And if you can convince the folks at the bank that you have a viable business at hand, the bank will lend you money. And lending means a periodic interest expense that you as a business owner will incur depending upon the terms you signed up for. Plus the money you borrowed to run and grow your business will have to be returned someday.

So your business must earn enough to not only cover all the expenses associated with building and selling your products but also enough to cover the interest expense plus eventually paying the loan off. And then whatever is left over are your profits.

What could you have done instead of borrowing that capital from the bank? You could have convinced the same folks at the bank to give you the money in return for a small piece of your business.

So now the folks who provided you with the much needed capital are partners in your business.

Plus there is no ongoing interest expense because the partners (investors) in your business now are in the same boat as you. And the money doesn’t have to be paid back…in theory. They are now part owners and they want you to succeed because if you succeed, they succeed.

Plus look at it from the bank’s point of view and their risk-reward situation. Their risk if you borrow the money is that your business fails and the bank not only loses the interest income but also the capital they lent.

But if your business turns out to be a startup that becomes the next Apple, they don’t get to participate in all that upside. All they are left with is collecting that measly interest income instead of the gusher of profits that would have flowed to them if they owned a stake in the next Apple. Or Amazon. Or Google.

Because with an equity stake in the business, they own a piece of that business and hence a piece of the profits made by that business.

So owners of businesses inherently make more than lenders because:

• As Naval Ravikant, the founder of AngelList says and I am paraphrasing here – when you are the owner of a business, you own the upside as well as the downside. But when you are a loaner to a business, you do own a guaranteed revenue stream (interest payments) but you also own the downside. So capped upside as a loaner with all the downside.
• Public businesses are run by some of the smartest folks around. We do occasionally hear stories about abuses here and there but in aggregate, these folks are running our businesses the best they could. And no business manager will borrow money at a cost (interest payments) that exceeds profits. So if you own a collection of them, you are bound to out earn a loaner.

The only advantage of being a loaner (lender) is that regardless of what happens to the profits in a business, the lender must get paid their ongoing interest and towards the end of the lending term, the entire loan amount (principal).

So there is a bit of a stability in the value of your investment being a loaner but that’s in the short-term. And that’s assuming the business survives.

As an owner, if business conditions deteriorate, profits decline and the value of that business declines. If that continues for long, the business could permanently shut down and the value of your ownership stake in that business will go to zero.

So stockholders (owners) suffer as well as the bondholders (loaners).

But that is if you own just one business.

The stock market and the bond market allow you to spread your money into hundreds of businesses and not all of these businesses will shutter.

If they did, the stocks will go to zero but so will the bonds. And you’ll have far worse things to worry about than worrying about money if that happens.

So if you are saving money towards goals that are more than a decade out, being an owner must pay out better than being a loaner.

But being an owner (stockholder) over a shorter-term means you are exposed to the full brunt of the volatility in business cycles and volatility as we know cuts both ways.

Thank you for reading.

Cover image credit – Jose Francisco Fernandez Saura, Pexels

But this apparently normal behavior somehow escapes the process of purchasing financial assets. And hence, an entire field of finance devoted to trying to understand why investors act the way they do while exhibiting perfectly rational behavior in other walks of life.

But I think investors behave the way they do because most fail to make a connection between buying say a box of Tide detergent versus buying shares in Procter & Gamble that makes that detergent.

And if we dig deep enough with anything we do or consume in our daily lives, there is always somewhere a connection between a product or a service and a business that delivers that product or a service. And that business, if publicly-traded, we can also own a piece of.

My younger daughter is all things LEGOs these days. I mean she spends hours building things like these…

And her gang is into it as well so we know she is not alone.

So then the discussion as usual leads to buying a piece of the LEGO making business. But she can’t because LEGO does not trade publicly.

But then that plastic that makes those LEGOs could be coming from a publicly-traded business. Or that oil that was dug up to make that plastic had to have a publicly-traded entity behind it. And so would the businesses that make those machines to injection mold these pieces or that steel that was used to make those machines or those semiconductor chips that control those machines and on and on.

