April 25, 2014

Mail Bag: Stocks Are Bad and Hope Is Lost

I mentioned the academic returns from Ibbotson & Associates again – the ones that showed the long-term average rate of compounding for investors who were passive and only held large, profitable businesses, with dividends reinvested came in around 10% with an experience range of 8% to 12% depending on the specific starting year – and received a message.

Mail Bag Joshua Kennon PenYou “Pie-in-the Sky’ Gurus seem to provide these “Dreamscape” non existent anymore theoretical returns that only exist in your out of date heads.
I`m 62 and i indeed have saved a few million over many yaers with high compounding rates that all but evaporated at the turn of the century, i still have a few years left on 3% & 4% CD`s but that will be it for really long time once they mature.
STOP “Projecting” returns of percentages that do NOT exist without extreme risks, Jeesus!!, you guys really give people vapor Dreams….

Samuel B.

Dear Samuel,

Thank you for taking the time to write.  I happen to be sitting at my desk going over some title papers and saw your message come through so I thought I’d respond.

Judging by your message, the tone, and the emotional rawness in your words, it seems fairly evident that this is a sensitive topic for you.  What should be a cold, logical fact-checking mission to your local library with zero emotion at all – a fact is either true or it is not – is, instead, causing you distress.  It sounds as if you were burned rather badly by owning stocks and now somehow think the problem is with the stock market itself.  I’d wager to guess that your plans are frustrated, yields are virtually non-existent on assets, and you think someone is to blame.  

But you took the time to write, so onward Christian soldiers!  Here we go.

1. I am not a guru.  I have no seminars to sell, don’t manage outside money, and am utterly agnostic on whether or not you think stocks are good for your own personal portfolio.  If you can make more money selling air conditioners than buying shares of General Electric, by all means, sell air conditioners.  Or roasted peanuts.  Or carpets.  Or whatever.  

2. It’s not my return assumption, it is a historical fact and as someone who believes in conservatism when it comes to economic projections, I think it takes an extremely powerful reason to think that reversion to the mean can be avoided.  The return calculations provided by Ibbotson & Associates, and confirmed by the best Ivy League universities in the nation, including the work of Dr. Jeremy Siegel at Wharton, include periods such as the post-2000 crash in the return calculations (which was really mild, a much worse case scenario was the 1973-1974 period), as well as things like survivorship bias.  For example, a firm such as Eastman Kodak going bankrupt.  Even then, returns were good for investors despite the stock going to $0 because of dividends: http://www.joshuakennon.com/eastman-kodak-example/

3. In all 25-year periods, including those that include the Great Depression which the most horrific, God-awful economic disaster in 600 years, when an investor held a block of broadly diversified, conservative, large, blue chip stocks, reinvested the dividends, dollar cost averaged regularly to take advantage of crashes, and left the portfolio alone, he compounded his money between 8% and 12%, with 10% being the overwhelming average.  There is no room for interpretation.  There is no debating the reality.  It’s a fact.  If history had been different, I would have used another figure.  I have no emotional attachment to 10%, I just think an investor needs a damn good reason to think that a 100-year period during which we saw the worst disaster in six centuries is somehow too optimistic going forward.

4. It is also a fact that most investors will not get those returns because most investors are emotionally incapable of managing their money.  Morningstar did a study that confirmed over a period when assets were earning 9% to 10%, the actual investors were only making 2% to 3% because they were incompetent.  They never picked good companies and locked them in a bank vault.  Instead, they sat around trading pieces of paper all day, making brokers and bankers rich.  This is precisely why the 401(k) system has been a disaster for most people as they cannot handle managing their own affairs; the pension system was far superior for the average worker as it outsourced the investment decisions to those who had the temperament to think long-term.

If the 2000 disaster was anything but a blip on your radar, you are fundamentally incapable of managing your own money in the capital markets.  That’s okay.  It is not a criticism.  You can get very rich without ever owning a single share of stock – I have older relatives and friends who are the same boat, lose money every time they attempt to purchase an equity, yet amassed millions in real estate because the rent cash is more tangible to them and causes them to behave rationally.  

There are no such thing as “stocks”.  There are simply individual businesses, that generate a certain amount of profit, and you are buying that profit.  The return you earn is determined by the price you pay for those earnings.  The exact same company, the exact same stock, will have very different returns for an investor who paid $10 for every dollar in profits than one who paid $100 for every dollar in profits.  Too many people fail to understand this and think buying Johnson & Johnson at 50x earnings is somehow acceptable because it’s a great company.  I will say it is probably a safe bet, with a high degree of certainty, this had a lot to do with your compounding rate collapsing: http://www.joshuakennon.com/earnings-yields-vs-treasury-bond-yields-as-a-stock-market-valuation-technique/

The bottom line?  If you think stocks can’t offer a 10% rate of return following the same recipe (6% real returns net of 4% inflation before tax adjustments), you shouldn’t buy them.  

