionaires.

3. 3D printing:  This is a bit of a backwards technology—the solution came before there was a problem to solve.  At Medtronic in 2014 we got a 3D printer and everyone thought it was super cool but it didn’t do anything.  It was huge (about the size of a phone booth, cost $300,000, could only “print” in one material, and only a few of the guys in the machine shop knew how to use it.  Honestly I think the most use it got was making trinkets for the local elementary school who came to our facility for a field trip.

 This year I went to a “STEM in schools” conference and there was one for $2000 that could print in up to 4 different materials (different colors but all the same material).  Clearly the technology is advances.  Now it just needs that “killer app”.

Again, predicting the future is a good way to look foolish.  Long-term you could imagine a 3D printer “printing” food and body organs, but that’s Jetson’s stuff still probably decades off.  In the more short-term I think it can revolutionize some medical device industries like orthopedics (about $50 billion in annual revenue) and dental crowns ($10 billion), just to name two off the top of my head.  You could also imagine more mundane things like plumbers and construction guys always having the perfectly sized piece. 

2. Solar panels:  Our appetite for energy will only continue to increase.  As political forces curb fossil fuels, renewables like solar become an obvious solution.  Over the past few years, solar has definitely gained traction and grown a lot, but it’s still only about a billion-dollar industry.

What makes me optimistic is that the economics work.  We installed panels on our roof about 3 years ago, and they have a long-term return of about 4%.  Since then panels have gotten better AND cheaper, so a similar system today would cost about 10% less than we paid and generate about 10% more.  That pushes that return up to about 6-8%.  For a risk-free rate, that’s amazing.  Everyone should be doing this.

Also, what makes me optimistic is that there’s a ton of room for growth.  It struck me when I flew in Los Angeles.  On the approach you pass over about 50 miles of urban sprawl.  There’s millions of roofs, and only a small, small fraction have solar panels.  And that’s in LA where the political climate is so pro-solar that they require new buildings have solar panels.  If there’s that much opportunity in a place like LA, imagine the rest of the country and the world.

1. Self-driving cars:  This is the biggie.  Just goofing around with Mike, a loyal reader who predicted this as the #1, I thought this could generate $5 trillion in value.  Now I wonder if I underestimated that figure.  Realizing the dream of a fully-automated car has the potential to be as big an innovation as the personal computer or the internet, and those created a few trillion-dollar industries.

Where to start?  First it will allow the current automotive industry (currently about $1 trillion in annual revenues) to offer a product SIGNIFICANTLY better than available now.  There’s a ton of money to be made there.  If you’re willing to pay $25,000 for an Accord today, how much if that same car drove itself?  $40,000 or $50,000?  More?

There’ll also be a real estate boom.  Real estate just in Manhattan is worth about $2 trillion.  Let’s say 5% is dedicated to parking facilities—that $100 billion just in Manhattan that can get redeployed.  Extend that to every city in the world and your talking trillions. 

Also, there’ll be a boom because real estate in outlying areas will increase.  Today, let’s say a person is willing to commute up to an hour.  So communities that are over an hour away from where jobs are lose a lot of value.  If cars drive themselves, people will gladly commute longer because they aren’t driving, they’re just browsing on the internet or watching movies.  Those communities will drastically increase in value due to higher demand.  Imagine that across suburbia and you’re similarly talking trillions.

Plus roads will last longer because computers don’t drive like idiots they way people do.  Tires and other auto parts will last longer for the same reasons.  The auto insurance industry just in the US has about $300 billion in revenue and that will be turned on it’s head.

Oh, and there’s that little thing call humanity.  The 35,000 annual fatalities and 3 million injuries will fall dramatically.  That’s probably worth a couple trillion right there.

I could go on and on for these, and I am sure there are others that are equally promising.  The pint is the future of investing is bright.  There are going to be amazing companies that are going to continue to create amazing value for those who are invested.

Top 10: Future innovations that will make a killing in the stock market

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All the stocks in the world add up to about $80 trillion.  I was surprised it was that low.  $80 trillion is definitely a lot of money, but for every publicly traded company in the world . . .

Interestingly, Microsoft, Google, Amazon, and Apple all have market caps of about $1 trillion.  That’s pretty astounding that a single company could be worth a trillion when all the companies combined are only worth $80 trillion.  It just shows you how big a really innovative company can get.

Second, look at that list—Microsoft, Google, Amazon, and Apple—either they didn’t exist not too long ago (Amazon, Google), or they did but what makes them valuable today are businesses that didn’t exist until relatively recently (Microsoft, Apple).

The point is that there are tremendous innovations that will come that will create tremendous value in the stock market.  As those four companies show, a single company with a powerful idea can really move the needle on the GLOBAL TOTAL.

Here is a list of 10 innovations that I think could easily create more trillion-dollar companies over the next few years.

10. Marijuana:  The past few years have seen a number of states legalize recreational marijuana.  I think it’s just a matter of time before it’s legalized nation-wide.

Right now the stocks of cigarette companies are worth about $700 billion.  The market capitalization for marijuana stocks is a tiny fraction of that.  Once the legal framework takes the brakes off marijuana companies, they are going to have a similar value.

In fact, it’s not unreasonable that marijuana stocks might be bigger than tobacco stocks.  Tobacco stocks are pariahs and they are constantly being harassed by different government agencies.  For what ever reasons, it seems the public is more accepting and embracing of marijuana compared to tobacco, so that removes a major headwind.

Second, there seem to be a lot more products that can be used with marijuana.  This is actually an area where Foxy Lady has been doing a lot of marketing consulting.  Obviously you can smoke it, but there’s also marijuana infused beverages, gummies, oils, and on and on.  It doesn’t seem like a stretch that marijuana could eclipse tobacco, and right now it is starting at pretty much $0.

9. Laboratory meat:  We just saw the IPO for a “fake meat” company.  The global meat market is a $1.5 trillion business annually. 

It’s also tremendously inefficient.  You have cows and chickens eating plants to “grow” the meat.  There’s a ton of pollution (cow farts, anyone?), slaughterhouses are disgusting, there’s the potential for nasty pathogens (hoof and mouth disease).  It’s just a messy, nasty, gross process.

If you can do that with grains and chemistry, you bypass all that.  Plus you use the land a lot more efficiently—you don’t need to grow plants to feed to cows which amass muscle; rather you just make the beef directly from the wheat and cut the cow out of the process.

Also, you can imagine that the process if you’re just dealing with tons of wheat and chemicals is much smoother than live animals and uniquely shaped carcasses.  This should certainly lead to lower prices per pound of meat while reducing tons of pollution.

