Investing in a world like this

  By Guest Blogger Sinan Terzioglu

Like millions of others I’m a big fan of Warren Buffett.  One of his most famous sayings is “Rule number 1: Never lose money.  Rule number 2: Never forget rule number 1.”  I think about these rules often.

Most investors should not hold individual securities, at least until they have built a balanced and diversified foundation to provide pension-like retirement cash flow.  How large that foundation should be depends on goals and circumstances but a good starting point is to aim for 30 times annual expenses.

Aside from the much higher risks in holding individual securities is the downside in holding these securities in registered accounts like RRSPs and TFSAs. We only get so much room in these, so they should be managed with a lot of care.  Most people lack employer pension plans so the responsibility is theirs to create and responsibly manage their own pension-like retirement portfolio.  Of course nobody buys individual securities thinking they’re going to lose money but the reality is the odds of suffering a loss are significantly higher than most realize.

I was recently asked: “I bought a marijuana stock a couple of years ago and it fell over 50% and now it’s bounced off the lows but I’m still down a fair bit.  I should average down because it’s so much cheaper and it has to go back up, right?”

Questions like this worry me.  Averaging down often results in throwing good money after bad and compounds the loss.  Most are better off to cut their losses and move on especially if a position has already become a decent portion of their portfolio.  Over the last 20 years, we have seen a handful of Canadian stocks that briefly became the most valuable companies listed on the TSX only to suffer catastrophic losses.  Twenty years ago Nortel Networks was the darling of the Canadian market before causing billions in losses.  A decade later Research in Motion (now Blackberry) fell from stardom and more recently Valeant Pharmaceuticals (now Baush Health) crashed, along with a countless number of energy and mining stocks.  When you lose 50% on a position you need a 100% return just to get back to even.  Think about the lost opportunity cost of the missed compounding.  That adds up to big money over the long term.

The odds of success holding individual stocks is a lot worse than most think.  Professor Hendrik Bessembinder of Arizona State University studied data on ~25,300 stocks listed in the U.S. for the period 1926 through 2015.  He found only 4% were responsible for the overall net gain in the U.S. market over those 90 years.  The other 96% collectively matched one-month Treasury bills over their lifetimes. 57% of stocks failed to even match one-month Treasury Bills.  More than half delivered negative lifetime returns.  Building and holding a diversified portfolio not only significantly reduces your odds of suffering losses but also significantly increases the chances of owning some of the super stocks that create incredible wealth over the long term and carry the indexes higher.

A new investor asked: “The markets are at an all-time high.  Do you think it’s a good time to be building a portfolio right now?”

Fact is, it’s never been a bad time to start investing when your time horizon is many years out.  When markets are hitting all-time highs one should certainly be cautious about valuations.  Twenty years ago when the tech bubble burst, valuations were astronomical.  Many outfits were not even profitable.  There are some tech companies trading today that remind me of that euphoria but I’m not concerned as the main drivers of the US market are by far the most profitable corporations ever, now trading at very fair valuations given their growth.  In 2019, companies in the S&P 500 index bought back nearly $1 trillion of their own shares.  Over the last five years Apple bought back ~US$250 billion worth.  That equates to consuming all of Royal Bank, TD and CIBC stock with just five years of free cash flow.  This is not a time to be fearful of owning index ETFs that hold a basket of cash cows like this.

Another client asked: “Do you think I should cash out after this run up?  The recent geopolitical tensions and now this coronavirus really scare me.  I just feel like it would be prudent to take risk off and go to cash.  If we get a pull-back I can buy cheaper and if we don’t I can always just buy back in”

Yes, we live in an uncertain world and must manage risk at all times.  From a portfolio perspective we start with balance, diversification and position sizing.  But the biggest risk is ourselves.  Over the years I have seen many investors get in their own way and attempt to time the market.  Most need to grow their savings at a rate that outpaces inflation and the best chance one has of achieving that goal is to craft an investment plan and stick to it. Time in the market is by far more important than timing the market.  The most successful investors know that patience and maintaining a long term perspective is critical.

By the way, a little over 40 years ago BusinessWeek published this:

The market was weak for a few years after this was published but then started an incredible run. Including dividends, the S&P 500 advanced 7,000%. Now imagine you were in your 20s, 30s or 40s in the 1980s and held off investing after seeing that publication.

Anything can happen in the short term but over a few decades the equity market has always produced very significant gains including periods of war, countless recessions and economic shocks. The best financial advice you can give to your children, grandchildren, nieces and nephews is to start as early as possible, stay invested and continue buying over time.  Maximize tax advantaged accounts and stuff TFSAs with growth ETFs.  Most importantly don’t lose money.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.