How Skydiving Can Help Explain Investment Risk

What can skydiving teach us about investing? It teaches about risk and reward, and can give you a perspective on risk that may change the way you think about investing.

Investing for the Future, Not in the Future

A version of this article appears in our spring 360 Insights quarterly newsletter.
 
“I have no doubt that in reality the future will be vastly more surprising than anything I can imagine.”
– J. B. S. Haldane
 
In the 1967 movie, The Graduate, the young, newly minted college graduate is advised by a family friend that the future is about one word: “plastics.” The advice was a deliberately absurd laugh line, but in today’s era of unprecedented technical and societal change, we hear a great deal of similar advice delivered with perfect seriousness. Self-driving cars will change the world! We are on the cusp of revolutions in biotech, renewal energy, robotics, genetics, artificial intelligence, etc. Heck, we might even get flying cars and jet packs one day soon.
 
Any and all of these great changes might and probably even will happen and could very well revolutionize society, but things rarely work out quite as predicted — and even when they happen exactly as planned, trying to invest in the future is still a very, very risky thing to do.
 
Some investors believe they will make a fortune if they can only identify the companies that will create the revolutionary products and services of tomorrow. Others believe that established industry leaders such as Apple, Facebook, Google or Amazon will continue to grow, innovate and dominate their competitors and thereby reward investors with strong returns.
 
If only investing were so easy.
 
To demonstrate some of the perils in investing in the future, let’s consider a groundbreaking and prescient Time Magazine article published in April of 1965 on “The Computer in Society,” which detailed all the ways computers were changing the world.
 
According to the article, “As the most sophisticated and powerful of the tools devised by man, the computer has already affected whole areas of society, opening up vast new possibilities by its extraordinary feats of memory and calculation….It has given new horizons to the fields of science and medicine, changed the techniques of education and improved the efficiency of government. It has affected military strategy, increased human productivity, made many products less expensive and greatly lowered the barriers to knowledge.”
 
Time noted that IBM was then the leading global computer company, with 74% of the U.S. computer market, “a dominance that leads some to refer to the industry as ‘IBM and the Seven Dwarfs.’ The dwarfs, small only by comparison with giant IBM: Sperry Rand, RCA, Control Data, General Electric, NCR, Burroughs, Honeywell.”
 
But Time’s reporting was already behind the times, neglecting to mention a computer firm which would transform technology and computing and become one of the 20 largest companies in America as well as the grandfather of Silicon Valley. Founded in a garage in Menlo Park, CA, in 1947, Hewlett Packard (HP) would enter the computer market in 1966 with the HP 2116A minicomputer — one of the first portable and “plug and play” computers.
 
As a thought experiment, let’s say that you were convinced by the Time article that computers would change the world and called your stockbroker and invested $100 in IBM as well as in each of the Seven Dwarfs at the beginning of 1966. After all, you wouldn’t want to put all your money in just one stock. You’ve also heard something about HP, so you invest $100 in their stock, as well as $100 in the S&P 500 for a little more diversification. If you’d stayed invested for the next 50+ years through 2016, here’s how your investment in the future would have done…
 

Some winners, some losers, but overall not too bad. Looks like investing in the future was a pretty good idea, until you consider the top-performing stock of that same period — a company that makes a heavily regulated, low-tech product. If you had invested $100 in Phillip Morris/Altria, it would have grown to $549,087 by 2016. Who would have thought in 1966 (and certainly in 2017) that tobacco, not computers would win the future (at least in terms of returns).
 
Even if you had known in 1966 everything that would happen in the world (except stock prices) over the next five decades, do you think you would have invested in tobacco stocks not tech? Like many of the realities of the stock market, it makes no intuitive sense.
 
Some of the other top-performing stocks over this period were also surprisingly non-innovative and low tech. For example, Coca Cola returned $34,403 and its cola rival Pepsico returned $21,084, better than any of the tech companies that would change the future.ⁱ
 
Or in the shorter-term, let’s look at the summer of 2004 when two firms went public, Google and Domino’s Pizza. One of these is a leading tech firm that revolutionized internet search, mapping, email and possibly, driverless cars. The other makes less than gourmet pizza. Most rational investors given the choice between the two firms would naturally assume that Google was the better investment. And they certainly did well over this period, returning 1,555% through January 14 2017. But Domino’s delivered a cumulative 2,401% return.
 
Or consider the top performing stocks of the Obama administration. While some, such as Netflix and Priceline were indeed innovators, the best performer was a chain of salons/beauty stores best known for their discounts, ULTA Salon, which returned 4,350%.¹
 
Why should this be the case? What are some of the risks in investing in innovation?
 