8. Virtual reality:  VR has been the playground of science fiction nerds and more recently hard-core tech nerds, but it isn’t even close to the mainstream.  Today it mostly exists in the video game world, and even then it’s pretty marginalized.  VR games sell a tiny fraction of popular consul games, and even then the technology is still clunky.

Yet is there any question this will get better?  It seems a lot like cell phones from the 1980s.  Cool technology that just isn’t as good as the status quo, but it’s obvious to everyone that it will advance and once it does it will change the world.  That’s exactly what happened for cell phones, and I think that’s exactly what will happen with VR

Certainty the $160 billion video game industry will be transformed.  Movies and TV too.  But I think the real value will come from applications that people are just imagining right now.  Think of technical training—med school or pilots or the firefighters.  Think about the real estate industry and taking a tour of a home from your sofa.

The tech seems a few years away.  As that happens it will open up entire industries that we can’t even imagine today, just like cell phones did.

7.  Cure diabetes:  This one is near and dear to my heart (or rather my pancreas), after working for Medtronic Diabetes for so long.  Diabetes is a horrible disease.  Yet it’s very treatable and manageable.  Just monitor your blood sugar levels and treat accordingly (if your blood sugar is high, give yourself insulin).

Of course it’s never that easy.  Measuring isn’t always timely and precise.  Synthetic insulin doesn’t always work as well as your body’s own stuff.  And the biggest issue is diabetics aren’t always vigilant—it takes a tremendous amount of discipline to manage it properly and people sometimes let it slide.

Just in the US it costs about $250 billion annually to treat diabetes, and worldwide it’s probably about $750 billion.  Luckily, thanks to Medtronic and others, we are on the brink of curing this horrible disease.  Sensors are getting better, lasting longer and coming down in price.  Pumps are getting better and integrating better with the sensors so those together act more like a healthy person’s body.

As these treatments improve, you reduce the MAJOR costs of diabetes which usually results from not controlling it precisely enough.  You have ER visits, car accidents, blindness, amputations—Yikes.

6.  Sports gambling:  The Supreme Court opened the doors on this one two years ago, and now we’re all waiting to see how things unfold.  Revenue from US sports (college and pro) is probably about $100 billion.  Revenue from American casinos is about $50 billion.

With legal sports gambling, those two behemoths have the perfect baby.  Obviously right now there’s a huge black market that is coming into the legal fold.  Just being legal with expand the amount of sports betting by orders of magnitude.  As sports betting gets traction and becomes more accessible, with more locations or the holy grail—internet gambling—that will similarly increase the total betting total.

Add on to that the considerable synergies that sports betting brings to both sports revenue and casinos, this move seems like there’s easily a trillion dollars of incremental value compared to what exists today.

Here’s the first half of my Top 10 industries that will create trillion dollar companies that don’t exist today.  Again, remember that right now the value of all the world’s stocks is about $80 trillion.  So these 5 ideas could increase the pie almost 10% just on their own (and you haven’t seen the top 5 yet).

Come back Wednesday for the exciting conclusion to this list.

Why you should probably have more stocks and less bonds

buried-money

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When I wrote my three ingredients post, a few of you commented that I was crazy to have so much of our portfolio in stocks and so little in bonds (less than 1% in bonds).  Did I have a death wish or something?  What if I told you that I think a ton of people are leaving  gobs of money on the table because they are investing too conservatively?  Tell me more, you say.

We know that you need to balance risk and return in our investments.  This is most clearly done when we choose our mix of stocks (more risky, higher average returns) and bonds (less risky, lower average returns).  As an investor gets older they want to shift their asset allocation towards less risky investments because their time horizon is shortening.  We all agree with this.  So where is this hidden pot of gold I’m talking about?

Let’s look at the example of Mr and Mrs Grizzly.  They are both 65 years old and entering retirement.  They worked hard over the years and socked away $1 million that will see them through their golden years.  They do some internet research and learn that a sensible asset allocation in retirement is 40% stocks and 60% bonds, so they invest $400k in stocks and $600k in bonds.  Knowing the long term average returns are 8% for stocks and 4% for bonds, they expect their $1 million nest egg to generate about $56,000 per year ($400k * 8% + $600k *4%) , knowing that some years it will be more and some years it will be less.   So far so good, right?

1 m

THEY ARE LEAVING MAYBE $20,000 PER YEAR ON THE TABLE.  That’s a ton of money.  How can this be?  They seem to be doing everything right.  The answer is they are being way too conservative with their asset allocation.  They shouldn’t be investing $600k in bonds and $400 in stocks; stocks should be a much higher percentage.

Waaaaiiiiiiiittttttttt!!!  But didn’t we agree that about 60% of their portfolio should be in less risky investments?  Yes, we did.  Are you confused yet?

Hidden cash

Here’s what I didn’t tell you.  Mr and Mrs Grizzly have other investments that act a lot like bonds that aren’t included in that $1 million.  Both Mr Grizzly and Mrs Grizzly are eligible for Social Security with their monthly payments being $2000 each.  If Mr Grizzly (age 65) went to a company like Fidelity and bought an annuity that paid him $2000 each month until he died (doesn’t that sound a lot like Social Security), that would cost about $450k.  So in a way, Mr Grizzly’s Social Security payments are acting like a $450k government bond (theoretically it would be more than $450k since the US government has a better credit rating than Fidelity).  And remember that Mrs Grizzly is getting similar payments, so as a couple they have about $900k worth of “bond-ish” investments.

Also, Mr and Mrs Grizzly own their home that they could probably sell for $300k.  They don’t plan on selling but if they ever needed to they could tap the equity in their home either by selling it or doing a reverse mortgage.  So in a way, their house is another savings account for $300k.

If you add that up, all the sudden the picture looks really different.  They have about $950k of Social Security benefits that have the safety of a government bond.  Plus they have that $300k equity in their house.  That’s $1.25 million right there.

Investing your portfolio

So now let’s bring this bad boy full circle.  Remember their $1 million nest egg they were looking to invest?  Look at that in the context of their Social Security and house.  Now their total “assets” are about $2.25 million.  If you believe that the Social Security and house kind of feel like a bond, just those by themselves account for 55% of their portfolio.  If on top of that if you invest 60% of their $1 million nest egg in bonds, they have over 80% of their money in bonds, and that seems way too high.

2 25 m a

On the other hand, let’s say they only put $100k of their nest egg into bonds and the rest into stocks, after you include their social security and home, they’d be at about 60% bonds and 40% stocks.  Isn’t that what they were aiming for the whole time?