So if she owned a diversified basket of global stocks, somewhere, somehow, she owns a piece of the supply chain that went into making those LEGO pieces. So she is all squared then.

Talk about supply chain, if you never came across this Milton Friedman video, well, you did now.

So the other day, I dug up some old notes and this one dates back to June 2nd of 2012. And that scribbling was all about yields – bond yields vs. earnings yield for a portfolio of global stocks. Earnings yield by the way is the inverse of price to earnings ratio.

So the 10-year Treasury bond yielded 1.5 percent at the time when global stocks were yielding 8.5 percent (price to earnings ratio of about 12). Global stocks here refers to the FTSE Global All Cap Index.

Stocks were a bargain then. How sweet of a bargain? The last time the spread was as wide was all the way back in 1962.

And yet investors were dumping stocks left and right, for some reason or the other and at the time, that reason appeared to be the Eurozone debt crisis. In just the April of that year (2012), U.S. investors sold a net total of 20 billion dollars worth of stocks. In May, they withdrew 26 billion dollars from the stock market.

All in all since 2007, investors withdrew some 530 billion dollars out of stocks and stock-type investments.

And where did most of that money go? Into the apparent safety of bank savings account and into bonds.

But that at the time could be considered as a reasonable behavior. Not right, not logical but reasonable. Investors were terrified of the slightest of turbulence. The trauma of the Great Recession was fresh in everyone’s mind.

And hence the equity risk premium. Stocks are risky because profits are not guaranteed. But if there was no risk, the earnings yield for stocks would collapse to meet that of bonds.

But earnings or profits for businesses can and do fall. And that causes the value of these businesses and hence the stock prices to fall. So the risk.

But in hindsight, that was THE time to plow everything you had into the markets.

And what was predicted at the time to be a great time to invest was indeed a great time to invest. I mean if you were anywhere close to the stock markets this past decade, you made money.

So where are we now? The bond yields are about the same but the earnings yield for stocks have basically cratered. That is, the equity risk premium got reduced.

And most of that reduction in the equity risk premium happened because of the expansion in multiples. I mean you were paying 12 times earnings for a portfolio of global stocks in 2012. Now you are paying 17 times that.

But then it sort of makes sense. Besides that small hiccup at the onset of COVID, we have basically forgotten what risk is. The Great Recession is a distant memory. The Dot-com crash of the early 2000s is like it never happened.

And hence the complacency.

What do I personally wish? I wish for a renormalization of interest rates. That’s assuming we know what “normal” is in the interest rate world. Maybe we are in a new era and maybe we never go back to the way things were but I think we must considering all the craziness that is out there in the markets these days.

I want things to reset a bit. I want the bond yields to grow and the equity risk premium to expand back up. So technically a double hit on the price of stocks.

Painful yes, in the short run but ideal for most of us in the long run. We rather take the medicine now than having to surgically remove a tumor later. Bubbles are painful when they deflate.

So if you are a millennial or a Gen Xer, you should get down on your knees and pray for a decade of flat returns. That’ll allow you to pump as much powder as possible into the markets while the bond yields normalize and the equity risk premium reflates.

None of it says that you sell your stocks. Because no one knows the future and you don’t want to get into the game of predicting the future. But if you’ve got a reasonable plan and a decent portfolio that fits that plan, you can tweak and make adjustments to that portfolio where and when necessary but you must stick to that plan.

That of course requires conviction and conviction only comes with knowing what you own is what you should own but once that’s done, all you can and all you should do is throw as much savings as possible into that plan and wait.

Thank you for reading.

Cover image credit – Tran Long, Pexels

Or does it?

First, because it is market-cap weighted, the biggest companies occupy too much of your portfolio if this is all you own. Nothing wrong with that but just to give you some perspective, these were the companies that occupied its top 5 slots in the year 2000: General Electric, Exxon Mobil, Pfizer, Citigroup and Cisco Systems.

Things change so diversify.