Many times, innovative companies fall victim to second mover advantage as other firms build on and enhance the original technology. Think of how social media platforms like My Space were superseded by Facebook or smartphone makers like Blackberry were outmoded by Apple’s iPhone. It is hard to know whether a company will be a failed leader or a successful follower.
 
Also, the initial results of innovation can be hard to maintain. Think of once great firms such as Wang Computers or Nokia or Kodak (the inventor of the digital camera) that could not keep up and fell by the wayside. By market capitalization, Apple is the largest company in the world. Millions of people use — and love — their products. But will they still be a tech leader 10 years from now? 20?
 
Newer industries often deliver disappointing returns when investors turn out to be too optimistic about the potential for future growth. As Professor Jeremy Siegel, an authority on long-term investing, notes: “Investors have a propensity to overpay for the ‘new’ while ignoring the ‘old’ … growth is so avidly sought after that it lures investors into overpriced stocks in changing and competitive industries, where the few big winners cannot compensate for the myriad of losers.”²
 
In comparison to growth stocks, which are very often innovative, forward-looking companies with strong earnings growth (or potential growth), value stocks are usually associated with generally less-innovative corporations that have experienced slower earnings growth or sales, or have recently experienced business difficulties, causing their stock prices to fall. Academic research has shown however that value company stocks have greater expected returns — and greater risk — than growth company stocks. Since 1927, U.S. Large Value stocks have returned 10.51% vs 9.43%³ for U.S. Large Growth stocks. This makes sense, since riskier companies must offer a higher potential return to attract investors.
 
In addition, old industries often continue to be surprisingly profitable. Consider the U.S. transportation index. From 1900 – 2015, railroads were the top performers, beating airlines, road transport (which joined the index in 1926) and the U.S. market, while airlines (which joined the index in 1934) trailed the market substantially.⁴ As Warren Buffet said about the Wright Brothers, “If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
 
The future may be uncertain, and the great companies of tomorrow may not always be the best investments. But the future, taken as a whole, may be the best investment many of us make.
 
If we are prepared to take a patient, long-term perspective and buy and hold securities from thousands of great companies around the world, we may benefit from two powerful forces:
 

1. Compounding, which allows your money to grow exponentially over time. If your portfolio grows an average of 6%, for example, it will double every twelve years. In 48 years, $100,000 growing at this rate becomes $1.6 million.
2. The dynamic potential of stock markets, fueled by human innovation, to create enduring wealth over time.

We don’t know which firms will be the next Domino’s or Google. We don’t know which firms will soar and which will fail, which will invent amazing new products and which will make money by doing what they have always done. But if we own many of them and invest for the future, chances are we will be rewarded over the long term.
 
All investing involves risk. Principal loss is possible. Past performance does not guarantee future results.
 
Diversification neither assures a profit nor guarantees against loss in a declining market.
 

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ⁱSource: Yahoo Finance
¹The Motley Fool, “The 10 Best Stocks During the Obama Administration,” January 19, 2017
²Siegel, Jeremy, 2005, The Future for Investors: Why the Tried and the True Triumph over the Bold and the New, New York, NY: Crown Publishing Group.
³DFA Returns 2.0. Fama/French US Large Value ex Utilities and Fama/French US Large Growth ex Utilities
⁴Credit Suisse Global Investment Returns Yearbook – 2015
 
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The Lesson of $1

Hypothetical value of $1 invested at the beginning of 1927 and kept invested through December 31, 2016. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. Total returns in U.S. dollars. Past performance is no guarantee of future results.
 
U.S. Stock Market represented by the Fama/French Total US Market Index Portfolio, which is an an unmanaged index of stocks representing stocks of U.S. companies. U.S. Small Cap Stocks represented by the Fama/French US Small Cap Index, which is an unmanaged index of stocks of small U.S. companies. U.S. Value Stocks represented by Fama/French US Large Value Index (ex utilities), which is an unmanaged index of stocks of large U.S. companies with low relative price, excluding utilities companies. The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. Long-Term Government Bonds, One-Month U.S. Treasury Bills, and U.S. Consumer Price Index (inflation), source: Morningstar’s 2016 Stocks, Bonds, Bills, And Inflation Yearbook (2016). Indexes are unmanaged baskets of securities that investors cannot directly invest in. Index performance does not reflect the fees or expenses associated with the management of an actual portfolio.
The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal. Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price. T Bills and government bonds are backed by the U. S. government and guaranteed as to the timely payment of principal and interest. T Bills and government bonds are subject to interest rate and inflation risk and their values will decline as interest rates rise. The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.

Hypothetical value of $1 invested at the beginning of 1927 and kept invested through December 31, 2016. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. Total returns in U.S. dollars. Past performance is no guarantee of future results.
 
