How to Be a Succesful Stock Market Investor

March 11, 2024

It does, indeed, make sense for most people to be stock market investors. According to Jeremy Siegel in his excellent book Stocks for the Long Run, the stock market beat inflation over the period from 1802 to 2021 by 6.9% per year. If you are uncomfortable taking Siegel’s word for it, from March 1957, when the S&P 500 index was started, through December 2023, it beat inflation by 6.5% per year.[1] At that rate the purchasing power of an investment doubles every 11 years.

While stocks are an excellent investment over the long run, bad things can happen in the short run. One of the worst periods for stocks was from October 9, 2007, through March 9, 2009, when the S&P 500 (with dividends reinvested in the index) lost 50.9%. If you had had a significant investment in stocks at that time you would have been sorely tempted to sell out at a loss. You would have done better to stick with it. It took a while for the S&P to recover, but it did get back to its October 9, 2007, level on August 15, 2012. For the ten-year period from October 9, 2007, through October 9, 2017, the S&P 500 index gained 7.3% per year—in spite of the terrible start.

6.5% over the rate of inflation is very good. Down 50.9% is very bad. In order to have the good, you must be prepared for the bad. You have to find the right balance, investing as much as you can in stocks without risking so much that you get scared out at the worst possible time.

Some important considerations in determining how much risk to take:

• INCOME

  If you have sufficient income to live comfortably without touching your stocks, you can invest a lot in stocks. If you are retired, planning to sell some of your investment for living expenses, then a drop in the market is much more likely to scare you. In this case you should have less invested in the stock market.

• YOUR OWN PSYCHOLOGY

  Some people are cautious while others are bold. If you are bold, you have to be careful not to be reckless.

• YOUR OWN KNOWLEDGE ABOUT YOUR INVESTMENTS

  If you have good reasons for owning what you own, you will have a good chance of sticking with your investments if they go down as long as your reasons for owning them hold.

• MAJOR EXPENDITURES

  If you have major expenditures coming up that will necessitate selling some of your investments, you may not want to wait until the last minute to sell. Suppose you have $500,000 invested and you are planning to use $100,000 of that to buy a new house. If you set aside $100,000 now, leaving $400,000 invested in stocks, and the market drops 25%, you will still have $300,000 invested. If, on the other hand, you wait to sell and the market drops 25%, your investment will shrink to $375,000 before you take your $100,000 out, leaving you with only $275,000. You will have a smaller base to build on.

• THE RISKINESS OF YOUR INVESTMENTS

  Some investments are riskier than others. In recent history the S&P 500 has dropped some 50%. That could happen again. There are some conservative mutual funds that have never dropped more than 35%. You can invest more money in such a fund than in an S&P 500 fund without risking a greater loss. If the ratio of expected return on the conservative fund to its risk is greater than the corresponding ratio for the S&P 500, then you can get a greater return by investing in the conservative fund than by investing in the S&P 500. 

• DIVERSIFICATION

  It is important to understand the role of diversification. The reason for it is to reduce risk, but when you diversify, you may also be reducing expected return. You want to make sure that you reduce risk by more than you reduce expected return. Suppose you believe you can stand a worst-case loss of $35,000, and you have a choice between two portfolios of stocks. One portfolio may lose up to 50% in a down market. The other portfolio, more diversified, may lose up to 35%. If you want to risk $35,000 but no more, you can invest $70,000 in the first portfolio or $100,000 in the second. If your expected return on the first portfolio is 10%, then you will prefer the second portfolio only if its expected return is over 7%. If diversifying to get to the second portfolio reduces expected return below 7%, you are better off not diversifying. Of course, you can’t know with any precision what is the worst-case risk or the expected return for any investment. These can only be roughly approximated. It won’t be absolutely clear which portfolio to choose. The point, however, is to think in terms of expected return relative to risk and to assess how diversification affects this ratio. Do not diversify solely for the sake of diversification.

Once you have a good appreciation of how much risk you can tolerate, you have to decide which stocks to buy. Analyzing the prospects of a company is complicated, and there are a number of different approaches. You may be wary of trying to choose individual stocks to buy. Fortunately, there is a reasonable way to invest in the stock market without having to evaluate companies. The way to do this is to invest in mutual funds or exchange traded funds (ETFs).