2 25 m b

Wow.  It took a long time to get there, Stocky.  The punchline better be worth it.  Remember that with $600k in bonds and $400k in stocks, they had an expected return of about $56,000 per year.  However, if they have $100k in bonds and $900k in stocks, because stocks are more volatile but have a higher expected return, they can expect about $76,000 ($800k * 8% + $100k *4%).  THAT’S $20,000!!! 

But aren’t they taking on a lot more risk to get that extra $20k?  Remember, there’s no such thing as a free lunch.  For sure, but if you look at it in the context of their Social Security benefits and their home, they have a fair amount of cushion from “safe investments” to see them through any rough patches in the stock market.

I wrote this post to show that people really need to take account all the financial resources they have.  In the Grizzly’s case, it was their Social Security benefits and their home.  Others of you may be getting a pension (Medtronic is generous enough to offer the Fox family one) or a second home or a dozen other things like that.

When you take those cash flows into account, all the sudden it seems a lot more reasonable to invest the rest of your money a little more heavily in stocks which you know over the long haul will give you a better return.

The Fox family’s 2018 investment performance

2018 was an “interesting” year for stocks.  Everyone wants to think “this one was different” but 2018 did seem to be pretty crazy. 

We had some wild swings pretty much the whole year: from January to December.  Going into December, I was marveling at what a genius I was with my prediction from the beginning of 2018 that the market would be up about 5% for the year.  Going into December it looked like I was going to be spot on . . . and then the bottom fell out of the market and you have where we are now.

Our stock performance

Just like most everyone else, we had a down year.  Of course, since we only invest in index mutual funds, by definition whatever the market did is the return we got.

Investment Ticker % of total portfolio 2018 return
US stocks VTSAX 50% -8%
Int stocks VTIAX 45% -18%
REITs VGSLX 5% -12%
TOTAL -12%

We were down 12%, and obviously that sucks, but . . .   There’s really no “but” so let’s not try to sugarcoat it, but maybe there is a silver lining.  Since the Great Recession in 2008, stock were up about 150% (about 11% annually) and had a 10 year winning streak. 

Dark blue was US stocks (down 8%) and light blue was International stocks (down 18%)

This year we had a down year, so it’s a bit hard to complain.  Historically, stocks are down for the year about 30% of the time.  We were probably due, so we shouldn’t get too greedy.  Still, it isn’t fun to go through a down market, but that’s life.

Notice any changes?

We also made a few simplifying changes to our portfolio starting in late 2017 and continuing into 2018.  At the end of 2017 we sold all our commodities as I discussed here.  In 2018, we also exited our Lending Club investment which was also a disappointment (although not nearly as bad as the commodities). 

That took us from five investments (US stock index fund, Int stock index fund, REIT fund, commodities ETF, and Lending Club) down to three.  If you remember the post on Three Investing Ingredients, I was getting closer to following my own advice.  The only thing still there was REITs.  In late 2018 we finally sold those off, so as of now, we are totally following the Three Investing Ingredients.  It’s nice to get back to basics.

At the beginning of 2020 when you read about how we did in 2019, there should only be two investments.

Inflation

The other thing I always look at at the end of the year is inflation.  US inflation came in at 2.4%.  It’s been inching up steadily over the past few years, and now it’s the highest it’s been since before the Great Recession.  Even so, 2.4% is still incredibly low.

We spend a ton of time talking about the impact inflation will have on your portfolio.  A few years back I even wrote almost a love note to the investing gods for 2015 being a no-inflation year.  The fact that inflation remains very tame compared to historical standards—I use 3% as a target for inflation—means we’re ahead of the game.

Wrapping it all up

Let’s chalk up 2019 to a crazy year and a “bad” year.  But we know sometimes we have bad years.  In the grand scheme of things it definitely could have been worse.

MY 2019 PREDICTION—I think our new normal for the next several years will be a lot of volatility, like we saw in 2018 and so far in 2019.  I never like trying to predict the stock market, but it just “feels” like we’re in for another down year.  I predict down 7%.  Of course I’ll use this as an opportunity to keep socking money away and buy stocks at prices that in 10 years will look bargains.

Light at the end of the tunnel for Bitcoin?

Last year about this time, the nation was gripped in Bitcoin-mania.  It was dizzying.

As with most bubbles, it transcended financial markets and wormed its way into the mainstream. Everyone was talking about it, from late-night talk show hosts to grandmothers and everyone in between.

I wrote my thoughts on the matter here.  Just after that post, Bitcoin rose another 10% and then cratered precipitously.  I predicted its decline would result from it being connected to a terrorist attack and world governments using that as a pretext to extinguish it.  As it happened, it just seems that the bloom fell off Bitcoin’s rose.  Sometimes financial markets are fickle.

In 2017 Bitcoin rose from about $1000 to a peak of almost $20,000.  As fast as the rise was, the fall has been nearly as fast; from $20,000 to about $4000 today.  But this post isn’t a victory lap—Bitcoin bears were clearly proven right, so what’s the point of adding on there?

The point of this post is to give a little bit of love to Bitcoin.  I wouldn’t say I’m making a bullish bet on Bitcoin (I certainly haven’t bought any, and have no plans to).  However, here is an argument why it may not be doomed.

You can actually buy stuff

The biggest problem for Bitcoin was that it had no intrinsic value.  That’s not a deal-breaker: fiat currencies (dollars, euros, yuan, etc.) are only valuable because their home countries say they are and pass laws that you can use those pieces of paper to pay for stuff (more on this in a second). 

Without that government backing, Bitcoin becomes a bit like gold or diamonds, inherently worthless pieces of stuff but are valuable because enough people in the world think they are valuable.  Of course, a big difference is that you can hold gold or a diamond, but not so much with Bitcoin.

In December 2017 enough people thought Bitcoin had value that it pushed the price to $19,000. Today, many fewer think it is valuable so it’s worth much less, hence the $3400 price.

Through it all, Bitcoin was missing a major component of a currency (like a dollar) or even a store-of-value commodity (like gold)—you couldn’t buy anything with it.  I don’t think you would have had near the crash (and probably not the run-up either).

Until recently, you could only buy stuff with Bitcoin on the fringes of the economy.  Certainly, the black market accepted it, but that’s not exactly what we’re going for.  A very small handful of regular stores(virtual or brick-and-mortar) did, but that was minuscule.