U.S. Stock Market represented by the Fama/French Total US Market Index Portfolio, which is an an unmanaged index of stocks representing stocks of U.S. companies. U.S. Small Cap Stocks represented by the Fama/French US Small Cap Index, which is an unmanaged index of stocks of small U.S. companies. U.S. Value Stocks represented by Fama/French US Large Value Index (ex utilities), which is an unmanaged index of stocks of large U.S. companies with low relative price, excluding utilities companies. The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. Long-Term Government Bonds, One-Month U.S. Treasury Bills, and U.S. Consumer Price Index (inflation), source: Morningstar’s 2016 Stocks, Bonds, Bills, And Inflation Yearbook (2016). Indexes are unmanaged baskets of securities that investors cannot directly invest in. Index performance does not reflect the fees or expenses associated with the management of an actual portfolio.
 
The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal. Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price. T Bills and government bonds are backed by the U. S. government and guaranteed as to the timely payment of principal and interest. T Bills and government bonds are subject to interest rate and inflation risk and their values will decline as interest rates rise. The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.

[/caption]One of the best opportunities to grow your money over the long term may come from making an investment in the stock market.
 
This chart illustrates the long-term growth of U.S. businesses over the past 90 years. If your grandparents had invested $1 in the U.S. Stock market, as measured by the Fama/French Total US Market Index, in 1927 and just left it alone, by the end of 2016 that $1 would have grown to $5,106. Invested in U.S. Small Cap Stocks, as measured by the Fama/French US Small Cap Index, that $1 would have grown to $24,586, and $8,050 if invested in U.S. Value Stocks, as measured by the Fama/French US Large Value Index. That same $1 invested in One-Month T-Bills would be worth $20 and if invested in Long- Term Government Bonds it would be worth $125.
 
Those who invested $1 back in 1927 would have had plenty of reasons to want to pull out of the market along the way — The Great Depression, World War II, Korea, Viet Nam, stagflation, the Great Recession — but by staying invested they could take advantage of every market recovery.
 
While we can never be certain about market direction in the short term, over the long-term we believe patient investors will be rewarded for staying invested.
 
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5 Reasons to Have an Investment Philosophy

David Booth, co-founder and executive chairman of Dimensional Fund Advisors, has said, “The most important thing about an investment philosophy is that you have one.”
 
Do you have one? And if you do, does anyone else know about it? Is it on your website, in your marketing materials and part of your prospect/client conversations?
 
Here are five ways an investment philosophy can impact your practice:
 

1. Efficiency
   Once you have a set of guiding principles that don’t change when the market changes, everything you do aligns with those principles. It may be easier to figure out what to spend time on — and what not to.
2. Client Experience
   You can’t provide a good client experience to someone looking for something you don’t offer. Having an investment philosophy — and being up front about it — may help you find clients who are a good fit, and avoid those who aren’t. Better to find out at the beginning than spend time cultivating a relationship that won’t last long term. And having one clear investment philosophy may allow you to be more efficient in working with clients and helps you deliver a more consistent experience.
3. Better chance of consistent investment results
   Changing investment philosophies every time the market changes is a bit like the driver who keeps changing lanes on a crowded highway. We’ve all done this before: The cars in the next lane keep passing you, so you change lanes…only to find that now the lane you were just in is moving and you’re stuck again. Choose a philosophy you can believe in, and stick with it.
4. Differentiation
   Having a clear and public investment philosophy may help you stand out from advisors who do not. You may also attract centers of influence who can help you build your expert team.
5. Client conversations
   Your investment philosophy provides a foundation for client meetings and conversations. Once your clients understand and believe in your philosophy, you can spend more time talking about their goals and how to reach them, and less time on what markets are doing.

“When you’re about to do something small, you need a reason. When you’re about to do something big, you need a plan. When you’re about to do something life-changing, you need a philosophy.”¹
 
Taking the time to determine your investment philosophy forms the foundation for your practice, and makes it possible to do something potentially life-changing for your clients.
 

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¹“How to Formulate an Investment Philosophy,” Investopedia, Zina Kumok, June 17, 2016.
 
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Your Clients’ Retirement — More Than Just Money!

William and Sharon were driving home from a meeting with Alan, their financial advisor to talk about their retirement plans. William had decided that he would leave his work next year and Sharon would continue to work for another couple of years. The couple had been diligently saving for “the big day” when they could consider themselves fully retired and now they had actual dates in mind.
 

6 Ways We’ve Just Enhanced Loring Ward’s Blog

In January of 2014 we introduced our Advisor Insights Blog with the goal of providing financial advisors and their clients with timely and timeless financial education and insights.
 
Since then, we’ve published more than 200 articles — with 85,000+ views — on a wide variety of topics, from Asset Class investing to financial planning, retirement, behavioral finance, practice management and marketing. We’ve even included a few recipes from employees along the way.
 

