Paul Winkler: And welcome to The Investor Coaching Show. Paul Winkler here, talking about investing, educating, because the educated investor is not easily taken advantage of. So that’s the idea and it doesn’t mean you have to know everything, but knowing the right things can be kind of an important thing.
I’m going to go a little bit more basic, more as a result of a meeting I had this week. I just, you know, when I have meetings with people, I’ll typically start at whatever level that I see them at. And so on every day, every once in a while, you know, you just make a mistake. You just don’t realize that people don’t know everything that you think that they might know. And that’s certainly the case. I certainly find myself in that, and you know, you do this for over 30 years and you know, I’ve gone out and gotten so many different designations, chartered financial consultant, registered financial consultant, chartered life, underwriter, life underwriter, Trent train counsel, fellow accredited, asset management, special specialist.
But I just, you know, sometimes you just don’t think that everybody’s interested in what you’re interested in and you know, so for me that often I’ll have meetings with people and I’ll be talking in typically I’m pretty good at figuring out where people are. And sometimes, maybe not so much, you might have a, let’s say a husband and wife, and maybe the wife is really into investing or the husband’s really into investing in the other spouse is not, you know, that can happen quite often, but it may be that, you know, you’re talking over one person’s head and talking right at the level that the other person is at.
How mutual funds are put together
So what I thought I’d do is share a little bit that happened in one of these meetings that I had now. It was a situation where either person really didn’t know a whole lot about what they had been investing and that they had been investing in real estate for many years and new real estate. Well, you know, they had some property and rental property that they had, and it was happening to be a strip mall. So, you know, it makes it easy to explain what I did versus, you know, owning a single property, like a single home or something like that.
Well, what happened was this, they had an investment account with a couple of mutual funds with a large mutual fund company. And what happened in the meeting, we were going through it. And I swear, you know what? There are certain things that you need to know about investing to be a successful investor. And one of them is, you know, that there are certain rules of investing. You’ve probably heard all your life and you want to make sure that you’re following those rules because the rules are there because they actually make some sense.
And, you know, for example: buy low, sell high. And so we don’t want to buy on past performance. We don’t want to buy based on history; that’s a big mistake. I see a lot of people making money right now, they’re buying funds or they’re getting rid of funds that have had poor performance than other areas of the market. So what they’re doing is they’re saying, I’m going to get rid of this. Well, you know, what’s the second one, you know, sell high, not sell low is the idea. And then go and, and invest in something that is low, but not, you know, not necessarily going in and shooting yourself in the foot by going and selling something that hasn’t done well recently.
And then buying something that has done well recently. So hence buying high. So, you know, I talk about that. And then I talked about, you know, diversification, you know, and the reality of it is you’ll auto on some things that haven’t done that well recently, as well as some things that have done well recently, like large US stock funds, growth funds, bigger companies. So, you know, let’s say that, you know, if I look at typically 401(k)s or retirement accounts or typical asset mixes from big investment firms, they’re usually overwhelmed with bigger companies.
And the reason is, because of familiarity. I’m familiar with big companies as an investor, I get more excited about big companies. So what happens is that when those big companies do well, people get a false sense of confidence that, Hey, look at this, look how smart the investment manager is. And this is exactly what happened in the late nineties before everything fell apart. And you had an 80% decline in tech stocks and 40% decline in big companies overall over 40%.
So, you know, it can really, really be very dangerous for investors to invest in what is familiar and be concentrated in there. Now, even small company funds, typically you’ll find 401(k)s are overweighted with bigger companies, bigger small companies. And, you know, you find some funds, they’re actually called small funds, but they’re actually investing in mid cap stocks. You’ll find that value funds aren’t really investing in value stocks. You know, they’re investing in more growth companies because why cause those growth, the companies are going to be by definition companies that are, are more popular and better known.
Whereas if we look at history, we see that value companies actually would have a higher expected return. Now it doesn’t mean it always plays out and you’ll have a period of time where growth stocks do better than value. And hence, you’ll have a situation where, you know, people will go, well, you know, forget those value stocks. And then all of a sudden you have like a 2000 where growth drops in value goes up. And same thing with 2001, the same thing happened. So that is a challenge to keep investors disciplined because they don’t really, they don’t, they don’t get this stuff, but you know, one of the things that kind of caught me by surprise is not even knowing what a mutual fund was and how they worked.
So I thought I’d just spend a couple minutes and talk a little bit about that. And the way I described it was this, you know, this account had two fidelity funds. And I said, well, you know, both of them only have both, both funds, only Amazon, both own Microsoft. And nah, I don’t like that company. I don’t like that company. I don’t like that. I was like, well, you own it. And most of your money is in those particular stocks. And so I don’t really get how this all works.
