Pot of Gold

There are no magical investing solutions

Lucky Charms was my favorite breakfast cereal as a child. I ate a bowl of Lucky Charms almost every day. Those sweet marshmallow bits and pulverized oats powered my brain on the mornings I learned to read, write, add, and subtract. I wasn’t one of those kids who ate only the marshmallows and left the oats behind. But I did wait for everything to become soft in the skim milk before devouring it.

The legend of the Leprechaun was burned into my brain as the box stared at me from across the counter. At the end of every rainbow, there was a magical pot of gold, if only you could find it.

Green clover, purple horseshoe, red balloon, pink heart, rainbow, orange star, pot of gold, and blue moon were the magical, lucky charms of Lucky the Leprechaun in the early ‘90s.

Like a child learning the truth about the pot of gold, I often find myself deflating the dreams of investors. “Why can’t we just own the stocks that are doing the best in my portfolio?” is a question I was asked recently. If only it were that easy.

One of the downsides to investing in the 21st century is having all the data immediately available. We can scan the market to identify which stocks were the top performers last year, last month, last week, and yesterday. If only we had owned those and nothing else.

Markets are a strange mix of human behavior and financial and economic data. There are some truths about investing; however, that seem to hold up almost like the laws of physics. Here are a few.

No risk, No Reward

There is no free lunch in investing. You have to to take risk to earn returns. That risk is not visible at all times, nor is it evenly distributed across your portfolio. Risk also takes various forms. It can be defined as the risk of loss of principal, price volatilty, loss of purchasing power, and underperformance relative to a benchmark, to name a few.

While risk and return are related, taking risk does not guarantee a return. Far from it. Taking more risk widens to possibly of outcomes, from very high to very low. Reducing risk narrows outcomes at both ends. It is possible to take an extremely risky bet and lose it all, just as it is possible to take a very risky bet and earn astronomical returns.

While we are having this discussion, it’s important to point that there are no “risk free” solutions for investing. Cash loses value through purchasing power, and cash under the mattress is easily stolen, lost, or burned in a fire.

TLDR: Risk is required.

You Cannot Have Your Cake and Eat it Too

Why not own stocks when the market is going up, but move to cash or bonds when the market is going down?

There are trend-following strategies that attempt to time to market. They are imperfect, flawed but often directionally correct. All are impossible for a human being with emotions to follow over the long-term. At best, you can pair a trend-following strategy with a long-term buy-and-hold portfolio. But do not expect magical results and be prepared for constant disappointment when trends whipsaw the portfolio back and forth through multiple losing trades.

If you are approached by a financial sales person with a strategy that seems too good to be true. It is. Period. Walk away.

Stairs Up, Elevator Down

I have no scientific basis for this phenomena. Stocks tend to creep slowly forward, making new all-time highs along the way. But when stocks drop, they drop fast. Days, weeks, or months of gains can be lost in a few trading days. I often joke that gravity has a hold of markets. In reality this is human nature in action. Everyone runs for the exit of a falling market at the same time.

No Crystal Balls

I keep a Magic 8-Ball in my office to remind me that no one can predict the future. Sadly, there are no crystal balls. For all the chart-gazing and data mining we do as analysts, nothing in that data can tell us what will happen tomorrow.

We can learn from the past, sure. We can make educated guesses about the future. We can study how investors are valuing parts of the market and hypothesize about next quarter’s growth in earnings and whether or not that growth will exceed investor expectations. We can memorize every data point in a company filing and every word uttered by management on the quarterly call. We can run billions of data points through AI simulations.

None of this will help predict the future. No one predicted a global pandemic in 2020. Even if we had known about the pandemic, no one could have guessed that markets would reverse a 35% drop to end the year up 20% because the government fired a bazooka of stimulus dollars to prevent an economic collapse.

But the Magic 8-Ball will answer any Yes or No questions you might have.

Compunding Returns

Now that I have properly deflated your optimistic views of finding the secret to beating the market. Allow me to leave you with something achievable that is truly awesome - the magic of compounding returns.

That’s right my friends. As your investments grow via interest, dividends, and price appreciation, you will start to earn returns on top of your returns. Slowly, over many years and multiple decades, these extra return begin to compound.

$1,000 invested in the S&P 500 Index in December of 1975 would have grown to $280,000 today if dividends were reinvested.

A recent college gradute in 1975, would be 72 years old today, hopfully enjoying a healthy retirement, having saved and invested consistently over that time. You can run your own calculations on Nick’s blog using Robert Shiller’s total return calculator. Spoiler alert - there are no 25+ year time-frames with negative returns.

So take heart. You don’t need the pot of gold at the end of the rainbow to succeed at long-term investing. You need only to stop looking for what doesn’t exist.