Many people fear losing money and therefore avoid the stock market. It’s complex and it can go up and down rapidly, they say. What if it goes down when I need the money? We hear stories and see movies of those who lost fortunes, which adds to our fear. Plus, many feel that it takes too much research and time to figure out the best way to invest. So, maybe you leave your money on the sidelines, letting the “experts” deal with the stock market.
Last week, I discussed whether the stock market was gambling. Check that post out here if you haven’t already. I concluded that we don’t have to dig through textbooks or stare at stock charts for hours, trying to find and predict the future winners. The historical returns of the stock market have been good, and a disciplined buy-hold strategy can get us far. This is good news, but the question remains: what are my risks?
The Risks Of A Stock
Let’s start with the risks involved with any one company. To lose all my money in a company like Apple, for example, they would have to go out of business. At first, when you think of Apple’s size, 132,000 employees, the strong brand name – valued at 300 billion – and over 200 billion in annual sales, it seems impossible to lose. True, with a powerful company like this, they’re probably not going to go out of business overnight, but it doesn’t take much for the stock price to plummet.
The most important thing to understand is that the size and strength of Apple is built into its stock price. It’s brand name, it’s assets, it’s revenue, it’s innovation – all built into the price someone is willing to sell it to you for. This means that Apple could sell 200 Billion dollars next year, and, all else equal, its stock price would drop. Think about that for a second. $200,000,000,000 in sales. It would take you over 6,000 years to count that high. Most companies in the world would do just about anything to reach that level of sales, and yet, if Apple sold that much, their stock price would drop.
Why? Because as of right now, Apple is projected to sell 256 billion for 2019.
Imagine yourself as an investor deciding between 2 companies to buy. The first has projections of 200 billion in sales for the year, and the second 256 billion. Remember, returns in the stock market are all about company profits, so, all else being equal, you’re going to want the company with higher projected profits. Thus, you’re going to be willing to pay a higher price for it. Now, imagine you buy the stock, but when the end of the year comes, profits were only 200 billion. You’re going to be disappointed. Your dividend will most likely be lower, the company won’t be able to do as much development as it thought, and because it didn’t meet expectations, the stock price will drop.
That’s how fragile stock prices are for even the biggest companies. Think of all the possible scenarios that could result in lower-than-expected profits for Apple. Price increases in the raw materials used to produce iPhones, new government regulations, an earthquake in California damaging their headquarters, a major lawsuit, an increase in the cost of cellular data, competitors like google taking more of the market share, negative news about the CEO or another officer, and much more.
Last week (on July 18, 2019) Netflix stock dropped 11% because it added only 2.7 million paid subscribers in the first quarter, when earlier in the year it sent out a letter to shareholders projecting to add 5 million. Suddenly, there’s a lawsuit by shareholders, negative headlines, and the price dropped further. Situations can change instantly for any company.
When enough of these types of things happen over time, they can take a big company down. Since 2008, the DOW (the 30 strongest US companies) has seen 10 new faces. That’s about 1 big company dropping out per year. AT&T, Kodak, GM, citigroup, Kraft, Bank of America, and GE are among some of the household names to fall off the list in recent years. Will they bounce back? Who knows, but many investors lost money if they owned these stocks in isolation.
You can see that the risks of losing money when owning single stocks is fairly high, and to go back to the question in my previous post “Is investing gambling?”, if your portfolio only consists of a few single stocks – even that stock – yes, you are gambling with your money.
So, what about mutual funds then?
The Foundation Of Reducing Risk
A mutual fund is a company that invests in multiple stocks and makes it easier for the average investor to diversify. A single mutual fund can have up to several thousand stocks in it, and for one share you can own a part of all of them. Doing this yourself might cost hundreds of thousands of dollars just to buy 1 share of each stock in a single mutual fund, not to mention the nightmare re-balancing would be. Mutual funds are the first step in diversifying, and they eliminate a significant amount of risk inherent with owning a few single stocks.
This brings us to the next fundamental of investing: diversification. When you increase diversification, you decrease risk. (The first fundamental is a buy-hold strategy)
When I own thousands of companies, if something specific happens to any one of them, it doesn’t affect my portfolio much. If a hurricane destroys Apple’s Accelerometer manufacturing plant in Taiwan, I own plenty of other companies to pick up the slack. Also, as certain companies start to fall off, they can be easily replaced by others. Enron was one of the hottest companies at one point, with 600 million in sales, and yet it’s stock went below $1 in less than 5 months, and bankrupt not long after. You live with that risk every minute when you hold just a few stocks. With a diversified portfolio though, when one stock drops off, another one takes it’s place.
So, what’s the risk of losing everything? If I own 10,000 of the most important companies across the world, what’s the chance they all go out of business at once and never bounce back? Or, think about it another way: If the 10,000 most important companies in the world all went out of business, we have more to worry about than the stock market, we’re talking about Armageddon. With a properly diversified portfolio, the risk of losing all of our money is remote.
There are still important risks involved with mutual funds though, and we’ll cover some of those next time by asking the question: what if the market drops when I need the money?
*Advisory services offered through Paul Winkler, Inc. (‘PWI’), a Registered Investment Advisor. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. There is a risk of loss or gain with any investment.