A good starting point is the S&P 500 index. As stated above, the return on the S&P 500 index has exceeded inflation by more than 6% a year over a long period of time, and there are a number of mutual funds and ETFs designed to track this index. Very good stock selection may do better, but the S&P 500 is difficult to beat. Another possibility is to invest in mutual funds or ETFs that have objectives other than matching the S&P 500. Many of these funds have undistinguished records and do not compare favorably to the S&P 500, but there are a few that have done better over long periods of time. To learn more about investing in mutual funds, read our guide to How to Invest in Mutual Funds.

At Northwest Criterion Asset Management, LLC, we have long experience in the stock and bond markets. We take very seriously the process of evaluating both the risk and return of potential investments. Please call us at 609-924-4488 or email us at invest@nwcriterion.com to discuss your investments.

[1] According to Bloomberg, the S&P 500 index with dividends reinvested gained 10.47% per year from the end of March 1957, through the end of December 2023. The Consumer Price Index gained 3.67% per year for the same period.

RISK: How to Think About It, Measure It, and Manage It — Part I

February 15, 2022

First some perspective

At the beginning of January 2022, all three of the major indexes—the Dow, the S&P 500, and the NASDAQ—were at, or near, all-time highs. In the past 40 years we have experienced four major stock market declines, the crash of 1987, the bursting of the tech bubble in 2000–2002, the mortgage debacle of 2007–2009, and the Covid crash of 2020. After all that, we continued to experience new highs. We can be just about as certain that in a few years the stock market will be higher than it is today as we can be that it will be warmer in August than in January.

Nevertheless, we can’t help worrying that the stock market will go down. That is especially true when the market has already gone down a lot. In late 2008 after the stock market had declined over 50% from its peak, it was almost impossible not to worry. Those who let worry get the better of them sold at that time. The risk to a stock market investor is not that the market will not recover; it is the risk that he will bail out when it is down. Buy high and sell low is not a good strategy.

How to think about risk

In order to take advantage of the fact that the stock market can be counted on to go up over the long run, it is necessary to be able to stick with your investment in good times and bad. You must avoid bailing out when the market is down. You have to make sure the bad times are tolerable. You must be honest with yourself about how much of a loss you can tolerate, and you must have a reasonable estimate of the maximum drawdown your chosen investment is likely to experience. It is a balancing act. Because the stock market rises over the long term, you want to invest as much as you possibly can. Because it sometimes falls enough to scare you into selling at the worst possible time, you want to limit the amount you invest.

A good measure of risk would be the expected maximum drawdown. Supposing you could know the expected maximum drawdown of an investment, how would that be useful in choosing among possible investments?

Example 1. Let us consider a very simple example. Suppose you are considering investing in one of two mutual funds, and you are trying to decide which fund to choose. You believe fund A is likely to return 10% a year over the long run and fund B is likely to return 12%. Fund B would seem to be the obvious choice, but there is another consideration. Suppose fund B appears to be riskier than fund A. Now it becomes a matter of balancing risk and reward. Do you want to play it safer and invest in A for 10% a year, or are you willing to take more risk to get 12% in fund B? To decide, you need to have some idea of how much of a loss you can tolerate. Suppose that you have $250,000 to invest, but you doubt you could stand to lose more than $100,000 before throwing in the towel. You also know somehow that the most fund A could lose was 40% and the most fund B could lose was 50%. If you invested the whole $250,000 in fund A, your maximum loss would be $100,000, which is tolerable; and you would expect to make a return of $25,000 in a year. On the other hand, in order to limit your maximum loss to $100,000, the most you could invest in fund B would be $200,000. The expected return from fund B in a year would be 12% of $200,000, or $24,000. You would be risking a loss of $100,000 in either case, but by investing in fund A you would expect to make $1,000 more than by investing in fund B. This shows us that it can be to your benefit to invest in a lower yielding investment if it is also a less risky investment.

How to measure risk

It appears, then, that a useful measure of risk would be the expected maximum loss. There is no way to know what the worst lost will turn out to be, but there is a way to get a good handle on the likely maximum loss. That is because the likely maximum loss is closely related to the volatility of the investment. We illustrate this with an example

Example 2.