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A Mutual Fund Explained
So you take a company and you split it up into little tiny pieces. So you get to own a fraction of the company, you know, cause you know, not too many people running around and can go, Hey, you know what? I’ve got about a hundred billion dollars sitting here in my pocket. I’m going to go buy this whole company. You know? So what you do is you split it up into pieces and they call those shares and now we all get to own them. And the problem that you run into is let’s say if you’re dealing with the S&P 500, now those are the 500 biggest companies in general.
It’s not always an, it’s not an exact thing, but in general, they’re about the 500 biggest companies in the United States. And you take those 500 companies. And if you want to buy stock in them, now you’ll have these fractional shares that they’re out there. You can buy fractional shares now and you’re paying more. We need to do that. But so I typically don’t even want to talk about that. That’s not something I’d want to do. I wouldn’t want to own individual stocks anyway, but when the only S&P 500, I want to be diversified between all 500 companies. And I want to keep my expenses low.
I will buy in round lots, which are a hundred share units. So, you know, you think about Wall Street. They don’t want to deal with little piddly shares. Matter of fact, there’s kind of this thing on wall street. If there are odd lots, if the investing in odd lots increases, and this goes back to like the depression, if the investing pre depression, if the investing in odd lots, which are smaller than hundred share units increases, it’s time to get out of the market.
And the reason that was the belief was because, Oh my goodness, if people are buying odd lots, which are these smaller share units, it must be that the small investors starting to get excited about investing in small investor, usually only gets excited before market downturns and they end up buying and shooting themselves in the foot. So, we look at odd lots and round lots. So if I want to keep my costs down, I buy round lots. So 100 share units. So I got 500 stocks and I buy and round lots, you know, so that’s a hundred.
And then let’s say that the average share price is $50 per share. Well, that means I’ve got to come up with $2.5 million just to get diversified in that area of the market. If I want to keep my cost down again. Now, if you look at that and you say, Whoa, that’s a lot of money. Well, what about small companies? Because a small company fund owning the entire market and in some funds make the mistake of only owning a piece of the small cap market, which is dangerous because now you’ve got a lot more risk because which small company you’re trying to pick winners and losers there, which small companies are going to survive, which are going to do well, which aren’t going to do well.
And that can be really dangerous, but you know, if I own the home market, I might own 2000, you know, like the Russell 2000, that’s 2000. Now, I’m not a big fan of investing in the Russell 2000, for those of you, the more sophisticated investors, because it overweights big companies, bigger companies in that, in that index. You’re overweighting the bigger of the small companies, which can be counterproductive when small companies are outperforming large ones, which is the majority of history now. Okay. So I have a couple thousand companies that have to buy there.
What about small value now? We got another 1400, 1500 companies. Oh, what about large value? Now we got another 500, you know, four or 500 companies there. Oh, well what about, let’s say international. Well, internationally, you got 1400 companies that are big international. What about US? Small international. Now you’re dealing in another 4,000 stocks right there. So you get to the point where you go, Oh my gosh, based on the math that just owning 500 and coming up with 2.5 million to do that. Now, how much is it? If I’m diversifying across all these areas, and that becomes insane.
So what do we do? Well, everybody pulls their money. All investors pull their money and they stick it into a big pot and that pot is divided up. So you own a fraction of the pot. So you take all the money and stick it in there. And let’s say between all these investors that stick money in the pot, there’s $2.5 million. And now the manager goes and buys those 500 companies. And now you own a portion of the pot and they charge a management fee to, you know, to do this for you.
And with large US stocks, it’s an extremely cheap area, the market to manage. And that’s why it’s such a hot area right now is, Hey, you got this. And I called it a perfect storm in a workshop that I taught recently. It’s a perfect storm. That’s the area of the market that had the best performance recently, big US companies. And they’re the most recognizable companies and it’s the cheapest area of the market to manage. So, you can see where it’s just like a fatal attraction.
Investors are flocking to it. And I’m shaking my head going, Oh my goodness. If they only realize, you know, historically those companies sell for about $2.40 for every dollar book value. Now there are over $3. Well, over $3.60, that doesn’t mean it’s going to crash, you know, imminently, but it does give you a reason for some pause, you know, going and doing that. Now, if we take this, say the, this pot of money, and now we just analyze it.
Now, if you look at it, you may own one 10000th of a share of Apple. Now, instead of, you know, owning a hundred shares of it, you know, so you can see how, when I do this, I can actually reduce my risk, my overall risk, because I’m diversifying a far greater level and you get rid of what’s called non systematic risk. It doesn’t mean you get rid of risk. Now there’s a risk in the system. In other words, Hey, even an entire portfolio of 500 companies goes up and down.
The Importance of Diversification
So there’s, it’s like the ocean, the ocean current, it goes up and down and up and down. If you imagine you had 500 boats on the Atlantic ocean, and you’re just kind of watching these 500 boats and as the tide’s going up, all 500 boats rise. And as the tide goes out, all 500 boats go down. Okay. Now think about what if you only owned two of those boats? What’s the possibility that a couple of those boats could sink high, high possibility. What’s the possibility that all 500 will sink, not as much.