That may be about to change in a profound way.  The state of Ohio recently announced that you can pay your taxes using Bitcoin. It’s hard to understate the importance of this.  Paying taxes, by definition, is about as legitimate a transaction as there is. All the sudden Bitcoin is a legitimate currency, at least to the state of Ohio.  To compound the point, I don’t believe you can pay your taxes in Ohio in euros or yuan (undeniably currencies)or gold or diamonds (undeniably stores of value).

How will this impact Bitcoin’s price

Now that Ohio will accept it, that will create a real market for Bitcoin.  That begs the question,what will that do to the price?  You should expect my normal answer: I have no idea. But I do have some thoughts.

Bitcoin’s price has been in freefall for months now.  This was caused in large part by the tiny, tiny issue of Bitcoin not being used anywhere. Now that has changed.  I still think Bitcoin could go down, but I definitely think it will not go down as much as it would have if Ohio hadn’t made it’s decision.  It’s impossible to know if I’m right or wrong on that, since we can’t test things in alternate dimensions.

It’s not to say Ohio is getting in the Bitcoin game.  It just takes the Bitcoin payments, sends them to a market to get exchanged into dollars, and they have their money.

Ohio has taken the first step and it’ll be interesting to see if any other states follow suit.  If a large state like New York, Texas, or California also starts accepting Bitcoin, I think that will definitely buoy it’s value as it becomes even more of an accepted currency.  And of course the coup d’etat would be the Federal government accepting it.

Overall, I still think Bitcoin will be volatile, probably to the downside.  However, I do think maybe we’ll back in five years when Bitcoin has settled to something of value,probably less than $4000, and look at this Ohio decision as the first step towards that stabilization.

First half of 2018—much ado about nothing

I wanted to write a recap of the stock market in the first half of 2018.  It’s taken me a little while to get to it because I actually have a job that I’m working on.  Sorry about the delay, but here it is.

 

At first blush, you might think that the stock market has gone crazy.  I don’t know if you can objectively measure things, but it seems the media which has always been in a frenzy the past decade or so, has gone into overdrive lately.

Obviously there are the big rocks like: school shootings and gun control, the #metoo movement, the eternal Russia meddling probe, the North Korea talks, the retirement and impeding replacement of Justice Kennedy, and the separation of families of illegal immigrants.  There are probably more but those are top of mind.

Most of those are social issues, but they have major economic components.  The gun control debate will have a profound impact on gun manufacturers, many of whom are publicly traded.  #metoo has forced the resignation of several business leaders.  North Korea and Russia talks impact trade and possible war with mass destruction, which of course has a hugely negative impact on the economy.

And this misses the most exciting/depressing/entertaining news item (depending on your persuasion): President Trump.  He alone creates enough material to fill the 24-hour news cycle.

 

US Stock Market . . . happy yawn

So with all this, what has happened with the stock market.  Despite a few gyrations, it’s been fairly stable over a long-term point of view.  It had a  great January (continuing the really strong momentum from 2017), and then things peaked.

There are a few important takeaways.  First, there were a couple huge drops at the end of January and the end of March, but we recovered from those fairly steadily.  Second, we are now at where we were when the stock market peaked in January.  Third, remember that all this 2018 performance is coming on the heels of a spectacular 2017.

All things considered, that seems pretty good.  The market is up 4% so far for the year.  Maybe that seems a bit dissatisfying because it’s been flat since the peak in late January, but up is still up.  Let’s not look a gift horse in the mouth on this one.

 

International Stock Market . . . interesting

What I think is most interesting is that since May the US stock market has marched higher while international stocks markets have gone the other way.  Look at the chart for 2018 so far.

Most of the time, US (blue) and International (orange) stocks tend to move in sync.  Sure, there are always small differences, but by and large when one goes up the other does too and vice versa.  That was the story for sure for the first part of 2018.  Then something happened in May; since then US stocks have marched upwards about 6% while International stocks have fallen about 3%.  That’s a 9% difference!!!

I’ve racked my brain, and I don’t have a clear reason.  Sure, the North Korea situation continues to be goofy.  Italy elected an anti-immigration government that turned a boatload of refugees away.  Brexit unfolds like a car wreck in slow motion.  Syria, Russia, Venezuela—all the usual suspects.  But what has changed in the past couple months that has been so good for the US and so bad for the rest of the world?

The only thing I can really think of is the trade war Trump has initiated.  Typically in these there are winners and losers, so maybe the market is predicting that the US will “win” this and the rest of the world (especially the developing markets since those stocks are down the most) will “lose”.  There are a ton of complications and nuances and a million different things could happen, but that’s the best I could come up with.  I guess we all need to stay tuned.

Either way, what is going on right now with such a disparity in the performance of major stock indices is not common.

 

If you put that all into the pot and mix it, things have gone pretty well for the investor.  That seems a bit different from the constant news stories about how the world is on the brink of disaster, but that goes to show you that long-term investing washes away a lot of those shorter-term swings.

As always we are and have been fully invested in this stock market.

Federal reserve makes markets dive

Nothing gets stock markets so excited as the Federal Reserve.  Here is a chart of the S&P 500 yesterday.  Quick, when do you think the Fed announced that it was going to raise interest rates?  Everything was going fine—it was a pretty smooth day and then at about 3pm the Fed made its decision and the bottom fell out of the stock market.  Why is the Fed so important?  What is it doing that can make a calm market move to much so quickly?

Basically (and this is very basic, as there is a boatload of nuisance in this) the Federal Reserve, and for that matter the central banks of any country, control the core interest rate.  That single, yet enormously powerful tool, allows the fed to influence the economy in a major way.

The guiding mission of the Fed is first and foremost to maintain a healthy level of inflation.  In the US that is around 2-3%.  Being too low has some problems that reasonable people can debate, but pretty much everyone believes that when inflation gets too high, that’s when really bad things happen.  So more than anything, the Fed is tasked with keeping inflation low.  Then a secondary goal is to promote a healthy and growing economy that keeps unemployment low.  So basically the Fed has two jobs, keep inflation low and keep the economy strong.

 

How does the Fed impact the economy?

Let’s imagine a really simple economy.  There are ten companies named A and B and C all the way down to J.  Just like in real-life, not all companies are created equal, with some being much more profitable than others.  Here A is the most profitable (maybe like Apple) while J is the least profitable (maybe like JC Penney).

Interest rates will play a big part in the profitability of these firms.  As interest rates go up, the amount they spend on interest for all their debt goes up as well.  Because A is so profitable, it would only start to lose money if interest rates went really high, up over 10%; however J is much more vulnerable and will become unprofitable if interest rates go over 1%.  All the other companies have a similar situation as shown in the graph.