Click on the table to view it in full size as a pdf.

The above table summarizes the results of a study we did of seven mutual funds during the period 1987 through 2022 using weekly return data from Bloomberg. We found all the drawdowns for each fund. A drawdown is defined as the maximum amount a fund declines from a high before reaching a new high. For example, the Vanguard 500 Index Fund (VFINX), which tracks the S&P 500 Index, made a high on August 29, 2000. It made its next new high in October 2006. In the meantime, by July 23, 2002, it had lost 45.90% (including reinvested dividends) before starting back up. This was a drawdown of 45.90%. For VFINX we found a total of 145 drawdowns. The worst was down 54.01%. 45.90% was the second worst. Only 5% of the drawdowns were greater than 12.85%. Half the drawdowns were worse than 1.65% and half were less severe than 1.65%. We found all the drawdowns for the seven mutual funds and present the summary statistics in the table.

The most important takeaway from this table is that the size of the drawdowns for each fund is roughly proportional to its volatility. This is a practical justification for using volatilities, which are easy to compute, in place of expected maximum drawdowns as a measure of risk. (There is also a theoretical mathematical justification, which we will not go into.) As a rough rule of thumb, we can estimate for any investment that the expected maximum drawdown over a long period of time to be around four times the annual volatility of the returns.

In this table we look not just at volatility and the worst drawdown but also at several other measures of risk. These include the 5th percentile drawdown, median drawdown, and maximum number of weeks from one high until the next new high. Note that all these measures tend to be closely associated with volatility. Generally speaking, the higher the volatility the greater the risk.

You may notice that there is an extra row in the table corresponding not to a single fund but to a portfolio comprising two funds, VWINX and PRWCX, in the ratio 5 to 3. We include this to suggest that by combining individual investments we may achieve better characteristics than for any individual investment. We won’t say anything more about this idea until we address it in Part II, to come in the future.

How to manage risk

How can you decide which is the best of several investments? Let us revisit Example 1. Your loss limit is $100,000. The maximum amount you can invest in fund A is
$250,000 = $100,000/0.4; and the maximum you can invest in fund B is $200,000 = $100,000/0.5. Your expected dollar return in each case is the product of the expected percent return and the amount invested: $25,000 = 0.10 x $100,000/0.4 and $24,000 = 0.12 x $100,000/0.5. Because the $100,000 amount is the same in both equations, you just need to compare the ratios 0.10/0.4 and 0.12/0.5. That is, you need to compare the ratio of expected return to expected maximum loss in each case. The investment with the highest ratio of expected return to expected maximum loss is the best one. Because the expected maximum loss is proportional to the volatility, however, the investment with the highest ratio of expected return to volatility is also the investment with highest ratio of expected return to expected maximum loss. Because the volatility is easy to compute, this makes a good way to rank several prospective investments. The higher the ratio of expected return to volatility the greater the return for a given level of risk.

Constraints

There is a complication. In investing there are two main constraints: The maximum loss you can tolerate is the first. The second is the amount of money you have to invest. Let us assume once more, for the sake of argument, that we know the expected maximum loss of the investments we are considering; and let us consider the seven mutual funds in the table. Furthermore, assume that the expected maximum loss, going forward, for each of these funds is as follows:  VWINX 25%, PRWCX 40%, ABALX 40%, AGTHX 70%, VFINX 65%, FMAGX 75%, and LAVLX 75%. Assume the expected return going forward is:  VWINX 7.8%, PRWCX 11%, ABALX 9.4%, AGTHX 12%, VFINX 11%, FMAGX 10.%, and LAVLX 9.9%. Also assume that the only risk-free place to invest is in Treasury bills, and the return on Treasury bills is, as has recently been nearly the case, 0.0%. Assume, therefore, that you can only choose between investing in a fund and holding cash.

If you have $100,000 to invest and know that the maximum drawdown you can tolerate is $25,000, then it is quite clear that VWINX is the right investment. Put all $100,000 into VWINX. Your expected return is $7,800 for one year. If you had chosen, say PRWCX, instead of VWINX, in order to limit your maximum loss to $20,000 you could have invested only $50,000. Your expected return for the year would have been $5,500.

