The stock market had a rough start in August after a mostly calm year. But what’s considered “normal”? Peter and Jonathan answer this question and discuss why all risk isn’t rewarded in this month’s episode. Plus, learn what you should do when you have a concentrated stock position and why now’s a worse time than usual to be sitting on cash.
Hosted by Creative Planning’s Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Transcript:
Jonathan Clements: This is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm, and we are Down the Middle. The stock market had a rough start to August, and that of course sparked all kinds of scary headlines and hand-wringing among market pundits. But mostly it’s been a remarkably calm year for stocks with share prices climbing gradually higher. So, Peter, what’s normal? The volatility we saw in early August or the calm we’ve seen during the rest of the year?
Peter Mallouk: What is normal is volatility. Now, August, we had one day, one specific day for a few hours, had abnormal volatility where it just spiked like crazy, but it really stood out because we hadn’t had volatility for so long. And the norm is a market that’s going up and down quite a bit, day to day, week to week, month to month, and it’s very abnormal to have the stability we’ve seen over the last year. So for example, a stock market correction is a drop of 10% or more, and we have a stock market correction depending on how far back in history you want to look, every year to every 18 months. That’s how normal it is for the stock market to go down 10%. And of course, the stock market doesn’t go down exactly 10% and then immediately come back up. The average correction isn’t 10%, it’s 14%.
So once we hit the definition of a correction, which happens every 12 to 18 months, then you’re really looking at usually a drop of about 4% more on average. So think about that from today. If we were to have an average correction today, the stock market would have to drop about … 6,000 points. 6,000 points, imagine the hysteria when that happens, and that would be completely normal. And we know about one in seven or eight of those corrections, depending again on the period of history you’re looking at — sometimes it’s a little more, turned into bear markets, which is a drop of 20% or more.
The most recent one we had that was real was around COVID, and the most recent one before that was 2008, 2009. But sometimes they come back to back like 9/11 and the tech bubble, and also bear markets don’t just go to 20 and very kindly turn around and go back up. The average bear market’s 34%. So it’s very, very normal for the stock market to go up and down. We’ve seen a lot of steady up, which is not normal at all.
Jonathan: So Peter, one of the tenets of investing is that risk gets rewarded or to be more accurate, that risk is potentially rewarded. We aren’t talking about crazy risk here, like betting everything on a single stock or a single market sector. So Peter, what sort of risk does get rewarded?
Peter: Yeah. It’s really interesting how you frame it, because there are people that don’t understand that risk is rewarded, and there’s people that think that risk is always rewarded, you take more risk and you get more rewarded. That’s not how it works either. It’s educated risks, calculated risks that almost always, but not always, get rewarded, right? And so let’s start with I think one of the basic tenants of investing, which is something called the risk premium, which is kind of a fancy way of saying, an example is if you buy stocks instead of bonds, you should do better because you’re taking more risk. So for example, a bond is just a loan. If we loan money to McDonald’s, then we have a bond with McDonald’s, and as long as McDonald’s doesn’t go bankrupt, we’re going to collect that interest on the loan. Let’s say it’s 4%, and when the bond matures, let’s say it’s in five years, I get my money back.
So if I loan $100,000 to McDonald’s at 5%, I’ve got a bond. Every year I’ll collect 5,000 and then I’ll get my money back at the end. Pretty low risk and the stock market can go up and down all it wants to, and I’m going to get paid as long as McDonald’s doesn’t go bankrupt. Now, if I buy McDonald’s stock, totally different story. Very normal for McDonald’s stock to go down 10%, 20%, 30%, and it’s normal for it to go up 10%, 20%, 30%. And over the long run, we don’t expect to earn 4% like if we were loaning money to McDonald’s. We expect to earn 8% to 12% on average for owning part of McDonald’s.
Now, why does anyone buy a stock if it’s going to go up and down 20% when I can buy a bond and know exactly what I’m going to get? The reason is we expect the risk to be rewarded. It’s the risk premium. It’s the premium return you get for investing in the equity of a company instead of lending to the company. And that’s across the market. So even when you’re looking at very big sophisticated investors and they’re determining their bond allocation, their stock allocation, a lot of that is driven by the premium they’re going to get in exchange for the volatility they’re going to be willing to accept.
Jonathan: But that premium, I think we should emphasize, accrues to people who have diversified portfolios. If you’re just holding a handful of stocks, if you own only McDonald’s, then there’s a chance that you’ll be taking enormous risk and not get rewarded for it.
