Win the War for Money and Success
Page 6
Historic Stock Market Returns
From
To
DIJA
S & P 500
NASDAQ
2/16/1885
02/28/2019
5.14%
N/A
N/A
12/30/1950
12/30/1960
10.09%
N/A
N/A
12/30/1960
12/30/1970
3.17%
4.73%
N/A
12/30/1970
12/30/1980
1.35%
3.90%
7.28%
12/30/1980
12/31/1990
10.59%
9.33%
6.43%
12/30/1990
01/02/2001
14.99%
14.57%
19.93%
12/30/2000
12/31/2010
0.70%
-0.48%
0.71%
12/31/2010
02/28/2019
10.40%
10.25%
13.68%
1940 - 1950
At one time, the stock market did grow along the lines of the American economy. The period from 1941 to 1950 encompasses World War II and the years immediately after. For the first half of the decade, America was on a war footing and most of the country was in the business of fueling the war machine. The government was the primary buyer of goods and many companies retooled to support the effort. General Motors made tanks, Ford made airplanes, etc. The latter part of the decade was a “war hangover” as companies switched back to domestic production and had to deal with an influx of workers returning to the home front. During this decade, the average return on stocks was 4.34%.
1950 – 1960
The fifties were an economic boom in the United States. Not only did the country have plenty of consumers making good wages to buy goods, the country was supplying many products to the world. The devastation of Europe and other parts of the globe made it difficult for companies in those countries get up to speed again. While they were struggling, America picked up the slack. If you look at the average growth of 10% in the stock market during this time, American companies were strong, as was the overall economy.
1960 - 1970
In the sixties, hiccups began to occur. American companies had international competition for many products. The country had internal struggles with civil rights and the Vietnam War. It is difficult to keep up any ten-year surge such as the one experienced in the 1950’s. If you throw all of that in the mix, companies began to slow down and not grow as rapidly. Internal turmoil in the country resulted in more conservative investment practices. The stock market reflects this in its average 3 to 4% growth rate that occurred during this decade.
1970 - 1980
If there were hiccups in the 60’s, then the patient was almost dead in the 70’s. Inflation was very high, as was unemployment, and there was a lack of confidence in the economy. This was the decade of Watergate, a president resigning in disgrace, and long lines of cars waiting for gasoline. It seems like the country was about to collapse under its own weight. Growth in the stock market or almost anything else was almost nonexistent during that time. You can see this reduction of growth was on average only 2 to 4% during the 1970’s, representing the lowest in the last 60 years of the 20th century.
Ironically, this was the last decade where the stock market coincided closely with how the companies were actually performing financially. It is important to note that up to the 1980’s, the leading investors in the stock market were very wealthy individuals and huge institutional investors. This would soon change.
1980 – Today
The best and the brightest tried to figure out how to infuse the stock market with a huge influx of cash. When you get past institutional investors and the few people who had more money than they knew what to do with, all that was left were the common folk. They never really had any means or way to get into the stock market. This was the target group that those running the markets wanted.
They laid the groundwork in 1974 with the enactment of the Employee Retirement Income Security Act (ERISA). Taxpayers could contribute up to fifteen percent of their annual income or $1,500, whichever is less, each year and reduce their taxable income by the amount of their contributions. These contributions could be invested in a special United States bond paying 6% interest that would begin paying out when the contributor reached the age of 59½. Originally, it was only available to workers that were not covered by a qualified employment-based retirement plan.
In 1981, the Economic Recovery Tax Act (ERTA) allowed all working taxpayers under the age of 70½ to contribute to an IRA, regardless of their coverage under a qualified plan. The IRS also raised the maximum annual contribution to $2,000 and allowed participants to contribute $250 on behalf of a nonworking spouse. This was the law that opened the floodgates for the average person into the stock market. As modifications to the law continued to come down the road, they allowed different financial vehicles to be established that met the criteria of the law, but allowed investment in stocks. For the most part, this was done through investing in mutual stock funds and a huge influx of cash poured into the stock market.
Companies established how many shares of stocks they could issue. They can split stocks as time goes on, or issue more for a specific reason, but it isn’t like the stock of a company was an infinite number. Therefore, when you have a great deal of money to purchase stocks, and only so much stock is available, the law of supply and demand kicks in. When demand outweighs supply, prices go up. Stock prices did just that, to an altitude never seen before.