So this is where the Fed comes in.  Let’s say the Fed sets the interest rate at 6%.  Firms A, B, C, D, and E are all profitable even when the interest rates are that high; but firms F, G, H, I, and J are not.  Because of that things won’t look good for firms F-J.  Maybe it’ll be so bad that they’ll go bankrupt or maybe they’ll lay off people or put a hiring freeze on.

At 6% interest, you have five firms that are doing well (A-E)—growing, hiring more people, expanding, etc.—and five that aren’t (F-J).  And at 6% the economy is performing at a certain level.  But what would happen if the Fed lowered the interest rate from 6% down to 5%?  One more firm (F) would be profitable, and in general it would benefit all the firms.  The profitable ones would be doing even better, and the unprofitable ones wouldn’t be quite so bad off.  And that would lead to a strong economy: more “stuff” would be produced and more people would be employed.

So there is very clear relationship that lower interest rates led to a stronger economy.  Having a strong economy is one of the Fed’s goals, so that begs the question, “Why doesn’t the Fed push rates all the way down to 0%?”

This is where it starts to get interesting.  It’s my favorite topic: Inflation.  Remember that the Fed’s first job is to control inflation.  Let’s look at the Fed’s decision to move interest rates from 6% to 5%, but now look at it with an eye towards inflation.

In our pretend world, let’s assume at 6% interest rates the economy is doing well.  Things are growing and unemployment is fairly low.  When interest rates go to 5%, firm F will become profitable so they’ll want to hire some people—makes sense.  But remember that unemployment is low, so F is going to need to tempt people who are already working for A or B or C or who ever to come work at F.  How does F do that?  They pay them more.

F starts to pay people more, but A doesn’t take this lying down, so A starts paying more.  This wage increase trickles through the economy.  But A and B and even F need to make money, so the increase in compensation they’re paying to their employees gets passed along to consumers in the form of higher prices.  When prices start rising, that’s INFLATION.  And controlling inflation is the Fed’s #1 goal.  So that creates the difficult balance for the Fed—they want the economy to do well but not so well that it triggers inflation.

So there you go.  You just completed a course in “Introductory Macroeconomics”.

 

What’s going on today?

Now that you have that little lesson under your belt, how does that relate to what’s going on with the Fed right now?  For the past couple years, the Fed has interest rates at historic lows, at about 0%.  Then about two years ago they started slowly raising interest rates to more normal levels, although even now the interest rates are still low by historical standards.  Obviously that’s super low, so shouldn’t the Fed be worried about inflation?

Remember the circumstances of how interest rates got that low.  At the beginning of 2008 the economy was going strong and the Fed interest rate was at over 5%.  But then the financial crisis hit, blowing up the banking industry, and sending the world economy into a very sharp recession.  A ton of people lost their jobs (unemployment went up) so prices stayed flat or even started to fall a little bit.

With all this going on, the Fed threw a life raft to the economy in the form of near 0% interest rates.  In the intervening years, the economy has rebounded and unemployment has fallen, but inflation has remained pleasantly low.  This is kind of the best of both worlds for the Fed—the economy is strong and there’s no inflation.  The two things they have to balance are both in happyland, so they have kept interest rates low.

 

What does it really mean when the Fed changes interest rates?

With all of this, are we just a bunch of idiots?  Should we really be so happy if the Fed is keeping rates low, and should we be so bummed if the Fed raises rates?

As the parent of two boys who one day may start sponging off Foxy Lady and me, I think the parent-child relationship is a good analogy.

Imagine you have parents (the Fed) who have a grown child (the US economy).  Times are tough for the child (the economy is doing poorly) so the parents help out (the Fed lowers interest rates).  The good scenario is that the child starts doing better to the point where he doesn’t need his parents’ help (the economy strengthens so it can withstand higher interest rates).  The bad scenario is the child becomes dependent on his parents’ help and is never able to make it on his own.

In this analogy the parents reducing the amount of help they give (the Fed raising rates) is a good thing, isn’t it?  It means that the kid is getting things on track and is standing on his two feet.  For this reason, I actually think it’s a good thing if the Fed raises interest rates because it means that the economy is strong enough that it doesn’t need insanely low interest rates any more.  Yet the markets react in the exact opposite direction.

I get it.  Just as the kid would be bummed if the parents said, “hey pal, since you’re starting to make some money now, we won’t be sending those monthly checks”, the companies are bummed that they can’t borrow money so cheaply.  But that isn’t sustainable.

I chalk this up to yet another of a million examples of how the stock market acts in a goofy manner in the short term.  And another reason why I NEVER try to time the market.  I just keep my head down and invest for the long term, regardless of what is going on with interest rates.  But watching everyone hang on Janet Yellen’s every last word does make for perverse entertainment.

 

As the current debate unfolds, what do you think?  Is the economy strong enough for the Fed to continue to take away the credit card?

BREXIT—when experts were idiots

On June 23, 2016, the UK voted to leave the EU—Brexit.  The outcome of the vote was unexpected and EVERYONE freaked out.

As it turns out, nearly all those dire predictions were totally overstated.  A more objective view shows that the UK and the broader world are doing JUST FINE, probably even better than fine.  This is a good lesson that just because experts say something, especially in this world of 24-hour news cycles where crazy proclamations get the headlines, doesn’t mean they’re going to happen.

Brexit is a really good example were most experts, at least the loudest experts, got it totally wrong.

 

Let’s everyone totally freak out

The general consensus among mainstream media was this was an unmitigated disaster.  The imagery of UK self-inflicting a fatal wound was pervasive.

CNN described the impending “Brexit hangover” as though the British were a bunch of youngsters who did something immature and thoughtless like vote to leave the EU (or go out on a drinking binge).  In the light of day they would realize their error and suffer economically for their folly (hangover).

CNN also had the headline “Brexit + Deep Uncertainty = Market Chaos”.  The first line claims, “One of the foundations of the political world was thrown in disarray.”  The world in disarray????  Maybe a bit melodramatic on that one.

Magazines and newspapers had provocative headlines and covers.  The Economist called the vote “tragic”; the New York Daily News called it “foolish”; the New Yorker equated it to a suicidal leap off a cliff.  Let’s be serious for a second.

Even President Obama lent his voice to the echo-chamber chorus, warning Britians before the vote that Brexit would put them at “the back of the queue” when doing trade deals.  Clearly this was meant to scare British as a threat to their economy and livelihoods.