It’s that simple.  

No one is telling you that you must own stocks.  You’re perfectly free to sell all of your shares, lower the price for the rest of us, and let us take over your ownership at much more attractive rates.  

In fact, it would be good for me in the long-term if more people thought like you.  I long for the days when the average American was terrified of stocks.  Back in 1973-1974, people were full of fear and great businesses lost 75% of their quoted market value in a very short period of time, while still churning out ever-increasing dividends and profits.  That is a dream scenario to me.  I can’t stand that some of the food stocks are 23x+ earnings right now.  I don’t want to own them at those valuations.  I want good businesses, churning out real profits.  The more I have to pay for every $1 in profit, the sadder I become because I want to see my income go up each year.  

So I like you already, Samuel, because you’re doing me an enormous favor.  I’m very sincere in this.  I benefit when you go on every message board you can, tell all of your friends, preach to your grandchildren, and take out advertisements on billboards in your hometown telling people that stocks are trash; that they will always lose you money; that you can’t win and there is no point in trying.  Preach the gospel.  Convert folks to your congregation.  Shout the hymns and shake the tambourine.

By doing that you are, without realizing it, hugely beneficial to me.  You’ll have helped make me even more successful, even wealthier, and even more emotionally content as I see wonderful firms fall in price.  I’ve been watching Brown Forman for years now and investors just won’t part with their ownership stake.  I’d love to see it fall so I can be there when it does, checkbook open, pen in hand.  Hershey is also a brilliant company that is just too high.  I’d love to buy a block of it and stick in a safe deposit box for my children and grandchildren, ignoring it for the next 50 years.  Coke is fairly valued now, but it would be a steal at 10x earnings.  I dream of my Disney shares collapsing from the $62 range they are in now to $45 or less.  McDonald’s at $88 or less is fantastic so I’d love to see people suddenly hate fast food stocks.

Keep up the good work.  You have no idea how much I appreciate the fact that people like you are so emotionally committed to driving interest in equities down.  It is a wonderful gift. 

Sincerely,

Joshua

P.S. Your certificate of deposits are not earning you 3% to 4%; not really, anyway.  Inflation is running about that same rate and you have to pay full Federal, state, and local taxes on the interest income, so your return on those assets is negative.  You shouldn’t think of them as investments.  They are temporary places to park cash that happens to result in a loss of purchasing power at a rate slightly lower than that experienced in a checking account.  Bemoaning their loss indicates a lack of sophistication that would make me think you might be better served by sucking up the 1% fee a well respected wealth management company charges so they can hold your hand and put together a collection of assets that is right for your own situation.  You are repeating the same irrationality that caused you losses back in 2000.  That may not matter given your age – a portfolio of several million can withstand a lot of folly if you are frugal – but you should still care, morally, if you plan on leaving something for your heirs or a charity as they will be the one losing out to the opportunity cost of your misallocation.

  • FratMan

    The post without a title. That is bold, good sir, yet somehow fitting with the nature of the article. Hipster Mickey Mouse would approve.

    • http://www.joshuakennon.com/ Joshua Kennon

      I forced a cache refresh; it should be showing up now.

  • al

    You seem to be missing a title on this post, Joshua.

    It is interesting though as I was reading Samuel’s message; just this morning, I was reading a cnnfn article about how individual investors are being screwed again by buying at the top of the market in May as everyone is becoming fearful again.

    • http://www.joshuakennon.com/ Joshua Kennon

      You’re seeing it too? I already pushed one cache refresh through. I’m guessing it has to do with the fact I restarted the distribution through Amazons CDN (we had to turn it off temporarily when they were testing the image scaling issue recently).

      I’ll try it one more time. It could be your browser grabbed the first version and is now recalling it from the local cache. I’ll go test it on another system and see if it is happening there.

      Thank you for letting me know!

      • al

        It’s showing up now.

  • Alexander Davis

    I know this will sound bad.

    I work in Business Valuation and have been investing for years, on auto pilot for at least 3.5 mil.

    But when I am out at happy hour sometimes and everyone is talking about their rent, car payments, and constant trips. I sometimes look around and think.

    “All these idiots are going to make me rich, without even really trying.”

    I feel a bit bad, but hey, its the thought that enters my head. It’s never been easier to invest in a sensible manner.

    I have the resources to pick value stocks but currently I focus on my career. I have Vanguard account with unlimited free etf trades. It is incredible, I can balance and reallocate any amount easily for less than 100 per share. The high dividend yield fund basically lists almost every company you discuss Joshua. And not even a 5 dollar TRADE FEE. WOOO HOO!

