Financial Questions for Bill Richardson Part 18
Question: It seems to me that the past few years have been highly volatile and unpredictable. How should an average investor learn to deal effectively with this volatility?
This is such an important question, I thought I would answer it in 3 parts, rather than answering three questions.
Let’s start with comparing owning your home vs. owning Royal Bank stock.
We don’t currently own Royal Bank but I am using it, as everybody knows the company and many of you utilize their services. We could use a stock we own, like Apple but the numbers look too exaggerated and besides nobody just buys one stock, nor would we recommend that.
Which is more volatile – the value of your home or the value of Royal Bank? As perception is reality, Royal Bank is definitely more volatile. Why do I say that? Because I can look at a price chart and I see a drop of 36% in 2000, 57% in 2008/2009 and more recently 24% and 21% (source: YCharts). For a house, it’s difficult to do that. I read about properties that are listed and sold in the area, so I have a reasonable idea about what the house might sell for, but I am just guessing until I sell.
That is where the problem starts with stock investors…too much information. When the price of your house dropped by 10%, you probably didn’t notice and if you did, you probably didn’t care because it is a long-term investment. You may even view it as an opportunity and use a drop in real estate prices to buy a cottage.
When the price of Royal Bank and other stocks drop 10%, people panic. “What if it drops another 10%?” “Is the company going broke?” This is exactly what people did in March 2020. They sold out of all their stocks right at the bottom and never got back in and missed a huge and totally unexpected rally. When they sold, did they have a plan? Most people in panic mode aren’t in a decent state of mind to think that far ahead.
Is this because most people don’t fully understand what they are buying or own when they buy stocks? They understand how house prices work but do they really understand stock prices?
Royal Bank earns billions of dollars every year. At the beginning of 2012, they earned $4.18 per share over the previous 12-months. Over the past 12-months, they earned $8.09 per share. Out of these earnings, they paid $2.08 per share (50% of earnings) and today they have paid $4.32 (53% of earnings). Royal Bank is more valuable today than it was 10 years ago. The market value of their shares has grown from $75 billion to $173 Billion. Investors received dividends of 4% in 2012 and 3.6% today but let’s say that you invested $10,000 in 2012, your yield based on your cost price is 8.3% (source: YCharts) which is good.
If Royal Bank drops 10% should you panic? Probably not. Buy more? Maybe.
Yeah, but all stocks are not created equal. Since 2012, Imperial Oil’s stock price has dropped 18.5% at today’s value but in the panic selloff in March 2020, it was down 63% for the year and was down 74% over the previous 10 years (source: YCharts).
If you tried to understand the two stocks, you would see that Royal Bank’s earnings have grown consistently and predictably whereas Imperial Oil’s earnings declined by 135% over the 10-year period (source: YCharts).
Famous investor, Peter Lynch, once said “I don’t think people understand there’s 100% correlation with what happens to a company’s earnings over several years and what happens to the stock.”
If you hold companies with consistent and predictable earnings growth over time and ones that analysts think will continue to grow, and you buy them at decent prices, there is no reason to panic. When you buy companies where earnings are falling, panicking might be the right strategy. Commodity oriented companies, like energy or mining stocks, are more volatile and longer-term directionless and are more suited to traders than longer-term investors and when they start to go down, traders should sell and try to buy back at lower prices. If you own poor, unprofitable companies with bad balance sheets, panic is an acceptable strategy. If you are highly leveraged (borrowed to buy the stocks), then stopping out your losses might be a good idea.
This leads me to part 2 – Understand your Timeframe.
If you have a 10-year time horizon, you are in what we call accumulation mode. As such, you will be adding money to your account. When prices drop, do you sell? No, you are happy to buy more shares at lower prices. You treat selloffs as buying opportunities. Again, this works for buying great companies but not so much for bad companies.
Too many people get lost in their time horizons. They may not need the money for 10-years, but they think like short-term traders. Then, the pressure is on to be right all the time and that’s never going to happen. They check prices daily, weekly and complain when they have a bad quarter. That’s too much heat for the average investor and at some point, they crack and do something impulsively. How do many car accidents happen? Somebody decides at the last second to change lanes without checking mirrors or blind spots. That’s what investors do when the heat becomes too much to handle.
Make sure you hold great companies or managers with good long-term track records and relax.
One final topic – Diversification.
For most people, they have money in very different types of investments. Real Estate, stocks, bonds and alternative investments. Some own private businesses or own shares in the company for which they work. If you look at stock holdings, you should spread your portfolio over different sectors, like financials, technology, industrials, etc. The more you diversify, the lower the volatility of your overall portfolio. All your eggs in one basket is much riskier and more volatile than a diversified portfolio. Don’t fall in the trap of being highly emotional on your stock holdings but calm with the other holdings. What really matters is how the overall portfolio performs, based on your timeframe and not how the individual holdings perform. That is micromanaging and that usually does not have a happy ending.
- Have a plan and understand what you own.
- Invest in quality companies with consistent and predictable earnings growth that is expected to continue.
- Understand your timeframe (and stop watching prices and the financial news so often.
- Don’t micromanage.
- Sleep well.
Until next time, have a great day!