Making it more local, my Facebook feed was filled to the brim with dire Brexit predictions.  Nearly all these posts are from graduates of the University of Chicago’s business school.  These are people who have studied economics MUCH MORE than your average Joe.  Look at some of those comments.  Equating Brexit to World War II???   Really???

The point is Brexit was fairly universally acknowledged as a total disaster in the making by the loudest (but not necessarily the smartest) voices.  It’s easy, just based on the volume and frequency, to imagine there was something to that.  It’s been almost two years, so let’s look at what has actually happened to the UK since its citizens voted for Brexit.

 

Just the facts

For all the talk that Brexit was going to tilt the ENTIRE WORLD into financial disaster, let’s be real.  First, the UK isn’t that important.  It’s 21st in terms of population (a country with 0.9% of the world’s population), and it’s 6th in terms of GDP (3.4% of world’s GDP).  Let’s not overestimate the impact, ambiguous at best, that such a political move might have on the world.

In case your curious, the world’s GDP grew about 2.5% last year.  Equity markets are up about 25-30% since the vote happened.  That seems pretty darn good to me.

Looking at the UK in particular, it seems like things are going okay too.  There’s no totally objective way to assess the “strength of an economy”, especially among people whose political views predispose them to think one way or another.  That said there are some widely accepted metrics to look at.

 

UNEMPLOYMENT—UK unemployment since the vote has fallen pretty much in lockstep with the rest of the EU.  In June 2016 it was at 4.9%, and now it’s at about 4.3%.  That’s very slightly above Germany (widely regarded as the strongest economy in the EU), and much lower than the other major EU countries who have embraced EU-ism: France (9.2%), Italy (10.8%), and Spain (16.4).  VERDICT: not total disaster.

 

GDP GROWTH—UK GDP growth has been at about 0.4% quarterly since the vote.  That’s fairly middle of the road.  As usual, Germany’s metric is a bit better (0.6% growth), while France’s and Italy’s are in line (0.4-0.5%), Spain’s is higher (0.7%).

GDP growth is a very fickle metric in that it looks at changes, not absolute values.  Were Spain’s higher numbers because it is doing well now or that it was doing so poorly a few years back, and today’s number just look favorable compared to crappy numbers.  You can see the challenge.  Either way, it’s pretty clear that the UK isn’t performing at substantially worse level than the other major EU players.  VERDICT: not total disaster.

 

STOCK MARKET—The UK stock index (FTSE) is up about 20% since the vote.  That’s a bit less than the US (33%) and Europe (26%).  Maybe that’s evidence that the stock market thinks the UK made a mistake.  First, being up 20% definitely defies the idea that the UK is a disaster.

Second, just like GDP growth, there are a lot of factors that make it a bit challenging on how exactly to interpret it.  Right after the vote, the UK’s stock market well outperformed the others, and then it decelerated.  I chalk it up to general market gyrations.  VERDICT: not total disaster.

 

EXCHANGE RATEAfter the Brexit vote, the exchange rate for the British Pound to the Euro fell from about 1.25 down to its current rate of 1.12.  Definitely you can see a clear move down.  Often times a depreciation in your exchange rate reflects negative circumstances for the country’s economy (see Venezuela).  Yet, that’s way too simplistic a view.  In the past year, the US dollar is down about 15% compared to the Euro, and I don’t think anyone seriously thinks the US economy is in a state of disaster compared to the European economy.

Also, if you look at the Pound/Euro exchange rate over a longer time period, the 1.15 range is actually where it has spent most of its time.  It was there in the early 2010s (when the UK was part of the EU), then it rose dramatically in 2015 when Greece’s drama unfolded as it nearly toppled the EU’s common currency (hmmmm . . . maybe that’s a reason why the British voted for Brexit).  Now it has fallen back to those previous levels.  VERDICT: not total disaster.

 

The point of all this is that it’s definitely not CLEAR that the UK’s Brexit vote was a total disaster.  Despite the incredibly smart people with a firm grasp of macroeconomics at CNN and the New Yorker among many, many others (I’m totally being sarcastic here—I think they’re idiots), just because they say something doesn’t mean it’s true.  They have the loudest voices in media today, but that doesn’t mean they have the smartest.  Remember, I am smarter than a Nobel Prize winner, and I do think Robert Schiller is really smart.

If you were Rip Van Winkle and slept through the last two years, and then upon waking were asked which Top 20 economy voted on an economic policy that was tantamount to “Tragically foolish suicide that pulled the world into chaos”, I’m not sure you’d zero in on the UK.  Actually, you’d think things look pretty good there, not nearly as horrible as that description would lead you to believe.

There’s a bit of a lesson here.  Keep this in mind when everyone in the media and on your Facebook feed starts talking about how obviously good or obviously bad something is.  Quick things that come to mind are: economic impact of Trump’s tariffs, inevitability of China overtaking the US in GDP, the impact/harm of the Trump tax cut.  These things are highly complex and very nuanced; rarely are they unambiguously good or bad in the manner that grabs headlines in our oversaturated media landscape today.  Don’t be a sucker.

Championship—Asset allocation v. Tax optimization

Basketball hoop

This is what we’ve all been waiting for.  After two weeks of amazing investing tournament challenge action (just indulge me, will you?), in this post we will crown the champion of investing strategies.  Here we have Asset allocation taking on Tax optimization.  In the Final Four, Asset allocation pounded Index mutual funds with higher returns early on and limiting risk as you approach retirement.  Tax optimization made it two thrillers in a row, beating Savings rate on the strength of major tax savings with a little bit of work and education, but not a lot of monetary sacrifice.  As always, see the disclaimer.

bracket-game 6

Obviously both these strategies have tremendous upside, otherwise they wouldn’t be here.  So how do you pick between them?  It’s no easy task, but for you, my loyal readers, I’m ready to take it on.  Let’s see who cuts down the nets.

 

Reasons for picking Asset allocation:

In some ways Asset allocation seems really easy, since all you’re doing is figuring out what percentage of your portfolio goes into stocks, bonds, and cash.  90% Stocks, 10% bonds, and 0% cash; there, I’m done.  That didn’t seem so hard.  Obviously it’s more complicated than that.  We already know that Asset allocation is critically important throughout your investing time horizon.  When you’re younger you probably want to be mostly in stocks (even now the Fox family is 99% in stocks).  As you approach and ultimately enter retirement you want to be more in bonds, but stocks still probably need to be a significant part of your portfolio.