Second, S&P 500 is a large cap index. It owns the biggest 500 public-traded U.S. businesses. So when you own just this, you own only one flavor of the market.

Third, tech businesses have come to occupy too big of a share of the index lately. And many of the tech businesses trade at valuations far richer than the overall market, some justifiably so, many not so.

And the reason the market affords a much higher multiple to these growth-oriented names is because of the historically low interest rate environment we find ourselves in. And low interest rates means equally low discount rates.

But then they are also more sensitive to changes in interest rates so if and when rates rise, the value of these growth-aligned businesses will decline, oftentimes precipitously.

And if what you own in your portfolio is skewed towards these names, your portfolio will suffer. It will eventually recover but that recovery could take much longer than your patience can handle. The decade of the 2000 is a perfect example. If a portfolio of S&P 500 is all you owned, you had less money at the end of that decade than at the start. We often forget but then we have the data.

But enough with the ramble and on to some number crunching. We’ll run through some test portfolios that are exclusively invested in one type of stocks and compare that to the one that’s globally-diversified across size and value spectrum yet still 100 percent invested in stocks.

The first is an S&P 500 only portfolio. Of course, this is past performance and future performance can and will differ but one thing I can almost reliably say is that if you expect an S&P 500 only portfolio to do over the next decade what it did over the last, it’s not going to happen. It could if business profits suddenly explode to the upside due to some breakaway technological advancements but these things don’t happen that often and hence.

So this below is the best and worst-case rolling returns of an S&P 500 only portfolio over these past many decades.

And just to give you some perspective on all the things that transpired during this timeframe:

• The 1987 stock market crash.
• The Savings & Loans crisis of the late 1990s.
• Gulf War I.
• Real estate recession of the early to mid-1990s.
• The Asian financial crisis 1997-1998.
• Dot-com boom and then a bust 1995-2003.
• 9/11.
• Gulf War II.
• The housing market crash and the ensuing global financial crisis of 2008.
• The European debt crisis 2012.
• And of course the pandemic.

And embedded in between these major events are the many micro booms and bursts that happen from time to time. They will always happen because it’s systemic. It’s the nature of the markets.

This below by the way is the exact annualized performance of an S&P 500 only portfolio over these last two decades…

What stands out is how most of the gains are back-loaded. That’s because S&P 500 sucked wind the entire decade of the 2000s. All the gains are packed in the decade that just ended.

So the best time to have loaded up on large-cap U.S. stocks was in 2010, exactly the time of maximum despair for a large-cap only portfolio.

But then there are businesses that are not in the S&P 500 that are smaller in size that can be found in say the Russell 2000 index. Smaller businesses are usually risker, both in terms of price volatility and in terms of their ability to survive.

The best and worst-case rolling returns for a small-size companies only portfolio over these last many decades…

And the actual annualized return for these businesses going back 20 years…

The shocker is not that small companies earned more over time. That’s expected. Not guaranteed but expected.

The real shocker is that they made you more money with less risk than their large cap brethren (compare the 10 and 20-year rolling portfolio returns for the S&P 500 only portfolio vs. the Russell 2000).

Now spreading our wings a bit more and looking beyond our borders with international stocks with a great barometer for that being the EFA index, EFA as in the Europe, Far-East and Australasia.

The same rolling returns for an EFA-only portfolio of stocks…

And the exact annualized returns for that EFA-only portfolio over the past two decades…

So not that hot compared to say the S&P 500 or the Russell 2000 but that’s expected. International stocks have treaded water for quite some time but that’s the nature of the game. They will shine again at some point, no one knows when yet no big deal.

But now we’ll mix and match all these and bring in emerging markets, value stocks, mid-size companies etc. that exposes a portfolio to all available factors and possible outcomes. The exact portfolio is not as relevant because there are tilts and tweaks you can apply based on where you find a better bang for your buck at any given moment but assuming a portfolio that’s designed keeping first principles in mind, you won’t go wrong. And of course assuming a portfolio that you will stick with, come hell or high water.