    It’s never been better and information never freer, but people still go about their lives like it’s some great impossibility or something.

    Oh well, if that is the modern decision, I would rather become a have rather than a have-not, as their car payments and purchases find their way as dividends into my account, buying me even more shares of high quality money machines.

  • Alexander Davis

    Haha, most excellent.

  • http://ianhfrancis.blogspot.com/ Ian Francis

    “If the 2000 disaster was anything but a blip on your radar, you are fundamentally incapable of managing your own money in the capital markets. That’s okay. It is not a criticism.”

    No, not a criticism at all.

    BTW, I see the title, but the link to the article is just /30773/. Is there a reason?

    • http://www.joshuakennon.com/ Joshua Kennon

      Sometimes I have to clarify that because people think it is insulting but we each have different strengths and weaknesses. I’d be great at owning a large hotel or apartment building but terrible at owning a tiny little rental house. My temperament isn’t geared toward it. It took me a while to realize that there are certain people, my hunch is it is mostly genetic and has to do with the perception of risk and a fight or flight response and / or an underweighting of the value of hyperbolic discounting to favor more immediate payoffs as an adaptation, that shouldn’t be involved in long-term ownership of anything that has a frequently quoted value. (In other words, I was once young, stupid, and naive enough to think people could be swayed entirely by rationality and logic when it came to allocating capital, then realized it isn’t worth it because financial payoff is not the only variable in the equation; peace of mind is for some people, even when it comes in the form of losing real purchasing power as foolish as that sounds.)

      The URL? I should have known you’d spot it, haha! That was the automatically generated URL that went into effect and since the cache program had already picked up the no-title version, changing it would have then caused broken links the RSS feeds and some other places so I decided it wasn’t worth it.

      P.S. What is going on with your water supply in SimCity? I’m trying to build my Disneyland resort and I’m up to almost $200,000 a day in profits as tourists flood in on my multiple cruise ships, high speed trains, British tour buses, municipal buses, and streetcars, but I suddenly get a warning that all is going to hell because you’ve cut off my water supply. I finally build a water pump – I think, maybe I went with the cheaper water towers. My tourists are surviving on Dole Whips and Coca-Cola. But the tourist thing is hard … I’ll be rolling in cash then suddenly I’ll go from making thousands and hour to a $15,000 hourly deficit, buildings imploding, and everything burning. There are still so many flaws in EA’s processes it is a joke.

      • http://ianhfrancis.blogspot.com/ Ian Francis

        Yea, I am a bit baffled myself. I tried to relegate power, sewage, and water to one city and share, but no matter how many water pumps I built, the other city wasn’t able to take enough to run on. Everything else seems to be working ok.

        I am also working on a tourism city, so maybe that is causing the problem. It was supposed to be just a gambling city, but I couldn’t get enough people to visit. I resorted to an amusement park to cover some of my losses.

        I finally figured out that the system, for whatever convoluted reason, bases the maximum level of tourists of each level of wealth on the number of parks for that class. I ended up building maybe 30 more medium wealth parks and that has seemed to help out quite a bit. I just don’t have any more room for more parks.

        The income thing seems to be due to the normal fluctuations of the casino profits. As tourists move around, sometimes the casino is running at a loss, sometimes it is running at a huge surplus. I think they just need to widen their averaging system so these fluctuations are damped.

        On that note, do we want an international airport or a space port? Both are good for tourism, though I might hazard a guess the airport is more so. The space port does provide education though. Plus my other city, which I need to rename now that I sucked the ground dry of oil, is ramped up for computer production, which would make the space port easier than the airport.

        The traffic seems to have improved. It takes a bit of work designing a road system that doesn’t cause traffic jams, but it can be done. Check out my non-gambling city. It was gridlock before I fixed it, now I hardly have any traffic waiting to come in. I did all this by REMOVING roads and intersections. Figure out where people are starting and ending and give them only one route with as few intersections as possible. I noticed that my traffic problems were mostly due to people driving in circles, to the point where a line of cars all wanted to loop around and around, but the line was causing traffic with itself by looping though the same intersection twice and it just stopped moving. It is still a bit screwed up, though it is leaps and bounds better than before.

        The traffic thing is the most important part of the game now, because if you get gridlock, your services stop working. You can have a hundred police cars, but if they cannot get anywhere it doesn’t matter. (you would think the criminals would have the same problem, but apparently not)

        Also, do your marinas (if you have any) show a connection to my cities? Mine seem to be functioning, but they don’t show any other cities as connected.

        Well my third city is just going to be a population city, so perhaps that will help with tourism. Who knows?