About 10 or so years ago, the mutual fund companies came out with a really cool innovation called target-date funds.  The basic idea is that these handle your Asset allocation for you.  Imagine today you’re 35 and you want to retire when you’re 60, in 2040.  You could invest in a fund like Vanguard’s Target Retirement 2040, and it will automatically shift your Asset allocation from mostly stocks today (currently it’s about 90% stocks, 10% bonds) to gradually less stocks and more bonds as you get closer to retirement.  It’s been a wonderful innovation that has proven extremely popular among investors.

So there you go.  Problem solved, right?  Well, not so fast.  I actually don’t think these really solve the Asset allocation problem because they figure everyone retiring in 2040 is in the same situation, but that’s definitely not the case.  Let’s say you and your twin retire in 2040, but you will get $1000 from Social Security while she’ll get $3000.  What if she had her house paid off completely while you have always rented?  What if you worked for a company with a 401k and she worked for a company with a pension?

All those scenarios are very real for investors, and require more individualization than knowing you want to retire in 2040 can give.  For all those, conventional wisdom would say that your twin should take on more risk (French for “invest in more stocks”) than you because she has other “assets” that are generating more cash.  Reasonable people can debate that last point, but clearly the idea is that Asset allocation is much more complex than just picking a year and being done with it.

So where does that leave us?  I am a firm believer in investing DIY, and Asset allocation is no different.  But I think this is one of the areas where the degree of difficulty is much higher just because you’re balancing a couple opposing forces and there’s never a clearly “right answer”.  You want to be in stocks but not too much in stocks, and then that changes over time.  Oh yeah, and the stakes are super-high.  Getting it “right” whatever that means could give you an extra few percentage points in return and it could also save your nestegg from catastrophic failure if another 2008 rolls around.  When I work on the Fox’s nestegg, this is probably where I spend the most time.

 

Reasons for picking Tax optimization:

As we’ve said ad nauseam, Tax optimization is important and can lead to enormous savings.  What makes taxes so difficult is that the tax code is constantly changing and the stakes are super-duper high (the stakes for Asset allocation were only “super high”).

Every year there are hundreds of changes to the tax code which keeps accountants employed and programs like Turbo Tax (the Fox family uses Turbo Tax) flying off the shelves.  With the new tax reform bill that just passed, there were major changes to your taxes like the deductibility of mortgage interest and local taxes.  Those changes have massive implications on choices of where to live–both at the level of which state to live in but also whether to buy or rent.  These were huge and made the news.  What about the others that do hit the media’s radar and you never hear about?

There’s always talk about more changes, perhaps profound ones like a wealth tax.  You have to keep up.  Also, it can get really confusing.  I think I’m fairly knowledgeable on these matters but I am still befuddled by the Alternative Minimum Tax, and I know I screw up the foreign interest paid on my international mutual funds.  This stuff definitely isn’t easy.

Also, look at the stakes.  If you screw up on your taxes, theoretically you could go to prison.  If it’s an honest mistake I don’t think the Internal Revenue Service will push it that far, but horizontal stripes are definitely in play as Wesley Snipes can attest.  What is more likely is the IRS will hit you with a fine composed of a penalty plus interest.  Oh, by the way, that interest rate is about 6%; that’s not “Pay-day Loan” high, but it’s still pretty freaking high these days.  That certainly can make someone cautious about how far to push Tax optimization, even when they’re clearly in the right.

However, there is a silver lining.  If you want professional help, there are thousands of Certified Public Accountants who are there to help you out.  For under a few hundred dollars most people can probably have their taxes done by a CPA who can make sure that you stay on the IRS’s good side.  Unfortunately, when it comes to developing creative Tax optimization strategies, my experience says there’s a huge range in quality that you’ll get from CPAs.  Several years back I had a horrible experience with H&R Block and thought they were border-line incompetent.  No way would I trust them to advise me on the finer points of maximizing the tax advantages of investing.  But there are amazing CPAs out there right now (like David Silkman who did our small business’s taxes when we lived in California) who I do think can really help.  But this is a real caveat emptor situation.  Maybe Angie’s List might help.

 

Who wins it all?

It all comes down to this.  In the end, I have Asset allocation pulling it out 76-70.  Obviously both investing strategies are amazingly important and getting them right can have an exponential impact on your portfolio.  For me I gave the nod to Asset allocation over Tax optimization for a couple of reasons:

First, if I met a total train wreck of an investor (he was just stuffing cash in his mattress) and I could only give him one piece of advice, I think it would be to get that money invested in some combination of stocks and bonds.  Tax optimization strategies like an IRA or 401k are nice, but first things first.

Second, I think the big rocks for Tax optimization seem to me better understood and more accessible than for Asset allocation.  Most investors probably know that investing in your 401k or an IRA is a good idea, and probably most could tell you why (at least be able to say “it helps with taxes”).  I think that’s different for Asset allocation where you have a lot of investors who are totally off on what is probably appropriate for their situation (age, income, other assets, etc.).

Third, there’s no real “right” answer for Asset allocation.  I could have a lively debate with my dear friends/loyal readers who work in the financial industry like Jessamyn and Mike, where we argued whether the Fox family should be more in stocks or more in bonds.  But there’s no right answer (other than if stocks go up a year from now, then you know you should have been more in stocks).  It depends on so many variables as well as risk tolerance which are super-hard to quantify.  With Tax optimization you can get closer to a right answer—either the tax code allows you to do that or not.  Of course, you typically sacrifice ease of access to your money for tax benefits, so that does add a complication.

Finally, I think it’s easier and cheaper to get expert advice on Tax optimization.  As I mentioned, a good CPA can probably really help guide you on Tax optimization.  Sure, the quality of CPAs is pretty wide, but good ones are out there, and probably they’ll charge you something with in the three-digit range.  With Asset allocation if you want professional help you typically need a financial adviser.  Unfortunately, and this is just my opinion, it’s a little more Wild West for financial advisers than CPAs.  A really good financial adviser is probably worth her weight in gold (140 pound of gold is worth about $2.6 million, so maybe they aren’t worth quite that much), but the range of quality is staggering; there are some real shysters out there.  Also, they’ll probably charge you in the four- or five-digits range.

So there you go.  Put that all together and I think Asset allocation comes out on top 78-71, finishing the sentence, “if you only do one thing in investing make sure you get Asset allocation right.”

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I hope you have enjoyed reading all these posts on investing as much as I have enjoyed writing them.  While Asset allocation “won” remember that all eight of these are important and should be definitely be considered as you think about bulking up your portfolio.