The rolling returns first…

And the exact annualized return for that global all-stock portfolio over the last two decades…

A few condensed takeaways…

• First things first, this is diversification within a category of investments (stocks) so it’s not what a true diversified portfolio can and maybe should look like.
• Small-caps (Russell 2000) did better than their large-cap brethren (S&P 500) not only from the performance perspective but also from the perspective of delivering better risk-adjusted returns. That’s with comparing the 10 and 20-year rolling returns as well as the exact annualized performance over the last 20 years. Not what you would have expected considering the hype around S&P 500 this past many years but that’s expected considering how recency bias plays tricks on us. But then we got the data.
• International stocks sucked in this timeframe and that is and should be expected from any asset category from time to time. They say that you only know when you are truly diversified is when you always own one or two segments in a portfolio that are treading water at a given time. If everything does good or bad at the same time, you have a problem. That is to say that your portfolio should own a lot of uncorrelated investments though these days with correlation of literally everything with respect to everything else approaching one (perfectly correlated), it’s not that easy but that’s our world today.
• And when you sprinkle the ‘right’ type of investments in the ‘right’ proportion, though individually they might suck, the blended portfolio almost always overcomes that individual performance disadvantage over the very long-term. For the statistically inclined, that’s because when the variance of one investment is added to the variance of the other, the resulting combined variance of a portfolio is always lower. And hence that shows up in better portfolio outcomes, not only with what you make in returns over time but making those returns with a reduced portfolio volatility. So a win-win all around.

That’s all I have to say.

Thank you for reading.

Cover image credit – Chris F., Pexels

And as it is with anything exotic and of the swash-buckling kind, the media couldn’t get enough of him. The New Yorker pronounced him the stock market’s ‘certified golden boy’. Investors’ money of course followed. And by the boatload. Assets under management in his fund grew from a mere $12.3 million in 1959 to $340 million by the time he called it quits in 1965 to venture out on his own.

He then launched the Manhattan fund seeking to initially raise only $25 million. And we know investors chasing performance never gets old and hence they clamored to get into his fund. He ultimately wound up with 10x more money than initially planned.

And you probably know how that movie ends. The Manhattan fund had two middling years and then the roof caved in. By July 1968, it was the sixth worst performing fund in the country. And just a year later, it had lost 90 percent of its value never to recover again.

About a generation later, in March of 2000 just as the bubble created by the Dot-com boom reached its zenith, Merrill Lynch, the then world’s largest brokerage firm jumped on the bandwagon with not one but two new funds to sell. The first was a “Focus Twenty” fund. The other was an “Internet Strategies” fund.

The offering of course was an incredible success. It always is towards the tail end of a mania. The funds collectively pulled in $2 billion at the onset.

But then again, we know how that movie ends. It was a money-making bonanza for Merrill but a disaster for their clients. The Internet Strategies fund tanked almost immediately. By the end of 2001, less than two years after the launch, investors lost 86 percent of their money.

The Focus Twenty did the same with a cumulative lifetime return through 2006 of minus 79 percent.

I bet if I were to try harder, I could come up with countless such stories across the many booms and busts the world over. They might all start differently but they end the same.

Something similar appears to be transpiring with some hot funds and investments du jour of the day. And you don’t have to look hard to find bubble assets. In fact there are many. Maybe I am too old-fashioned but sometimes amazed at all these businesses selling at twenty, thirty, fifty times revenues with never a sight of profits. And profits are the only thing that matter eventually.

One or two of these bubbly assets could grow into their valuation if ever but these many, never.

So we know how this movie will eventually end and that end’s not going to be pleasant. But you have a choice to make. You can either be a willing participant in the making of that movie or you can watch it on Netflix whenever it comes out. I prefer the latter.

Thank you for reading.

Cover image credit – Jonathan Borba, Pexels

Say you are 20 years old today and you invest a dollar at say 8% annual rate of return and leave it invested till you are 65. What would that dollar become? 34 dollars.

