GameStop (GME) was trading at about $19 per share until January 12 or so. Then something changed. Trading volume increased dramatically and the price started going up. So much so that it more than doubled in less than two days, causing a lot of hype, more interest, and finally closing at $328 per share on January 29. That’s 17 times more than on January 12! How can it be? And what does it mean for long term investors?

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It would be great if we could just pick companies like Amazon, Apple, 3M, or [your favorite growth story here] and invest in those very early on, but we can’t. There is plenty of evidence that highly paid professional investors can’t do that reliably, let alone average investors. Accepting this fact is the first step to a much better investment experience and low levels of investment-related anxiety. 

So what can we do? As we showed in part 1 of our series, we don’t need to be able to pick winners or have a crystal ball to benefit from the stock market. We can leverage the idea that, while fluctuating, stocks have tended to rise in value on average and over time, generating handsome returns for long-term investors. These potential returns can be pursued by investing broadly across stocks, a strategy that goes by the name of diversification. 

Diversify, Diversify, Diversify

There is simply too much risk in picking single companies. Differences in returns across stocks are such that a small number of stocks strongly outperforms the average, while the majority of stocks underperforms the market average. In fact, fewer than 50% of stocks beat short term Treasuries in a given year. The chances of picking the right one year in and year out are stacked against you. 

But you can use the diversity of returns across stocks over any given period to your advantage by spreading your investment across many stocks.  Doing so means that the bad returns of some companies can be offset by the good returns of other companies. The more companies you include, the closer you will get to earning average or market returns. This will help you eliminate extreme risks and smooth out some of the bumps in investment performance over time.

How many stocks should you include? The answer is basically all of them. Investment solutions are available that let you do just that, and at a very low cost. The three golden rules of stock investing are Diversify, Diversify, Diversify.

Choosing Mutual Funds and ETFs

Most individual investors don’t buy stocks directly. They invest in stocks using pooled investments like mutual funds and exchange traded funds, or ETFs. Because putting together and managing a portfolio of stocks requires expertise, time, effort, and a sizable investment, most investors prefer to use a professional manager to do that for them. That’s what mutual funds and ETFs do, they professionally manage a portfolio for you. Unfortunately, given the variety of funds out there, choosing a fund can be even harder than choosing stocks individually. According to the Investment Company Institute or ICI, there were over 11,000 mutual funds and ETF as of December 2019. So, how is one to pick?

Avoid Actively Managed, High Fees, And High Turnover Funds

The first thing we can do is to eliminate actively traded mutual funds. These are funds that try to beat a market index (like the S&P 500) by trying to actively pick winners or by timing when to enter or exit a certain sector or market.  Professional money managers aren’t much better than the average investors at beating the market average. Recent research by S&P Dow Jones shows that over the last 15 years, 87% of funds that actively managed US funds failed to beat a passive market index. Not only that, less than 50% of the funds at the beginning of the 15 year period are available for investing today, because they did not survive for 15 years! Turns out the median life of an active fund is only about seven years. The risk of losing everything after seven years is not what most investors sign up for when they are saving for important goals. 

You can find out whether a fund is active from the prospectus of the fund, which is usually readily available on the manager’s website. However, a good indicator of active management are high fund fees. The median active fund has fees well over 1% per year. You can safely eliminate all funds with total annual fees above 0.65%, which is the 10th percentile across equity funds according to ICI data. 

High fees are also a good indicator to eliminate funds that target a narrow market or don’t have enough diversification (like industry specific funds), and funds that target asset classes that are not appropriate for most investors (e.g. individual commodities). Reading the prospectus sections on fees, investment objectives, investment strategies, and turnover can also help you determine whether the fund is worth considering.  

You don’t necessarily want to eliminate a fund just because of higher than average fees, but the fund must have compelling objectives and strategies for your goals. This is where you may want to consult with a trusted and objective advisor before investing.

Get to know index investing

As we reviewed in part 1, an index includes all stocks in a selected group or category, called a universe. For example, the S&P 500 includes the 500 largest companies traded in the US stock market. The Russell 3000, another index, includes the 3000 largest companies traded in the US stock market. Because there are a total of about 4000 stocks in the US market, the Russell 3000 is more comprehensive as a market index than the S&P 500. The S&P 500 is a better representation of the performance of large US companies. 

Index funds are mutual funds and ETfs whose investment objective is to track a specified index. Their investment objective is the conceptual opposite of an actively traded fund, which makes active attempts to beat the index by picking stocks or bonds.

You can find out if a fund is an index fund in the prospectus, under the investment objectives or investment strategies sections. The way stocks are combined in most indexes is by market capitalization: if company A is twice the market value of company B, it gets twice the weight in the index. 