This completed the transition from the stock market being a somewhat accurate barometer of the corporate strength of the nation’s companies to becoming a manufactured entity. Its gains and losses had more to do with the proliferation of money available to invest in the stock market, rather than the performance of the companies on the stock exchange. You often hear financial and political commentators say there is a disconnect between Wall Street and Main Street (meaning how well the stock market is doing compared to the average American’s income.) This is where that disconnect began.
Other man-made factors affected stocks. Income tax rates saw their biggest cut ever, especially at the high end of the income scale. People with large incomes had even more money to invest, and the stock market was one of their targets. Financial companies were coming up with products as fast as they could to feed the public’s thirst for the stock market. This was like throwing wood on an already out-of-control fire. The money going through the stock market increased its size and value dramatically. The thing is, even though the economy was getting a little better as compared to the 1970’s, it was nowhere near what was the actual growth of the stock market.
This artificial stock market boom lasted for a good twenty years. It is arguably one of the longest periods of prosperity in the stock market history. However, any resemblance to how Wall Street was doing compared to the rest of the country was purely coincidental. Some industries like technology boomed, but other mainstays of the American economy such as automobile manufacturers suffered. As you can see from the chart, the 80’s and 90’s had unprecedented growth.
It came to a grinding halt during the first decade of the 21st century. America had the tragedy of 9/11, wars in Iraq and Afghanistan, and a sense of uncertainty throughout all facets of the country. Then the recession of 2008 hit, and people discovered that many of our financial institutions were built on a foundation of sand. The government had to bail out the same large corporations that used to look at them in disdain whenever they tried to impose government regulations. The world was upside down.
The government’s rescue of the economy helped Wall Street to make up what it lost and to gain ground. For instance, the Federal Reserve basically allowed large institutions to borrow money for free as a way to get the economic machine moving again. Ma
ny companies took advantage of miniscule interest rates, and took the money they borrowed to put into the stock market. Again, the stock market took advantage of a new infusion of cash to grow.
Now and in the future, the stock market is its own entity with almost no bearing on the actual strength of its underlying companies. If you listen to many companies today, their mission is not necessarily putting out the best product or providing the best service. Companies are shooting for increasing profits, but more often than not, a company primarily wants to keep their stockholders happy. For a CEO, not realizing a decent dividend in a year may cost him or her their job. This focus plays havoc with the management of companies.
While the stock market has had its booming years in recent history, remember what we talked about in an earlier chapter about looking at numbers. They can be skewed to fit almost any picture that a person wants to make, if you don’t know the full story.
Overall, the stock market is a good hedge against inflation over the long haul, but not by any large margin. It should certainly be a part of an investment portfolio, but care must be given to the percentage of money you want to put into stocks. Then you have to decide what kind of stocks you are going to buy with that set amount of money.
The stock market’s allure has been the undoing of many investors. It is a game that is played for huge stakes. Only a little over a decade ago, many people lost their investments in the stock market when things went belly up in 2008. While the ship righted itself, it wasn’t on its own, and there are no guarantees that it will do so again if things go south.
Summary
Stocks are the highest performing asset class compare to any other asset classes over the long term and deserve a place in most people’s investment portfolios. The biggest learning from this chapter is to expect reasonable rate of returns from stocks, and limit the allocation to balance the two economic powers – the power of short fluctuating return and the power of actuarial science. You will learn more about this in Chapter Twelve and Chapter Fourteen. The asset allocation model of Ray Dalio’s “All Weather Portfolio” is also a great guiding principle for the right allocation in stocks as we discussed in the previous chapter.
The dynamics of the stock market have changed dramatically over the past eighty years. The performance of a stock used to closely mirror the success (or difficulties) of its company. That is not necessarily the case these days. Huge amounts of money are invested in stocks every day. While a company’s performance will still affect its stock, other issues like taxes, money supply, interest rates, the international situation, and a host of other factors all have a bearing on the market. Investing in stocks always had the potential of volatility, but that is truer now than ever before.
Keep in mind, in the second decade of this century, the stock market has had incredible highs as it constantly breaks records after bottoming out in 2008, when it almost took down some very large companies and financial institutions. Some investors made a lot of money in this time, but many lost a lot, too. The thing that surprises many people is that with all the hoopla surrounding the stock market, the average investor will only realize a 7% return on the money they put into stocks. You may hear of people making a “killing” in the stock market, but they are few and far between and that is their life’s work. Others have lost almost everything on the turn of a bad stock.
That is something to keep in mind with all but the most conservative investments: there are no guarantees. That should be your mantra as you explore the stock market, and other investments for that matter. Your goal is to create wealth, not end up breaking even…or worse.
CHAPTER 7
The Bond Market
“Rule number one: Don’t lose money.
