- Many people shy away from investing because they don’t understand how the stock market works and are afraid of its volatility.
- Today, Alexander Green shares why owning stocks is the single best way to build wealth and how asset allocation reduces your risk – and fears.
In several of my recent columns, I’ve discussed the many advantages of equity ownership.
Not only are stocks easy to buy and inexpensive to trade, but no other asset class – not cash, bonds, real estate or gold – has generated long-term returns that come close.
So why do fewer Americans own stocks now than before the Great Recession?
One reason is fear.
Stocks are volatile. When the market makes you feel like you’ve suddenly stepped into an empty elevator shaft, it can be unnerving. I get that.
In my previous life as a money manager, I had a few nervous clients who would cut and run at the first sign of danger. And then kick themselves for months afterward.
One day nearly 30 years ago, I got a panicky call from one of them.
With the market down big for the day, he wanted me to liquidate his entire portfolio starting with one of his biggest gainers: McDonald’s (NYSE: MCD).
“I’m not sure you want to do that,” I told him. “Remember what happened last time? You realized you acted emotionally not rationally.”
“I just can’t stand the thought of it falling any further,” he insisted.
“Where are you right now?” I asked.
He told me he was in his car downtown.
I suggested he drive to the nearest McDonald’s, go inside and look around.
“Why?” he asked.
“Just do it,” I said.
A few minutes later, he called me back.
“I don’t know what I was thinking,” he confessed. “The parking lot is full, like always. There are lines at the registers, like always. And those registers are filling up with money! Don’t sell my shares. Don’t sell any of my shares.”
He realized the day’s share price fluctuations had nothing to do with the company’s fundamentals.
That’s not always the case, of course. Sometimes a firm’s shares are down because the business outlook has taken a change for the worse.
But even then, it’s often temporary.
Investors who have held McDonald’s for a long time are certainly glad they did.
One hundred shares bought at $22.50 on the IPO in 1965 are worth more than $15.8 million today. (In addition, you would be receiving a quarterly dividend that amounts to over $370,000 a year.)
And this is just McDonald’s, not some cutting-edge genetics company.
Volatility is simply the price of admission for stock investors. If you could own a passbook savings account that gave equity-like returns, everyone would do it.
But you can’t. You have to own stocks.
There are less risky ways to do this, however.
For example, value stocks – companies that are inexpensive relative to their sales, earnings and book value – are less volatile than growth stocks.
Large companies – with a market capitalization of $10 billion or more – are less volatile than small and midsized companies.
And domestic stocks are less volatile than foreign stocks. (That’s partly because foreign stocks are generally denominated in other currencies.)
There is also less risk when you diversify broadly. Owning 50 stocks, for example, is less risky than owning five stocks.
If you wanted to cut your stock market risk, you might invest in domestic, large cap value stocks.
But – counterintuitive as it may seem – it is actually less risky to divide your portfolio among large caps and small caps, growth stocks and value stocks, and foreign companies and domestic companies.
This is called asset allocation.
The father of it – Harry Markowitz – won the Nobel Prize in economics for conclusively showing that blending riskier assets together in your portfolio leads to higher returns with less risk, not more.
Higher returns with less risk is the holy grail of investing.
And if you want to make your portfolio more conservative still, you can add government and corporate bonds with long- and short-term maturities, Treasury Inflation-Protected Securities (TIPS), real estate investment trusts, and even gold shares.
In fact, The Oxford Club recommends just that. Here is our asset allocation model.
This is what intelligent risk-taking looks like. It’s the way serious investors handle their serious money in a serious way.
And it works. A $100,000 investment in 2003 in our Gone Fishin’ Portfolio – which uses Vanguard mutual funds to implement this asset allocation strategy – was worth over $415,000 at the end of last year.
You can read more about that here.
In short, there are conservative ways to take advantage of stock market opportunities. And there are other more aggressive strategies for earning higher returns.