Index funds are an effective way to build a highly diversified portfolio for your goals. The returns of an index fund should approximate the return of the market or market segment it is tracking, minus the cost it takes to manage the fund. Because index funds don’t have to spend money on the research and management necessary for actively managed funds, their fees tend to be much lower. The median index fund charges 0.33% in fees, and many common index funds charge between 0.04% and 0.12% in fees, a fraction of what active funds charge.

Some Common Indices by Market Segment

The most common index providers are S&P Dow Jones, CRSP, and Russell for the US market, and MSCI, FTSE for international markets.  Some of the most common indices in terms of invested assets are listed in the table below. The goal is not to be complete, but to get familiar with some of the names and the market they represent. Your 401(k) plan or IRA may have fund options that track some of these.

Region	Company Size	Index
US	Total Market	CRSP Total Market Index
		S&P Total Stock Market Index
		Russell 3000 Index
	Large Cap	S&P 500 Index
		Russell 1000 Index
	Small Cap	S&P 600 Index
		Russell 2000 Index
International Developed	Total	FTSE Developed ex-US All Cap Index
	Large	MSCI World ex-US Index
		FTSE Developed ex-US Index
	Small	MSCI World ex-US Small Cap Index
Emerging Markets	Large/Mid	FTSE Emerging Index
		MSCI Emerging Markets Index

There are thousands of indices. However, most investors will benefit from a very broad exposure to different markets, so just look for broad coverage areas, like the table above. For the US, total market indices are preferable. However, even an index like the S&P 500 covers over 80% of the total US stock market value. Stocks of smaller companies are typically riskier than stocks of large, established ones, but have yielded higher returns, on average. International developed indices track the markets of 23 internationally developed countries around the world. Emerging market indices track the performance of 26 emerging market countries. 

A global market index would have approximately 60% US stocks, 30% internationally developed stocks, and 10% emerging markets stocks. These percentages represent the share of each region in the global stock market. So with three funds one can build a highly diversified portfolio containing over 12,000 securities, at a fraction of what the average actively managed fund may charge. 

Additional Considerations

Index investing is common sense investing. All investments involve a certain amount of risk, for which we expect to be compensated by future returns. We can’t eliminate all risk if we want to benefit from higher potential returns. However, with a diversified portfolio we can eliminate extreme risks that go with trying to pick winners and instead focus on earning average market returns, which historically have been substantial. 

Is indexing the best we can do? If all investors held the same portfolio, it would have to be a portfolio with 60% US stocks, 30% international stocks, and 10% emerging markets stocks, like the index approach. That’s because in aggregate all investors have to hold the market, which is roughly split this way. So the market aggregate is a great starting point for the average investor. Deviating from the market may make sense, but whether and how to do it depends on individual needs and preferences. We will describe some general framework for doing so in future posts.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.

Stocks and bonds are very effective tools to grow and manage wealth. You can combine stocks and bonds to help you save for virtually any goal, from growing a nest egg for retirement to saving for college education, to a safety net. In practice, however, many people don’t have the confidence needed to select stock and bond investments. In addition, they may have had bad past experiences, particularly with stocks. The difficulty in selecting portfolios of stocks and bonds, combined with individual biases and past experiences, causes many people to hold suboptimal investments or others to avoid stocks and bonds altogether, to the detriment of their financial plans.

If you have felt like one of those investors before, we have good news for you. It turns out that a few basic principles grounded on economics and data can help us make sense of stocks and bonds, and guide us in making better decisions with our savings. We start with stocks this week, so follow us to learn more about bonds and how to put your investment portfolios together in future posts.

Stocks vs Bonds

When you buy stocks, you buy a small piece of the corporations that issued them. Therefore, with stocks you have a claim to a company’s current and future profits, after costs and other obligations have been paid. Bonds are a promise to make payments back at specific times in the future, and typically include semi-annual payments and a repayment of principal (the amount invested) at the end of the term of the bond (which can be up to 30 years). Both governments (from local to federal) and corporations issue bonds. 

Generally, neither bonds nor stocks guarantee investors that they will get back the money they invested. However, because bonds are typically issued by governments with tax powers or more mature companies, bond repayments are relatively more predictable. In contrast, because a company’s future profits can vary unpredictably over time, the amount that can be returned to stockholders is much less predictable. If a company issues both bonds and stocks, payments to bondholders have priority over payments to stockholders.