Peter: That’s right. In fact, I think it’s surprising to people that two-thirds of stocks underperform the market. So when you buy one stock, you’ve actually increased the odds you’ll underperform a diversified portfolio. In fact, over the long run, most stocks underperform bonds. What the benefit of the diversified portfolio is, you get Nvidia this year, you get Apple a couple of years ago, you get Southwest Airlines or Monster Energy before that. You get the stock that goes up. Thousands of percent that lifts up the index return. And people say, “Well, what about the stocks that go down?” Well, the stock can only go down 100%. So you get Enron, you get Lehman brothers, you go down … One stock goes from $1,000 to zero, another stock that you have a thousand dollars in, it can go up 20 times and offset the losers and a bunch of the average stocks and lift the return.
That’s the benefit of the diversified portfolio. But I want to go a little further in the unrewarded risks. On Twitter if I would tell people, “Don’t buy these NFTs” and “don’t buy these pictures of rocks and monkeys,” and “this is stupid,” and “don’t buy these meme stocks,” and “don’t invest in these SPACs, you’re going to lose your money.” And you know Twitter’s a cesspool of hate, right? So a lot of people put out there like, “Well, Peter, you’re an idiot. You don’t understand risk and you’ve got to take risks to get rewarded.” And that’s again, not correct. As you pointed out, it’s intelligent risks get rewarded.
Just because you do something crazy, that does not mean it’s going to be rewarded. And the people that bought these NFTs and these SPACs and these meme stocks, most of these are down 70% to 100%. The risks were not rewarded. So you can’t in investing just say, “The more risky this thing is, the more it’s going to get rewarded.” You’ve got to compare a diversified basket of bonds to diversified basket of stocks to a diversified basket of private investments to really make sense of how risk premium really works.
Jonathan: Yeah. Just a quick addition to that, a lot of people look at their portfolio and say, “Oh, I want better performance.” So they start thinking, “Well, I’ll have to buy better mutual funds or buy better stocks.” But if you really want to improve your portfolio’s performance, nothing’s guaranteed but the sure way to do it is to simply increase your allocation to a diversified portfolio of stocks. You have more in stocks, and that is a diversified collection of stocks to the extent that the stock market rises over time and does better than bonds and does better than cash, you’re going to get better portfolio performance. But if you go out and you bet more on some aggressive mutual fund or some hot stock, the odds are you’ll take that risk and you’ll not get rewarded. So Peter, back to volatility, people were not happy about the volatility we saw at the start of August, but to some extent, shouldn’t people view that volatility as the price of doing business?
Peter: I like to tell people that you’re a bad investor if you panic with volatility. You’re a good investor if it doesn’t bother you at all, but you’re a great investor if you get excited about it, because what volatility does is it drives people that don’t understand markets out of the market. And this is where the risk premium comes from. If everyone understood, “Hey, this generally worked. I’m getting overly rewarded for this volatility,” then the return would be lower because there would be more and more people that accept this premise. And so the reason that stocks pay more than bonds is everyone is not willing to accept the volatility that you as a great investor are willing to accept. It’s that volatility that delivers the higher returns.
You know, I want to go off a little bit too, and I want to address something just because I get asked a lot about this. I want to talk about illiquidity too because there’s this mythology that illiquidity immediately results in a premium. So you get these people that go, “I’m going to put my money in the hedge fund. And then hedge fund I can’t get out of the hedge fund for a year or two or a certain period of time, and because of that I’m going to be rewarded for that illiquidity.” That’s completely untrue in many instances. A lot of times your money’s just locked up and you’re not actually getting a premium for it.
There is a premium sometimes with real estate and private businesses, which is logical. If you’re investing in real estate and private businesses, then yes, the manager can do better if they decide when they collect your money and they can decide when they can dispose of an asset and they don’t have to dispose of an asset in a down market. That can be a real premium too, where you can expect a better return in exchange for tying up the money. But it doesn’t really apply to people that are investing in publicly traded markets like stocks, which is why I just have such a tremendous distaste for hedge funds, which historically underperform almost all of the time but charge higher fees and create more taxes.
Jonathan: All right Peter, so before we wrap up here, one final question. One of the reasons stocks bounced back in August is because investors are anticipating that the Federal Reserve will cut short-term interest rates in September. But that actually raises the question, why would a rate cut be good for stocks?
Peter: It’s very interesting to see how excited or upset people get about interest rate increases and decreases, because they’re not as correlated over the short term as people think to stock market performance. But here’s the bottom line of how people should think about this. The stock market only cares about one thing, and that is the future earnings of a company. That’s it.
