Do Good Companies Make for Good Stocks?

The following is an excerpt from an audio presentation given by Bob Clyatt, author of, Work Less, Live More: The New Way to Retire Early, (Nolo) in which the best-selling author details six common stock market myths.

Myth #1. Find a Hot Fund Manager

Have you heard this Myth before? “Sure, you and I may be investment amateurs, but this fund manager I heard about is a genius. He has outperformed the market now for eight years, through up markets and down. Your best move would be to just invest with him, beat the market, and grow rich.”

Now here’s the Reality: While there is nothing wrong with looking for fund managers with good track records—assuming their fees are reasonable, which they usually are not—expecting to actually find ones who will outperform in the future is nearly impossible. On average, only about a quarter of fund managers outperform their relevant index, after fees, in any year; and only one in 10 outperforms for three years running. One study shows the average mutual fund underperforms the market by 1% and Vanguard’s John Bogle recently calculated that the average stock mutual fund achieved just 9.9% in annual returns from 1984 to 2004, falling 3.1% short of the S&P500 Index, which returned 13%. He argues that fees and trading costs make up the difference in this zero-sum game. With thousands of funds out there, a few can always be found that outperform for several years running. But you can never be sure if this year will be its last. Far better to invest to match the market, with low fee index-style mutual funds, than to try to bounce around trying to find a manager who will beat the market over the long run.

Myth #2. Bonds Are for Wimps

This Myth can be summed up like this: “If the average rate of return on stocks is 12% per year and the average long-run rate of return on bonds is 6%, then why would I ever want to own bonds? I am a long-run investor, so I’m going to load up 100% on stocks and trounce the balanced investors over the long run.”

Here’s the Reality: Sure, you can load up on stocks if you don’t need to withdraw money for a very long time. And if you have a stomach made of cast iron. But as an early retiree, you will likely need to make annual withdrawals for decades, so you’ll be selling some assets every year. That means you’ll need to sell some of the stocks in your portfolio even if the market has dropped like a rock. In short, this myth ignores volatility: An asset class that has a high expected rate of return over time is almost invariably riskier. That is fine as a small portion of a balanced portfolio, but if the volatile asset is your only asset and you need to sell some of it for living expenses every year, you can be wiped out.

Myth #3. All-Bond Portfolios Are All-Safe

The Myth: “I know how to retire early and be really safe. I’ll buy a portfolio of 20-year AAA municipal bonds with enough tax-free interest every year to support me in fine style. Who needs to think about asset allocation or risk? All bonds means no worries.”

The Reality is that this myth neglects to factor in inflation. Enticing as this approach is on the surface, this strategy will safely and securely decimate the real value of a portfolio and its withdrawals. Whether the bonds are municipal bonds, long-term CDs, or regular taxable bonds, the dilemma for the investor is the same. First, what the bondholders receive each year from this portfolio is a fixed coupon that diminishes in spending power every year. Second, what the investor gets back at the end of 20 years is the original principal, which, at 3% inflation rates, will be worth about half of its original value in real terms. The investor now has just half of the spending power he or she had at the beginning of retirement, permanently eaten away by inflation. And note that the popular strategy of building a bond ladder—an array of bonds with varying maturities—won’t solve this problem.

There is nothing inherently wrong with bonds or tax-free municipal bonds, though most early retirees will be taxed in such low brackets that the tax advantages of munis will be wasted. The problem is not properly setting aside the first 3% or so of yield each year for inflation. After you have done that, you can withdraw safely and know the real value of your portfolio will remain intact, though there may be little left to withdraw. In order to set aside 3% for inflation and withdraw the desired 4%, Safe Withdrawal Rate, you’d need a high quality bond yielding at least 7%, something as scarce now as snowballs in July.

Myth #4. Good Companies Make Good Stocks

This Myth runs like this: “This stock-picking business isn’t so hard. I can just buy the shares of good, profitable growing companies whose products I really like and hold on. I’m bound to do well.”

The Reality? Of course, quality companies with strong growing revenues, steadily rising profits, well-known brands, and solid managements can provide investors with good stock returns. But it happens much less frequently than you might assume. That’s because these firms, their successes touted throughout the business press, are well-known and attractive to investors—and their stock prices are almost always already high. While you might want to buy their products, you’ll generally want to avoid their stocks. Because they start out expensive, growth stocks’ returns tend to lag behind those of value stocks, which are on the other end of the spectrum.

Unloved, unknown, or temporarily embarrassed, the riskier value stocks should be an investor’s friend, as they outperform the broad market averages over the long term by as much as 3%. Of course, these are averages and trends. There are some growth stocks that start out expensive and just keep going up. And no one wants to get caught in the “value trap” in which they buy a depressed stock—after all, it is cheap for a reason—and then have it go bankrupt. These frightening emotional totems are what produce the value-stock premium, which is created anew each day as investors flinch at the thought of owning a value stock or smile at the thought of owning a growth stock, and adjust their prices accordingly. When the growth stock slips, it is mercilessly hammered down. Investors have long since given up on the value stock, so when the company finally turns around, the stock is brought up smartly due to the upside surprise. That is when the value fund sells it. And the cycle starts again.

Myth #5. The S&P 500 Index is the Stock Market

This Myth isn’t so dangerous, but it is still worth noting here. It runs like this: “I shouldn’t try to time the market, pick stocks, or even pick a fund manager. I’m just going to load up the equity portion of my portfolio in a low-cost S&P 500 index fund and be done with it.”

The Reality: Actually, this approach does get us closer to long-term investment sanity than many of the other myths, but the S&P 500 is only a part of the world’s stock market—and not the most important piece at that. For example, it is among the most heavily skewed of the major indices, with just the top 22 stocks comprising a third of the overall weight or movement of the index and the bottom 150 stocks in the index comprising just 5% of the index weight. So tying your fortunes to the S&P 500 essentially ties you to the fortunes of a tiny fraction of America’s firms. The S&P 500 is a convenient way to track some megacap firms, but to get real diversification into less-correlated asset classes—such as small stocks, international stocks, and value stocks—you will need to go beyond the S&P 500.

Myth #6. Foreign Assets Are Un-American and Unnecessary

“Why should I bother with foreign stocks? After all, U.S. firms are bigger, safer, and better understood than all those other companies out there. And besides, American companies are so global in their operations that good times overseas will surely be reflected in my U.S. company stocks.”

In Reality, while most people are drawn to invest more heavily in their local markets, there is little economic rationale for it any more. American stocks and bonds do represent about 40% of the world’s financial assets, but now that investing overseas has become safe, inexpensive, and convenient, it is time for Americans to look further a field. The goal is to find low-correlation asset classes with liquid markets, quality securities, and reasonable transaction costs. While emerging markets and the chances for shenanigans still put those securities at the furthest limit of acceptable risk, well-documented scandals in major American companies don’t exactly measure up to a gold standard of corporate probity, either. In any case, the global marketplace is fast growing up and foreign companies offer great potential for returns at reasonable prices.

The idea that strong overseas operations for American firms will capture that growth in their stocks is not supported by historical data. Global American companies’ stocks tend to rise and fall with other American companies; their international operations do not provide meaningful diversification. An investor gets far better diversification, both through non-dollar currencies and the actual foreign companies themselves, by owning pools of foreign stocks.