Present Values and Stock Prices

Many goods and services that we consume provide us with value over time, including cars, clothes, watches, our home, and many others. Their market value depends on the total value or benefit they will provide over time. Compare two identical houses in the same location, one with a brand new AC system and one with a 10-year-old system that works great today. Both houses can provide you with the same benefits, today. However, the house with the brand new system will be worth more because it can provide air conditioning for many more years to come. The market value of the house represents the present value of all future benefits, net of future costs.

The same concept applies to businesses. The value of a business depends on the total amount of profits that it will be able to generate over time. Therefore, the stock price of a company reflects the present value of all the profits that the market believes the company can generate in the future. Even a company with no profits today can have a positive present value, if investors in the stock market believe the company will generate profits in the future. For example, Amazon was founded in 1994, and had no profits until 2001. However, a share sold for $18 when it went public in 1997. Over time, the value of Amazon has changed to reflect investor’s expectations of its ability to generate future profits. 

Uncertainty and Risk

The idea that the market value of a business is the present value of future profits helps us understand why stock prices fluctuate so much. Future profits are hard to predict, even for large, established companies, let alone smaller ones. Profits depend on many factors, including the overall state of the economy, the amount of competition, technological factors that may make a product obsolete, government intervention, the weather, pandemics, and many other factors. As all these factors change over time, so does the market view of a company’s future profits. If we think about it this way, it’s no surprise that stock prices change so much over time.  

The degree of fluctuations is such that some companies experience exceptional growth (Amazon, Google, Apple, 3M, Coca Cola, etc.), while others succumb after a few years. Research shows that the average company is listed on the NYSE for about 7 and a half years. Unfortunately, you can’t know ahead of time which companies will survive and prosper and which ones won’t. This makes investing in single stocks very risky. But should this surprise us? Not really. Estimates of the median life of any business are of similar length of time.

The lesson here is that while stocks attract a lot of attention and feelings of both greed and fear, common sense and economics can go a long way in explaining what we see in stock markets. We should not be afraid to invest in stocks any more than we are investing in any business or investment property. If anything, financial markets make it easier to invest in stocks relative to other alternatives.

Risk and Return 

The good news about stocks is that bearing the uncertainty that comes with stocks has benefited investors historically. While stock prices fluctuate over time, they also tend to grow. After all, who would invest in a risky investment without the potential of future returns?

The growth potential of stocks is easy to understand in the Amazon case by comparing the stock price at the end of 2000 with the price in 1997. Even though there were no actual profits in either year, the company was worth much more in 2000. Not only the profits that were expected in 1997 started to look much more real, but by the year 2000 investors expected even higher future profits from Amazon.

Amazon is a particular case that has experienced exceptional growth, both in value and in actual profits. But the idea applies generally to stocks. As the general economy grows and brings a general increase in profits, we expect stock prices to increase in value. Historically, stock returns, including dividend payments and stock price appreciation, have been positive over long periods of time in the US and globally. For example, the US stock market has delivered annualized returns of over 10% between 1926 and 2019, as measured by the S&P 500 index, an index of the current 500 largest corporations traded in the US. A dollar invested in the S&P 500 in 1926 would be worth $9,237 today! 

Growth of the S&P 500 Index (1926-2020)

This is a hypothetical scenario for illustration only. Data Source: Dimensional Fund Advisors.

The high average returns did not come without risk. There have been relatively long periods of negative or very low growth, most notably during and in the aftermath of the Great Depression (1929-1941), and in the decade 2000-2009. The high average return on stocks is earned on average and over time for bearing periods of low returns.

A Key Point: It is important to realize that the S&P 500 contains the largest 500 companies at a point in time. The companies that make the index in 2000 are different from the ones in 2020, although some do overlap. Many companies are added and many drop out over time as some grow to become the next Amazon while others may not grow or even fail and get delisted. The returns you see in the chart above are obtained by buying all of the companies, the ones that grow, and the ones that fail. The chart shows that you don’t have to be good at picking stocks or have a crystal ball to realize handsome returns if you are a long-term investor.

What’s a Market Index?

The S&P 500 is a “market-weighted” index of the 500 largest companies in the US by market value. It represents the returns of a hypothetical portfolio that invests in the 500 largest companies in the US, where companies are assigned a weight proportional to their market value. So if company A is twice the market value of company B, the index gives twice the weight to company A relative to B. This means that the returns on the index are equivalent to the returns of a hypothetical investment that purchased the 500 companies in their entirety. It turns out that the 500 largest companies represent about 85% of the total value of the US stock market. That’s why an index like this is often called a market index. There are other indexes besides the S&P 500, and we will review some of the most common ones in a future post.

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These basic facts and principles can go a long way in getting us started with investing in stocks. How many stocks should you own in your portfolio? What is the most effective way to do that? Stay tuned for part 2 of our guide to find out.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.