Millionaire Teacher
Page 12
But long term, how would the attack affect American business profits? As catastrophic as the event had been, it wasn’t likely to have a permanent effect on the number of Coca-Cola cans or McDonald’s hamburgers sold worldwide or Safeway’s food sales. Americans are resilient, and so are their businesses.
And yet, when the stock markets re-opened after the terrorist attack, US stock prices dropped.
Short Term, Most Investors Prove Their Irrationality
Many investors don’t think about the stock market as a representation of something real—like true business earnings. Fear and greed rule the short-term irrationality of stock markets. But thinking about the market as a group of businesses, and not a squiggly line on a chart or a quote in the paper, can fertilize your wealth. When there’s a disconnection between business profits and stock prices, you can easily take advantage of the circumstances. What happened in the stock markets after 9/11 was the antithesis of the boom times of the late 1990s. Stock prices fell like football-sized chunks of hail. But business earnings were hardly affected.
When the New York Stock Exchange reopened after the 9/11 attacks, it might as well have held up a giant neon sign: “Stocks on sale today!” The US stock market opened 20 percent lower than its opening level the previous month. Scraping together every penny I could muster, I dumped money into the stock market like a crazed shopper at a “going out of business” sale. Speculators hate doing that because they’re continually worried the markets will fall further. Real investors never think like that. They care more about what the markets will be doing in 20 years, not next week.
Worrying about the immediate future is letting the stock market lead you by the gonads.
Most People Have a Backward View of the Markets
The Oracle of Omaha, Warren Buffett, laid out a quiz in his 1997 letter to Berkshire Hathaway shareholders. If you can pass this quiz, you’ll be on your way to doing well in the stock market. But most investors and most financial advisers would fail this little quiz, and that’s one of the reasons most people are poor investors.
He asked his readers whether they would prefer to pay higher or lower prices for items like hamburgers or cars in the future. Of course, it makes more sense to wish for lower prices. He then asks another question. If you expect to buy stock market products over at least the next five years, should you wish for higher or lower stock prices? Buffett says that most investors get this one wrong. They prefer to pay higher prices. Instead, he says people should think about stock prices the same way they would think about the prices of hamburgers or cars:
Only those who will be sellers of equities [stock market investments] in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.15
Young People Should Salivate When Stocks Sputter
William Bernstein, the former neurologist turned financial adviser, says investors in their 20s or early 30s should “pray for a long, awful [bear] market.” He wrote If You Can, a short e-book about investing for Millennials.
Most young people want their investments to rise right away. They want immediate confirmation that they’re doing the right thing. But instead, they should hope for stocks to sag or limp.
Think of stocks as cans of nonperishable food. Workers buy these cans and stuff them in the cellar. Once retired, they eat that food. If the price of those items rises rapidly after they retire, the retirees can celebrate. After all, they’ve already bought their cans.
That isn’t the same for young investors. They’re in the collecting phase. They get less for their money when prices rise quickly.
We can’t control stock market levels. But we can control how we feel about market prices. Young investors should smile—and keep investing—when stocks don’t rise.
Imagine a young investor named Lisa. She starts her career at age 22. She invests every year. Over the next 30 years, should Lisa prefer to see stocks rise by a compound annual return of 15 percent annually for 15 years, followed by an equal time period when stocks average a compound annual return of 2 percent? Or should she prefer stocks to compound annually at 2 percent per year for the first 15 years, followed by 11 percent per year for the next 15 years?
Instinctively, most people would choose option 1. They would want to see their investments make money right away. After 30 years, that would give Lisa $922,817.99. But Warren Buffett and William Bernstein are right. Young investors benefit when markets are weak. The second option is better. With it, as seen in Table 4.6, Lisa’s money would grow to $1,235,866.87.
