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1-Page Summary of The Four Pillars of Investing
“The Theory of Investing”
Stock markets are unpredictable and random. They can fluctuate wildly, but over the long term, they tend to go up. If you had invested $1 in US stocks in 1790, your portfolio would have been worth $23 million by 2000. Even if your returns decreased by 1% per year (which is unlikely), after 210 years it would be worth about $3 million. Taxes and commissions eat away at profits so it’s important to consider them when investing for the long-term as well
Stocks remain the investment of choice. From 1901 to 2000, stocks averaged 9.89% in annual returns (6% after inflation), compared to 4.85% for bonds (1% after inflation) and 3.86% for Treasury bills (zero after inflation). Stocks balance safety and return better than other investments because they are not completely safe but still have a higher rate of return than other investments that are completely safe.
Stocks are the best investment in the long run, but they can produce gut-wrenching losses. In 1973 and 1974, stocks plunged 40% even as inflation hit record highs. The real loss was 50%. Stocks did worse during the Great Depression—they lost 83% of their value from 1929 to 1932. They bounced back only to plunge 50% again in 1937.
Stock market experts don’t have the faintest idea of what stocks will do in the short term. The stock market is like a dog on a leash, going here and there. However, its master (the economy) is going in one direction even though it seems that the dog keeps changing directions.
Bonds don’t have the same returns as stocks. They can go down for years and then continue to decline. Stocks often rebound after a drop, but bonds are more stable. Investors should be prepared for severe losses if they want to make money with their investments.
Ugly Stocks, Handsome Returns
To ensure a comfortable retirement, you should invest in stocks. Surprisingly, bad companies can be the best investments. Investors divide shares between growth and value stocks. Walmart is the quintessential growth stock because it’s managed well, garners admiration and is financially robust. Struggling rival Kmart is the epitome of a value stock because it went bankrupt but still yielded better returns to investors who were willing to risk their money on such an enterprise.
A study of stock returns from 1926 to 2000 determined that annual returns for large value stocks were 12.87%, outperforming large growth stocks’ returns of 10.77%. Another validation came from an Oklahoma State University researcher who found that the companies featured in In Search of Excellence did well, but not as well as those laggards she followed. Value stocks don’t always perform well; they underperformed during the 1929-1932 and again during the tech bubble.
Most investors have no idea how much a share is worth. When you buy a stock, you’re buying the income it will provide. To calculate the value of future income streams, apply a discount rate to determine a present value. Say you’re at an airport about to leave for Paris and the ticket agent offers you five weeks in Paris ten years from now if you give up your spot on this flight—wouldn’t that be amazing? The problem with such an offer is that it’s not as good as one week in Paris today because time has value and things are more valuable when they happen sooner rather than later. Therefore, we can estimate how much something should cost by using its discounted cash flow (DCF) model—you subtract the discount rate from 1 to get your DCF number, then multiply that number by all future expected cash flows (income).
The Gordon Equation is an equation that says the discount rate (also known as market return) equals dividend yield plus dividend growth. The average yield and growth were both 4.5% over the last century, which means the actual return was 9.89%.
