The Real ‘Nuclear’ Threat
I purchased my first stock in high school, RYKA, a footwear company trying to become the next Nike for women. I was an avid athlete and runner, so I related to company’s products. I should have bought the industry leader, NKE, but that is a different story. At that time Reagan was in office and the Russian Cold War was in full swing. I was convinced I would not make it to adulthood given the ever escalating arms race and threat of nuclear war. I’m sure there are many high schoolers out there today with similar thoughts as they read daily news about North Korea and the US administration’s approach to dealing with this rogue nation.
In today’s ‘information at your finger tips’ environment (when I started investing we actually waited to read the next morning’s paper to see how stocks had performed the prior day….and quotes were in fractions like 1/8ths!) it is important to re-examine the real drivers behind long-term stock performance. While geo-political issues and threats are often very real, when it comes to investing in stocks, the actual threats invariably come from within the companies we invest in – or ourselves – and rarely if ever some exogenous source. Yet most investors spend the vast majority of their time analyzing – and worrying about – the news of the day, believing if they could just discern the tea leaves, if they could just predict the outcome of an election or OPEC meeting or some other event – and the market’s reaction thereof – then they could be a successful investor.
Look at a company like KO. It has thrived in every market, political, economic, and social environment since its forming in 1892. World wars, depressions, major terrorist events, Trump tweets… they have seen it all. And today KO is making more money than ever. The company has paid out an ever increasing dividend for decades. Essentially nothing could destroy this company – at least nothing the world has thrown at it for the last 120+ years.
So if the accurate analysis of thousands of unpredictable events is not the source of most market participants’ investment failures, what is? Here are some considerations:
Company Leverage: When the going gets tough (economic recession, drop in commodity prices, etc.), companies with weak balance sheets can get hit hard. Understanding leverage risks is vital for surviving inevitable economic storms.
Portfolio Leverage: Margin debt cuts both ways. It can be a source of enhanced returns when the world is sunny, but it doesn’t take a major storm for losses to mount quickly when excessive leverage is involved. More money has been lost through imprudent leverage leading to forced sales than any short-term market movement driven by headlines.
Valuation: Price matters. Even a great company like KO can be a bad stock if the valuation metrics are excessive. Going into the 2000s, KO was sporting a P/E ratio in excess of 40X, far higher than its historical average of 12X – 18X. Indeed, for the next 10 years, even though the company experienced increasingly greater earnings, the stock price went essentially nowhere as the P/E contracted from nose bleed to normal levels (P declined even as E went up, resulting in a normalized P/E ratio over the 10 year period form 2000 – 2010).
Panic Sales: Even if not forced to sell because of a leverage-induced margin calls, investors often sell stocks in a panic driven by dire headlines. Though the black ink blaring bad news is often soon forgotten, the red ink from selling a stock at a low (think BREXIT or other events that were big news for a few weeks and caused massive panic selling at the time, but ultimately became essentially non-events for US companies) is often permanent – or at least takes a very long time to make up for. Take moments of strength and calm to determine what you will do not if but when the next market correction occurs.
Being Overly Concentrated: Too much of a good thing can turn out bad. This is a common investment mistake that can lead to bad results, especially if the investment is also a place where the investor works. It can be a double whammy to lose ones income while seeing a retirement account stuffed with company stock get whacked on some fundamentally bad news.
Does the daily news move stock prices in the near term? Sure, but if you are engaged in short-term trades as a means to make money in the stock market, you are a speculator, not an investor by definition. I can’t tell you how many reasons I’ve heard for why the next crash will occur since I started investing in the 1980s. Thus, while it is easy to point to headlines - something going on ‘over there’ as the source of stock/portfolio risk - as with most things that ail us, the real source is closer to home: the investment itself, or the person making the decisions.
If you are not sure if your portfolio has any hidden time bombs that may explode with the next economic downturn, or if you may not behave 100% rationally when the proverbial stock market music stops (and bear market ensues), consider working with a professional who has seen decades worth of market movements and knows what key issues to focus on to ensure you stay on your path to achieving your important financial goals.