Rule number two: Don’t forget rule number one.”
Warren Buffett
A
bond is a financial security in which the issuer of the bond is taking the bondholder’s money with a promise to pay it back with interest. Sometimes referred to as a debt security, the terms of the bond dictate when and how much the issuer pays back to the holder of the bond. Unlike stocks, which have no clear timetable and rate of return, bonds clearly state how much interest the issuer will pay and when. Monthly, semiannually, or annually are the usual timeframes.
There is also a maturity date fixed to the bond. This date is when the issuer will also pay back the original principal paid for the bond. A very simple example is that you purchase a $50,000 bond with a ten-year maturity date and an interest rate of 3% payable annually. Every year you will receive $1500 as an interest payment, and you will get back your $50,000 investment after ten years.
Bonds allow the issuer to bring in a great deal of money when initially selling the bonds. They can then use that cash for whatever purpose they issued the bonds for. We will go into more detail on this a little farther in the chapter, but there are three main issuers of bonds:
1. Government – sold by a national government where income from bonds helps finance current expenditures.
2. Municipal – sold by states and local municipalities who earmark the funds raised by the bonds to fund a particular project – usually infrastructure related.
3. Corporate – as the name implies, issued by companies to fund expansion, research, mergers & acquisitions, etc.
Once you buy a bond, you can transfer it into the secondary market where it can be bought and sold, similar to a stock. In other words, a bondholder does not necessarily have to hang on to a bond until its maturity date. It can be sold ahead of time. Even though bonds are thought of as a stable investment, they can have a high volatility based on the movement in general interest rates.
As you can see, if you buy a bond you are basically receiving an IOU from the issuer. You are the lender, and the issuer is the borrower. Before the advent of electronic transactions, physical bonds were issued with coupons attached that the bondholder would turn in for their interest payments. For that reason, you will often hear the interest rate referred to as the coupon rate. That amount is what you the lender receives as payment for the use of your money.
Maturity Date
Before we explore the varieties of bonds available on the market for investing, let’s look at some terminology that is important to know. I have already alluded to the maturity date. This is when the issuer has to pay the bondholder the face value of the bond. Let’s say it is the $50,000 bond in the earlier example. The bondholder is due that fifty grand on the maturity date. The issuer has no further obligation to the bondholder after the maturity date as long as it made all payments on the bond.
Rating of Bonds
Potential investors look at the credit rating of a bond as a leading indicator of the amount of risk involved with investing in it. The higher the credit rating, the more secure the investment. Credit rating agencies such as Moody’s and Standard & Poor’s use letter designations, which characterizes the soundness of a bond. Moody’s assigns bond ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C. Standard & Poor’s ratings are similar: AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
Investment grade (or IG) bonds have a credit rating of BBB or higher by Standard & Poor’s or Baa3 or higher by Moody’s. In the judgement of the rating agency, these bonds are likely to meet their payment obligations.
The ratings also help determine the amount of interest an issuer needs to pay on their bonds. The issuers’ borrowing costs are going to be greatly affected depending on if the rating agencies rate them as investment-grade or speculative-grade. Bonds that are not rated as investment-grade bonds are known as high-yield bonds or more derisively as “junk bonds.”
Type of Bonds
Government Bonds
A national government issues this type of bond. In general, the government promises to pay periodic interest payments on the bond and to repay the face value on the maturity date. Government bonds are usually issued in the country’s own currency. United States bonds are issued in dollars, of course, and they are backed by the
“full faith and credit” of the United States government.
The Netherlands issued the first general government bonds in 1517. Issued by the city of Amsterdam, the average interest rate at that time fluctuated around 20%. Britain issued the first national government bond through the Bank of England in 1694 to raise money to finance a war against France. Since that time, the issuing of bonds has become standard practice for many countries. It has progressed from a way to pay for a war to financing the everyday operations of the government.
Federal Government bonds are theoretically “risk-free” since the government can raise taxes or create additional currency to meet its debt obligations. Rarely does a country default on its bond obligations, though it has happened. Russia did this back in 1998 when it was going through its “ruble crisis.” Those instances are very rare. Governments are also rated on their ability to pay back their debts. If you are looking at the bonds of other countries, you need to pay attention to that factor.
If you are considering investing in United States Treasury securities, there are three categories of bond maturities:
1. Short term (bills): maturities between one and five years. (Financial instruments with maturities less than one year are called Money Market Instruments.)
2. Medium term (notes): maturities between six and twelve years.
3. Long term (bonds): maturities greater than twelve years.