First Round: Asset allocation versus Diversification

I’ve got my tickets to the Regionals in Charlotte, thanks to my neighbors Mr and Mrs Nittany Lion.  In honor of that I am kicking off the investing strategy tournament to determine which is the single best investing strategy if you could only pick one (which fortunately isn’t the case–you can pick all these).  As always, I am not an expert.  So without further ado, we’ll start with the contest between Asset allocation and Diversification.

bracket-begin

Reasons for picking Asset allocation:

Asset allocation is picking the right mix of stocks, bonds, and cash which maximize your investment returns while also limiting that chances that you hit a bad patch of time which cripples your portfolio beyond recovery.  The basis of the concept of asset allocation is the fact that as your expected investment returns increase, so does its volatility.

So for example, cash (or money market accounts) are the least volatile investments around where the chances of you losing money are nearly zero, but they also offer the smallest return at about 1-2%.  On the other end of the spectrum are stocks which historically have averaged about an 8% return, but where about one-third of the years you lost money.  Bonds are between those two, both in terms of returns and risk of losing money.

In my experience screwing up Asset allocation, especially among young investors, is one of the most common missteps.  The conventional wisdom is that you want to take more investing risk when you’re younger because you have more time to “recover” from any market downturns (as was the case with me in 2001 when I was just starting out).  That means that typically (and of course, each individual is different) younger people should allocate more to stocks than bonds or cash.  However, so often I talk to younger investors who have a significant chunk of their 401k in bonds or worse yet, cash.

Why is this so bad?  Well, over a period of decades, the investment horizon when you’re in your twenties or thirties, you end up leaving a lot of money on the table.  Using historic averages, if the 25-year-old you invested your 401k in stocks and your twin invested in bonds, when it comes time to hang up the spurs, it’s no contest—you’re so far ahead of your twin.  Remember that historically, stocks have returned about 8% while bonds have returned 5% and money markets (cash) have returned about 2%.  Just doing some really simple math, the historic difference between stocks and bonds has been about 3%–that adds up to huge differences over an investing career (remember from “The power of a single percentage” how big a difference 3% can make?).  Who knows if it will be like that in the future, but based on history that could lead to hundreds of thousands or even millions of dollars over time.

Of course, you probably read A Random Walk Down Wall Street, so maybe you’re saying, “but when you invest in stocks you’re only getting a higher return because you’re talking on more risk.”  There’s no such thing as a free lunch, and right you are.  That argument is exactly why Asset allocation is so important.  If you were 60 years old and getting ready for retirement, it probably wouldn’t be a good idea to risk losing a big chunk of your portfolio by investing the majority of your money in stocks.  But if you’re 20 or 30 years old, then you can invest in stocks to get the higher return knowing you’re at less risk of a catastrophic loss because you have three or so decades to ride out any storms.

 

Reasons for picking Diversification:

Diversification is the strategy of picking multiple investments so that you can reduce the volatility of your portfolio.  When some of your investments are down, others will be up.  This is really Investment 101 stuff, and I don’t think you’ll find many legitimate investors who would not say it’s a good thing.  But if you think about it, how much is Diversification really doing to help you achieve your financial goals?

The fact of the matter is that Diversification does not increase your investment returns, on average (“on average” is a critical phrase here).  If that’s true, then why does everyone make such a big deal about Diversification?  Because by diversifying with several stocks you even out the highs and lows that would occur with a single stock.  As an example let’s look at investing in an S&P 500 index mutual fund which is considered highly diversified, and compare that to investing in a single stock.  Here I picked Catepillar because from 1980 to today, it and the S&P 500 had largely the same performance (they were both up about 2300% over those 38 years).

Over that time both investments had their ups and downs, but the difference was that Caterpillar’s ups were much higher and its downs much lower.  Since 1980 (38 years), the S&P 500 index had eight negative years with its worst year being 2008 when it was down 39%.  It also had 13 years where it had a return of 20% or better with its best year being 1995 when it was up 39%.

Now compare that to Caterpillar over the same time, remembering that over the entire 38 years they both had total returns fairly similar to each other.  Caterpillar had 17 years with negative returns, the worst being 2008 when it fell 55%.  On the other side, it had seven years where returns were over 55% (16% better than the best year of the S&P 500 index), with the best year being in 2010 when it increased 90%!!!

So think about that.  If you decided not to diversify and put all your money in Caterpillar back in 1980, you would have ended up in pretty much the same place as your twin who diversified with the S&P 500 index, but you would have had a much crazier ride.  2008 would have sucked for both of you, but much more so for you than your twin.  Also, almost half of your years would have been negative (15 out of 34 years) where it was only about 7 out of 34 years for your twin.  Of course, that would have been offset by some real “bumper crop” years (I had to get a farming analogy in) like 2010 when your portfolio would have almost doubled.  No one is complaining about a year like that, but it that a good thing?

Even recently, with Caterpillar you would have had 2014 and 2015 which were down over 10%, but that was made up in 2016 and 2017 which were both up over 60%.  Meanwhile, the S&P 500 was trudging along at double digit gains.  Holy Cow!!!

How do you plan for something like that?  Pre-2010 you were probably figuring you’d have a moderate retirement, and then 2010 rolled around and life all the sudden got a lot sweeter.  Exact same story after 2015.  Just look at the graph—far and away the most common annual return for the S&P 500 index was the 0-20% bucket; for Caterpillar the returns were all over the board and the most common was -20% to 0%–a loss!!!

And of course, I picked Caterpillar because over the 38 years it was pretty close to the S&P 500.  Remember that if you picked a single stock randomly from a broad index like the S&P 500, you would expect the stock to do just as well as the index, because the index is just an average of a bunch of those stocks.  And it’s true that on average a single stock will do as well as an index, but what if I randomly picked United Airlines which went bankrupt just like many, many other companies do every year (there’s no real chance that the value of the S&P 500 would go down to zero in a similar way)?  Or if I picked Medtronic (one of the greatest companies ever) which outperformed the S&P 500 some 8x?

My personal preference with investing is that I want as much predictability as possible, and that is even tough to come by when you’re highly diversified; when you aren’t diversified, there’s no chance.  Maybe if you like those types of thrills that putting everything into a single stock brings, you may want to think about BASE jumping or free diving.

But assessing it honestly, Diversification does not lead to higher returns on average.  It just reduces the crazy swings up and down.

 

Who wins?

Asset allocation wins this one pretty easily, 86-59 (I just made that up to look like a basketball game score, but it seems about right).  Diversification definitely helps smooth things out, but Asset allocation can undeniably increase your returns which translates to real money.

bracket-game 1

So Asset allocation moves on to the Final Four.  Make sure you come back tomorrow to see Free money take on Index mutual funds.