Happy Pi Day (Cherry Pie Included)!

In case you are feeling short of things to celebrate, there is always Pi Day – March 14 (3/14).
 
As you remember from high school math, Pi (Greek letter “π”) is a mathematical symbol representing the ratio of a circle’s circumference to its diameter — which is approximately 3.14159.
 

3 Ways to Use Technology to Help Your Aging Clients

I was recently presenting at a retirement education event, where the age range of the audience and speakers was between 40 and 85 years old, when we started to experience technical difficulties.

It’s Always a Good Time to Talk About Risk and Volatility

 
In the 68 trading days in the U.S. stock market from 11/11/16 to 2/17/17, the Dow Jones Industrial Average (DJIA) set new all-time high records on 26 of those days. In the last seven consecutive days over the same period, the Dow closed at a new record every day.

Why Uncertainty Might Just Be an Investor’s Best Friend

This blog is from the March issue of Portfolio Perspectives.
 
With many stock market indices at all-time highs, Washington awash in political turmoil and unsettling news around the globe, many investors may be unsure what to do next.
 
And we believe that is a good thing.
 

Do You Offer What Retirees and Pre-Retirees Are Looking for?

Mark and Wanda Taylor, a couple on the verge of retirement, have decided to fire their financial advisor. “We are not really sure about how to plan for retirement,” Wanda told us at a recent workshop. “What we are most uncomfortable with is that we aren’t convinced that our advisor understands how to plan for retirement either!”
 

3 Reasons Investors Should Update Their Investment Policy Statement

Just as regular health checkups with a qualified physician are an important proactive step to maintaining your physical health, regular financial checkups with an experienced financial advisor are an important proactive step to maintaining good financial health.
 

The Folly of Chasing Dividend Yield

This blog is from the February issue of Portfolio Perspectives.
 
Since the “great recession,” interest rates have been considered low by historical standards, and it’s not just a recent phenomenon. Real interest rates and inflation have been in decline since the 1980s. While this trend has been a potential boon to borrowers, it’s been a source of irritation to savers and retirees trying to live on the income from their investment portfolios.
 

Stupid Stock Market Tricks: The Super Bowl Indicator

As millions of people around the world prepare to watch Super Bowl LI this Sunday, at least some are concerned more about how the outcome may affect their portfolios than the game itself.
 

Not Your Parents’ Retirement!

“I remember when my parents retired,” my client Sue told me as we sat down to talk about her and her husband Brian’s retirement plans. “They both quit at 65 and looked forward to traveling in their fifth wheel to visit friends and family around the U.S.”
 

Q4 2016 Investment Committee Briefing

Without question the biggest story of the fourth quarter, in fact all of 2016, was the U.S. presidential election. Regardless of your political leaning, it is a fair bet that market performance during and after the election qualifies as what market analysts like to call “an unanticipated event.” In this fourth quarter briefing we will briefly examine how the presidential election seemed to reverse a slight decline of recent highs for the stock market (and also to accelerate declines in the bond market). Then, using events in this most recent quarter as a backdrop, we will take a much broader historical look at whether market reversals are predictable in and of themselves.

The Dow Jones Hit 20,000…Does it Really Matter?

I well remember when the Dow Jones industrial average reached 10,000 in 1999, as I was working at Dow Jones Indexes at the time. It had been more than 100 years since Charles Dow created his venerable stock “average” and we were approaching a historic milestone. The exuberant 90s were in full swing and the stock market had more than doubled the prior four years.

Hindsight is Clearer Than Foresight

This article is featured in the winter edition of our 360 Insights Quarterly Client Newsletter.
 
Predictions on November 7, 2016, the day before voters elected Donald Trump as our next president…
 
“As the historic 2016 U.S. presidential election approaches, major Wall Street analysts agree that the S&P 500 will likely sell off if Donald Trump wins, and at least hold gains if Hillary Clinton wins.” CNBC
 

Financial Risk through a Wide-Angle Lens

This blog is from the January issue of Portfolio Perspectives.
 
The world is risky. The future is uncertain. And many of the decisions we make can have a profound impact on our future welfare. This is where financial advisors can add value by helping their clients navigate an inherently risky world. Risk cannot be eliminated, but it can be managed.

The Future Isn’t What It Used to Be — The Great Predictive Failures of 2016

This article is featured in the winter edition of our 360 Insights Quarterly Client Newsletter.
 
The New York Post headline the day after the 2016 U.S. elections put it best: “Pundits, Polls, Politicians, the Press: EVERYONE WAS WRONG.”
 
From the U.S. elections to Brexit to economic doomsaying, 2016 saw a series of spectacularly erroneous predictions. Again and again, experts were proven wrong and had to scramble to explain why they had missed the mark so badly.