Table 4.6 $10,000 Invested Annually
Scenario 1: Stocks Gain 15% Per Year for 15 Years, Followed by 2% Per Year for 15 Years
Scenario 2: Stocks Gain 2% Per Year for 15 Years, Followed by 11% Per Year for 15 Years
Year Account Balance
Compound Annual Growth Rate
Account Balance
Compound Annual Growth Rate
$10,000.00
$10,000.00
1. $21,500.00
15%
$20,200.00
2%
2. $34,725.00
15%
$30,604.00
2%
3. $49,933.75
15%
$41,216.08
2%
4. $67,423.81
15%
$52,040.40
2%
5. $87,537.38
15%
$63,081.21
2%
6. $110,667.99
15%
$74,342.83
2%
7. $137,268.19
15%
$85,829.69
2%
8. $167,858.42
15%
$97,546.28
2%
9. $203,037.18
15%
$109,497.21
2%
10. $243,492.76
15%
$121,687.15
2%
11. $290,016.67
15%
$134,120.90
2%
12. $343,519.17
15%
$146,803.32
2%
13. $405,047.05
15%
$159,739.38
2%
14. $475,804.11
15%
$172,934.17
2%
15. $557,174.72
15%
$186,392.85
2%
16. $578,318.22
2%
$216,896.07
11%
17. $599,884.58
2%
$250,754.63
11%
18. $621,882.28
2%
$288,337.64
11%
19. $644,319.92
2%
$330,054.78
11%
20. $667,206.32
2%
$376,360.81
11%
21. $690,550.45
2%
$427,760.50
11%
22. $714,361.45
2%
$484,814.15
11%
23. $738,648.68
2%
$548,143.71
11%
24. $763,421.66
2%
$618,439.52
11%
25. $788,690.09
2%
$696,467.87
11%
26. $814,463.89
2%
$783,079.33
11%
27. $840,753.17
2%
$879,218.06
11%
28. $867,568.23
2%
$985,932.05
11%
29. $894,919.60
2%
$1,104,384.57
11%
30. $922,817.99
2%
$1,235,866.87
11%
How about a constant annual compound re
turn of 7 percent over 30 years? It would be easier on the nerves. Instinctively, it also looks better than facing weak stock returns for the first 15 years. But the market laughs at instinct. As seen in Figure 4.3, this third scenario would see that money grow to $1,020,730.41.
Figure 4.3 Compounding Growth of Differing Scenarios
Facing the first 15 years of horrible returns, followed by 11 percent per year, would provide $215,136.46 more.
Nobody can control stock prices. But people can control their behavior and perspective. Young people, especially, shouldn’t be afraid to invest when the markets sputter.
Instead, they should invest every month—and smile when markets lag.
Opportunities after Chaos
When the stock market reopened after 9/11, it was trading at a discount. As a result, I added more money. But where did I get it?
I sold some of my bonds. It didn’t take any kind of special judgment on my part. I just stuck to a mechanical strategy, which I’ll explain further in Chapter 5.
Unfortunately, the money I invested in the US stock market index in September 2001 went on to gain 15 percent over just a few months. By January 2016 (even after the financial crisis of 2008–2009), the value of my stock purchases in the autumn of 2001 was up more than 158 percent, including dividends. But that upset me. Yes, you read that right. I was upset to see my stock market investments rise.
After 9/11, I wanted the markets to stay down. I was hoping to keep buying into the stock markets for many years at a discounted rate. It’s a bit like betting that a sleeping dog on a long leash is eventually going to have to get up and run to catch its sprinting owner. The longer the leash and the longer that dog sleeps, the more money I can put on the dog, which will eventually tear after its owner up the hill, pulling my wheelbarrow load of money behind it. Sadly for me, the stock market didn’t sleep in its discounted state for long.
Of course, not everybody is going to be happy about a sinking or stagnating stock market. My apologies to retirees. If you’re retired, there’s no way you’re going to want to see plummeting stock prices. You’re no longer able to buy cheap stocks when you’re not making a salary. And, you’ll be regularly selling small pieces of your investments every year to cover living expenses.
Younger people who will be adding to their portfolios for at least five years or more need to celebrate when markets fall. I didn’t think I would get another opportunity to benefit from irrational fear after September 2001. A plunging stock market is a special treat for a wage earner—one that doesn’t come along every day. But another opportunity fell on my lap again between 2002 and 2003 (as shown in Figure 4.4), with the stock market eventually selling at a 40 percent discount from its 2001 high, after the United States announced it was going to war with Iraq.
Figure 4.4 US Stocks Offered a Wonderful Sale
Source: Yahoo! Finance historical price tables for Dow Jones Industrials
Was the average US business going to make 40 percent less money? Were businesses like PepsiCo, Walmart, Exxon Mobil, and Microsoft going to see a 40 percent drop in profits? Even at the time, it would have been really tough to find anyone who believed that. Yet, US businesses were trading at a 40 percent discount on the stock market. I was salivating, and hoping that the markets would stay down this time—for years if possible. I wanted to load up.
I didn’t know how low the markets would fall, so I wasn’t lucky enough to buy stock indexes at the very bottom of the market’s plunge. But it didn’t matter to me. Once the “20 percent off” flags were waving in my face, I was a chocoholic stowaway in Willy Wonka’s factory. The stock market continued to fall as I continued to buy. If I could have taken an extra job to give me more money to take advantage of cheap stock prices, I probably would have done it. For some reason, most investors were doing what they typically do: they overreact when prices fall, sending stocks to mouthwatering levels. They sell when they should be buying. They become afraid of a discounted sale, hoping (and yes, this is a true representation of insanity) that they can soon pay higher prices for their stock market products. They miss the point of what stocks are. Stocks represent ownership in real businesses.
Again, I hoped that the stock markets would keep falling in 2003, or that they would stay low for a few years so I could gorge at the buffet.