Now suppose you have $100,000 to invest and know that you can tolerate a drawdown of $40,000. In this case, the amount of money you have to invest, $100,000, is the constraint that binds. To risk $40,000 in VWINX you would have to invest $160,000, but you only have $100,000. (If you could borrow another $100,000 at a very low rate, that would be another story, but suppose you can’t.) As before, $100,000 invested in VWINX risks $25,000 and is expected to return $7,800. This time you can improve your situation by investing in PRWCX. An investment of $100,000 risks $40,000 and has an expected return of $11,000. If you thought about choosing AGTHX, for example, you would have to limit the size of your investment to $57,142 to keep your expected maximum loss to $40,000. In that case your expected dollar return would be $6,857 = 12% of $57,142.

Conclusion

Our objective is to invest as much money as possible without exceeding our tolerance for risk. To do that we need to have a practical way to measure risk. The standard deviation of returns is a good, practical measure of risk that can be used to estimate the likely maximum loss. Once we have estimated the likely maximum loss, we need to find the investment that offers the best return on the amount we have to invest, subject to our risk tolerance.

This is just an outline of what needs to be done. There are other considerations and a number of details to be worked out.

In Part II we will discuss how to combine several investments—possibly including individual stocks, mutual funds, and bonds—into a portfolio that gives us the best return given the amount of money we have to invest and the risk we are comfortable taking. We will discuss the role of diversification in this process.

Inflation

January 31, 2022

According to the Consumer Price Index, inflation for the calendar year 2021 was 7%.[1] Some people say that this inflation is “transitory,” but it may very well continue for some time. Faced with inflation how should we invest? Fixed income is almost certainly a loser. The yield on the ten-year Treasury note is about 1.75%, and the yield on the 3-month T-bill is about 0.18%. Even if inflation abates, a yield of 1.75% will not be enough to offset it. If inflation keeps up, interest rates must rise causing bond prices to fall.

What should we think about stocks? We have three thoughts:

1. Stocks are an excellent investment for the long run.

2. As long as the earnings yield of the S&P 500 is above the 3-month T-bill yield, stocks will outperform bills and other short duration fixed income. With inflation, longer dated fixed income is out of the question.

3. While inflation is not good for the economy, stocks can nevertheless hold up during an inflationary period.
   
   

STOCKS FOR THE LONG RUN

We cannot know whether stocks will go up or down in the next week or month, but we can be virtually certain they will continue to reach new highs. Just a few weeks ago stocks were at an all-time high. This in spite of the fact that in the past 21 years we experienced the deflation of the tech bubble in 2000–2003 (down 47%), the financial crisis of 2007–2009 (down 55%), and the COVID crash of 2020 (down 34%). To see how well stocks have overcome serious setbacks, consider a concrete example. If we had bought the S&P 500 at a very inopportune time, the end of September 1987, just before the October crash (down 25%), and stayed with it, we would have gained over 3,000% by the end of 2021. That amounts to a 10.6% annual return. If, instead of the S&P 500, we had bought the Growth Fund of America (AGTHX), the total return would have been over 4,800%, or 12.1% per year.

Just a few weeks ago stocks were at an all-time high. This in spite of the fact that in the past 21 years we experienced the deflation of the tech bubble in 2000–2003 (down 47%), the financial crisis of 2007–2009 (down 55%), and the COVID crash of 2020 (down 34%).

STOCKS VS. HIDING OUT IN T-BILLS

It is tempting to think that by switching into T-bills at the right times it would be possible to reduce the volatility and increase the size of our returns. That may be, but it is far easier said than done. We did a study in which we showed that you can benefit by switching from stocks to bills and back from time to time.  A strategy that worked very well was to switch to T-bills whenever the yield on T-bills exceeded the earnings yield on the S&P 500 by 1.6% and to switch back when the earnings yield exceeded the T-bill yield by 1.1%. (Earnings yield is the reciprocal of the price/earnings ratio; that is, E/P, rather than P/E.) There were only nine switches during the 63-year period studied. Currently, the earnings yield of the S&P 500 is over 4%, while the yield on the 3-month T-bill is under 0.2%. Now is not a good time to switch.

The earnings yield of the stocks in our clients’ portfolios is even higher than that of the S&P 500. For the Equity Select portfolio it is over 9%; for the Dividend portfolio it is over 5.5%; and for the Mutual Fund portfolio it is just over 5%.