If, Jonathan, I was selling you a store that makes sandwiches and it makes $100,000 a year, and you come to visit it and you find out in your research that the day before there was food poisoning, and you found out there’s going to be a roadblock in front of my place while they work on the road, and you find out they’re tearing down the apartment complex nearby, you probably are going to ignore the fact that I made $100,000 a year for the last three years because you’re focused on the future. And with food poisoning and apartment complex closing and the road closed, you’re not going to make $100,000 a year and that’s all you care about. So you might not buy it at all or pay a small price.
If instead I’m selling you the same place, it’s making $100,000 a year. You come to visit and you see a line out the door because some new sandwich I’m offering is a big hit. You see an apartment complex going up in the same parking lot. You see that there was construction, but now it’s about to be over in a week. You’re probably going, “Hey. I’m going to make more than $100,000 a year. I’m going to pay even more.” You as an investor are always looking at future earnings. We all logically think that way in our day-to-day. But for the stock market, people find it confusing because there’s all this noise about, “Well, this drives markets and that drives markets.” Really the only thing that drives markets is expected future earnings.
So let’s get to interest rates. If I own a business and my business makes a profit of $1 million a year but I have debt and I’m making these debt payments and I’m making debt payments at 8%, and the Federal Reserve lowers rates, most rates are tied to what the Federal Reserve is doing, if you’re on a variable home mortgage, which some people are on, or if you’re a commercial property variable or a business owner, it’s almost always variable. Well, if the Fed lowers rates, there’s a way this happens, but all the rates come down. So now my interest payment as a business owner has gone down, which means I have more profit. And I’m going to do something with that profit. I’m going to go spend it. Maybe I’ll remodel a house or buy a car. Maybe I’ll employ more people to grow faster.
But no matter what I do with that money, it’s probably going to be helpful to the economy. It’s more money to spend. If interest rates go up, if I’m used to paying 8% and now I’m paying 11%, well, I have less profit. I don’t have as much to buy equipment for my business or invest in technology or hire people. It’s hurting my earnings. So the market looks and says, “Well, interest rates are probably going to go down because the Federal Reserve says, well, unemployment’s up a little bit. Inflation’s under control. We want to make sure we don’t have a recession. So let’s lower rates a little bit to keep the economy going.” And so everyone says, “Well, that’s great. Everyone’s going to have more money to spend. People are going to borrow more, buy more cars, buy more houses.” This is how we got out of the COVID crisis and the ’08, ’09 crisis. The Federal Reserve kept lowering rates until people started buying things.
And this last time, they lowered them too much and people bought too much stuff, and we had high inflation. They’ve been trying to get out of this unfortunate mess. But here’s the problem is it’s not that perfect. We can’t draw a line from A to B and go rates down market up because the reason rates are going down is because the Federal Reserve sees signs the economy is weakening. And so we have to take into account if the economy is weakening, it means corporations might not be making as much money. And that’s why the Federal Reserve is lowering rates. And so the interesting part is the raising rates when the economy is too hot and they’re lowering rates when the economy is slower. And so interest rates is one variable, but it doesn’t move the markets by itself.
Jonathan: All right, Peter, so we’ve reached that point in the podcast. What’s your tip of the month?
Peter: So I’m going to talk about individual stocks. I know this applies to a minority of listeners, but if you’ve got one stock that’s become a disproportionate amount of your portfolio, what I recommend that you do is figure out, well, how much money do you need to be in great shape, to accomplish your goals? At least diversify enough of the position to go to bed at night knowing you’ve secured your financial future. And if you want to leave the rest in that stock, fantastic. Go ahead and leave the rest in it. I’m not big on talking people out of the horse that got them there, and that they’re very emotionally tied to, but there are lots of ways to diversify that stock. You can use a donor-advised fund, you can create your own charity, you can use a charitable trust, you can use a tax-loss harvesting strategy, you can just sell it and pay your taxes because capital gains rates are the lowest they’ve been in decades (and probably going to go up no matter who the president is), so there are a lot of different ways to do this. If you have a piece of your portfolio, that’s gotten too big relative to everything else, take a moment and figure out what you need to be independent and explore the strategies to diversify it and retain the rest. How about you, Jonathan?
Jonathan: My tip of the month is this: many conservative investors have had an easy ride in recent years. They’ve been able to keep their cash and money market funds and high-yield savings accounts and earn a half decent return. But those yields could shrink sharply in the months ahead if the Federal Reserve does indeed cut short-term interest rates. Folks with large cash holdings might want to consider taking more risk with their cash. For those with the financial advisor, this would be a good time to have that conversation. So, Peter, that’s it for this month. This is Jonathan Clements, Director of Financial Education for Creative Planning. I’ve been talking to Peter Mallouk, the President of the firm, and we are Down the Middle.
Disclosure: This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels.