It was not to be. I was disappointed as the US stock market index began a long recovery from 2002–2003 until the end of 2007, rising more than 100 percent from its low point in just four years. Retirees would have been celebrating, but I was crying in my oatmeal. The big supermarket sale was over.
As the stock market roared ahead in 2007, I didn’t put a penny in my stock indexes. I bought bond indexes instead. Following a general rule of thumb, I wanted my bond allocation to equal my age. For example, I was 37 years old and I wanted 35 to 40 percent of my portfolio to be comprised of bonds. But the rapidly rising stock market in 2007 was sending my stock indexes far higher than the allocation I set for them. As a result, my bonds represented far less than 35 percent of my total account, so I spent 2007 buying bonds—even selling some of my stock indexes to do it.
Figure 4.5 Worldwide Stock Market Sale
Source: Vanguard historical prices for total US and international indexes
I resumed my aggressive stock-buying plan in 2008 when the stock market traded at a 20 percent discount to its 2007 peak. Figure 4.5 shows what kind of hammering the stock market took in 2008. And I happily increased my purchases with my monthly savings as the markets plummeted by 50 percent from 2007 to a low point in March 2009. It was like wandering into an Apple computer dealership and seeing the discount bins filled to the brim with the latest iPhones. Stocks were selling at 50 percent off—and nobody was lining up to buy them! At one point, the stock indexes had fallen so far that I sold a large amount of my bond index so I could buy more of my stock index, mindful of keeping a balanced allocation of stocks and bonds. When the stock markets fell, my bond allocation ended up being significantly higher than 35 percent of my total portfolio. Selling off some of my bond index to buy more of my stock index also helped bring my portfolio back to the desired allocation.
With stock prices falling so heavily, I finally understood Buffett’s comments in 1974, when he was interviewed by Forbes magazine. Faced at the time with a stock market drop of a similar magnitude, he said he felt like an oversexed guy in a harem.16
Again, did the economic crash in 2008–2009 eat into the profits of US businesses? Certainly some of them lost money, but not all. If stock prices fall by 50 percent, it can be justified only if business earnings have fallen (or expect to fall) by 50 percent. As always with the stock market, investors’ fear and greed can produce irrational price levels. In 2008–2009, I prayed stocks would remain cheap.
Obviously, praying for something so nonspiritual was the wrong thing to do. Perhaps divine intervention punished me for it when the markets rose. Between March 2009 and January 2016, the US stock market index rose 223 percent and the international stock market index, which I was also buying, rose 104 percent. I’m not the sort of guy who normally gets depressed, but the indexes I was buying were getting pricier by the month. I would have preferred it if the markets had stayed low.
People don’t normally get such wonderful opportunities to take advantage of crazy, short-term discounts. But with sensational financial television programs based on financial Armageddon, with a rough economic period, and with the Internet spreading news of emotional market sentiment far and wide, we had a recipe for some remarkable stock market volatility over the past decade.
Unfortunately, the enemy in the mirror thrashes most investors. They like buying stock market investments when prices are rising, and they shrink away in horror when they see bargains. How do we know? We just need to observe what most investors do when stock markets are falling or rising. John Bogle, in his classic text, Common Sense on Mutual Funds, reveals the startling data while asking the rhetorical question: “Will investors never lea
rn?”
In the late 1990s, when stock markets were defying gravity, investors piled more money into the stock market than they ever had before, adding $650 billion to stock mutual funds during this period. Then when stock prices became cheap in 2008 and 2009, with the biggest market decline since 1929–1933, what do you think most American mutual fund investors were doing? When they should have been enthusiastically buying, they were selling off more than $228 billion of stock market mutual funds.17
What we do know about the future is that we will once again experience unpredictable stock market shockers. The markets will either fall, seemingly off a cliff, or they’ll catch hold of a rocket to soar into the stratosphere. Armed with the knowledge of how stock markets reflect business earnings you won’t be seduced to take silly risks, and you won’t be as fearful when markets fall. By building a responsible portfolio of stock and bond indexes, you’ll create more stability in your account while providing opportunities to take advantage of stock market silliness.
The next chapter will show you how to do this.
Notes
1“Mind The Gap 2014,” February 27, 2014, Morningstar.com, http://www.morningstar.com/advisor/t/88015528/mind-the-gap-2014.htm.
2Portfoliovisualizer.com, accessed July 7, 2016.
3John C. Bogle, The Little Book of Common Sense Investing (Hoboken, NJ: John Wiley & Sons, 2007), 51.
4Andrew Hallam, “Are Index Fund Investors Simply Smarter?” AssetBuilder.com, December 8, 2014, assetbuilder.com/knowledge-center/articles/are-index-fund-investors-simply-smarter.
5Jonathan Clements, “Are Index Fund Investors Smarter?” The Wall Street Journal blog, March 26, 2015, blogs.wsj.com/totalreturn/2015/03/26/are-index-fund-investors-smarter/.