The earnings yield of the stocks in our clients’ portfolios is even higher than that of the S&P 500.

STOCKS VS. INFLATION

Inflation is not necessarily good for stocks, but stocks can still perform well in a period of high inflation. We looked at the last period of very high inflation, from the end of 1972 to the end of 1981. During that period inflation averaged 9.2% per year. The S&P 500 did not keep up, but it did gain 5.2% per year. A well-managed portfolio, however, did considerably better than the S&P 500. The Growth Fund of America (AGTHX), which was started on December 1, 1973, returned 14.3% per year from its inception until the end of December 1981. The S&P 500 returned 8.2% per year for the same period. Inflation averaged 9.3%.

We looked at the last period of very high inflation, from the end of 1972 to the end of 1981. During that period inflation averaged 9.2% per year. The S&P 500 did not keep up, but it did gain 5.2% per year. A well-managed portfolio, however, did considerably better than the S&P 500.

OUR OUTLOOK

The S&P 500 has risen at a rate of nearly 15% a year for the past 10 years. Many people worry that because it has risen so fast it is on the verge of a major decline. We agree that some of the stocks that have led the market higher are now vulnerable. In 2021 five stocks accounted for about a third of the S&P 500’s gain. According to Bloomberg, all five have P/Es above 28. One, Tesla, has a P/E of 177. The others are Microsoft with a P/E of 34.7, Alphabet (Google) 29.7, Apple 28.7, and Nvidia 66.7. A big part of the reason these stocks sport such high P/Es is that interest rates are extremely low. Because bonds yield practically nothing while still representing risk, investors have preferred stocks to bonds. As a result, stock prices and P/Es have gone up. The earnings yields of the companies just mentioned range from 0.56% (Tesla) to 3.5% (Apple). With low inflation and the 3-month Treasury bill at 0.18%, these may be acceptable levels, but as inflation and interest rates rise, they won’t look very good.

With rising interest rates stocks that have low P/Es, good dividends, and solid balance sheets should hold up much better than those that have high P/Es. To get an idea of what could happen, take a look at the bursting of the tech bubble. From March 24, 2000, to October 9, 2002, the S&P lost 47.4% of its value (with dividends reinvested in the index). For the same period, three mutual funds with more of a value orientation did much better. The Victory Sycamore Established Value fund (VETAX) lost 14.1%, the Lord Abbett Mid Cap Stock fund (LAVLX) gained 20.2%, and the T Rowe Price Capital Appreciation fund (PRWCX) gained 24.2%.

With rising interest rates stocks that have low P/Es, good dividends, and solid balance sheets should hold up much better than those that have high P/Es. Three well managed mutual funds performed better than the S&P 500 during the tech bubble burst.

We don’t think the current situation is as extreme as in the year 2000, but we think there is some similarity. At that time tech companies had risen to prices that could not be justified by any foreseeable earnings. Today the tech companies that have been leading the market higher do have earnings, but even accounting for projected growth, their prices are hard to justify. There is no law to say the prices of overpriced stocks can’t go higher. If they do, lower priced stocks should also do well. If the high-priced stocks go down, stocks with earnings yields well above the 3-month T-bill rate should hold up much better or even go higher.

[1] CPI for urban consumers, not seasonally adjusted went from 260.474 on December 31, 2020, to 278.802 on December 31, 2021.

Value Investing

Broadly speaking, there are two major approaches to investing in the stock market, Value investing and Growth investing. The idea of Value investing is to buy companies at prices below what the companies are worth. The most important indicators of good value are a low price/earnings ratio and a solid balance sheet. The idea of Growth investing is to buy companies based on the belief that they will grow even if their prices may be high from a value perspective.

Does Value investing work?

Read our detailed report for more information.

How to Invest In Mutual Funds

Mutual fund investing is a great way to achieve a diversified portfolio with the purchase of just a few securities. And you don’t need a large amount of money to get started.

Our how-to guide explains the basics of mutual funds, including the types of assets funds may own, the way funds are classified, the styles of management, and their fee structures. In addition, we offer a series of tips for choosing the right funds for your risk tolerance and objectives.

How to Invest in Mutual Funds