So what I’m doing by owning all of these companies is I’m getting rid of that non-symptomatic or that risk that just a couple of them might go under, but they’re probably not all going to go under. So that’s the idea behind diversifying that broadly now, still not quite getting a concept here, the person wasn’t quite getting it. So I said, let me take this into your world. You owned a strip mall. She said, yeah.
How many units in it? 13. So, okay. Okay. 13 units. And did you own it by yourself? No. Had a partner. Okay, cool. Great. Basically what happened is all 13 units, let’s say that they were a hundred thousand dollars per unit. Let’s just use that as a number and you had 13 of them. So it’s 13 times, $100,000, which is 1.3 million, and you only had enough money to buy half of it. So, you know, you had the $650,000 and a friend of yours had $650,000.
Now what you do is you put your money in a pot, the $650,000 each, and now you’ve got enough money to buy all 13 units. Now you have unit a and B and C and D and all the way up now, going up to the 13th letter of the alphabet. And now you own half of the unit and she owns half of a unit. You own half of unit B, she owns half of unit B, and so on and so forth. And you split the profits, right? Bingo. That’s the idea behind a mutual fund.
You basically own all of these companies in common, and you get a proportionate share, whatever we’re senators your ownership. If you own 1/100000th of a stock company’s value in stock, you get one, 100th of a hundred thousand of the earnings of that company. And if they declare, you get one, 100000th of the dividend of that company. If it goes up in value, your share of that value growth is one, 100,000 of the value of that company.
So, hence, you know, when we look at investing in the market and owning a mutual fund, that’s basically what you’re doing. You’re diversifying and you’re owning lots of different things. Now, the problem is when you own mutual funds, like I was talking about, and they own the same stocks. When those companies go down, when Apple goes down, you’re, you’re double whammied on that, because now you have two mutual funds that are heavily invested in that one stock. And both of them go down as a result of it. So what we’ve got to do is look at other areas in the market that you want to be invested in and make sure that you have those other areas.
Now you can have funds that are investing in large companies. You’re going to funds that are investing as small companies. And they’re, they’re focused just on companies that are like $1 billion in market cap value. Or if you buy, you can buy the whole company for a billion, whereas you’ll have big companies, you know, be well over a, you know, $100, $200, $300 billion, and even higher than that. And then you can have companies that are funds that only focus on value companies. You can have funds that are only focused on international large companies and, and only ones that are investing in emerging markets, small companies, and value companies and all of that.
So that’s the idea of making sure that you split it up and the thing is here. Here’s why do I invest in stocks in the first place? Cause it can go up and down in value. Well, think about if I put all my money in CDs, what does it always do? Unless the bank fails or something, you know, something happens like that, which is unlikely. But if that happens, if I invest in that, I just get an interest payment and I don’t have to worry about it fluctuating in value, but that interest payment, you know, they, especially, if you look at it right now, you’re actually losing money after inflation.
So you’re losing 1% to 2% per year after inflation. Whereas with stocks, if you look at the history of it, large companies, average return after inflation throughout all of history for large companies, it’s about 7% above inflation. And for small companies, it’s about 9% for large value. It’s somewhere in the neighborhood of about 8% or so with small value, of somewhere in the neighborhood of 11% above inflation. So you’re making money historically after inflation.
Why, why does stocks do that? Well because what’s inflation price is going up. So what are stocks companies? Who’s raising prices, companies. You own the companies. Now, the way I look at it, when it comes down to, when I explain this to people, I say, well, hey look, why, you know, what, what is it about stocks? Why is it that the returns have historically been higher? And the reason comes down to, well, guess what you got to put up with ups and downs in order to attract investor money, you better be paying a higher rate of return or promising the potential for a higher rate of return.
Otherwise nobody’s going to invest. So I always look at ups and downs in the markets and I go, yay, great. It’s fantastic. You know, it is literally, and if it weren’t for those ups and downs, we wouldn’t have the higher returns of stocks. So I embrace it and reframe it as this is good. Now with fixed income investments, you don’t have the ups and downs. So now there’s, there’s no pain involved or potential pain involved. So no potential pain, then you don’t get the returns. And that’s basically the way it works.
So, you know, investing in the market, you know, mutual funds work; it’s a great way of doing things. ETFs are very similar. They’re just like mutual funds that trade, in terms of you might be able to buy an ETF at nine o’clock in the morning and sell it at 10, bad idea. But, you know, that’s the idea that ETFs can work in some asset classes. I don’t recommend them for all, but it is basically the same type of concept in investing. It gives you the ability to spread risk out and you can have all different types of areas of the market and you can do it inexpensively.
That’s the idea.
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