But say for some reason you waited till you were 30. So instead of the thirty-four dollars before, you’d have less than half of that or about sixteen dollars. Wait another 10 years to invest and you’d have a mere $7. Wait till you are 50 and you’ll have just $3 at age 65. Another ten years and it’s over.

So start early.

But of course a few tens of dollars will not change anything for you. You need more, a lot more to meet goals that are much bigger than what a few dollars can provide. We hear all the time about what you have to do to become a millionaire. But that is so last century. I’ll revise that to how to become a multi-millionaire.

Or at least a double millionaire. And say that is the goal. And you want to get there as fast as possible because you don’t have a lot of time. You’ve got just one life and you have many things you probably want to do with it than just think about money.

So say you are fresh out of college and you are fortunate enough to be making a great income. What’s a great income? How about $100,000 a year.

I know it sounds big but I see and hear that a lot of college graduates make that kind of money nowadays, at least in the Silicon Valley that I live in.

So say you take $10,000 of what you make each year and are able to invest that at 6%.

Oh wait, why 6%?

Yes, I did talk about 8% before but remember what we are trying to do here – we are planning for the worst and hoping for the best.

So let’s plan for our $2,000,000 goal assuming a 6% rate of return and $10,000 of annual savings.

And this is how it looks…

So 44 long years to get to that goal. That is way too long.

Can you speed that up? Yes, but it doesn’t come easy because that requires you to save more.

But I say it’s doable because you are making great income. All that’s needed is a little bit of discipline and expense management. It’s your life we are talking about here after all.

So here are four scenarios with four different saving amounts…

So going from saving $10,000 a year to $25,000 drops the number of years to reach your goal by almost 14 years. That is a lot of life you are getting to buy just because you were able to squirrel away more.

But what if you could earn a higher rate of return, say 8%. Now this is an aggressive assumption and it is completely possible but I wouldn’t count on it. But what would that do to your time scale?

So of course, you get to your goal faster because the rate of return is higher but did you notice that the gap in years between saving $10,000 vs. saving $25,000 is not as wide anymore?

Maybe it’s not as evident so let’s try two more rates of returns – 10% and 12%. I would definitely not count on that kind of a rate of returns for the near future but let’s just see.

So as the rate of return increases, the effectiveness of saving more decreases. And that makes sense. With a lower rate of return, the amount you save is a bigger proportion of the total accumulated wealth, especially in the early years as shown below.

But with a 12% rate of return, the proportion of total wealth that comes from pure savings drops at a much quicker rate with growth taking over. So you don’t have to try as hard. I mean you don’t have to scrimp and save but I hope it is not a sacrifice.

But we know that we are supposed to plan for the worst and hope for the best so with that in mind, what if you want to reach your goal in the same number of years as 12% rate of return does but assuming only a 6% rate of return? You can but you just have to save more as shown below.

So like before, the saving component is a bigger contributor to your total wealth. And you didn’t have to try as hard. I mean you didn’t have to take undue amount of risks to avail of that mystical 12% rate of return. For each and every year. For decades. 

All you had to do is save more which is a much safer bet. And $25,000 a year might feel tough in the initial years but over time, as you grow and as your income grows, it gets easier and easier.

That’s about it.

Thank you for reading.

Cover image credit – Anna Shvets, Pexels

And we know that quote we still remember him by, “A penny saved is a penny earned.” But he is also known for another quote that describes the process of compounding as best as one can. That quote, “Money makes money, and the money that money makes, makes money.”

He died in 1790 and bequeathed his life savings, a cool $10,000 (of that time so big money then) to be equally split between two of his favorite cities, Boston and Philadelphia but with a condition. The first half of that money should be invested and should remain invested and can only be used after 100 years. The second half needs to remain invested and can only be spent after 200 years.

And that’s what the cities did. In 1890, at the end of the first 100 year period, both cities used $500,000 each to be spent on public goods. That’s what 100 years of compounding $2,500 that each city received does. The calculated rate of return to turn $2,500 into $500,000 after 100 years ~ 5.44%. So very ordinary.

And here are the numbers over time…

So that was the first 100 years.

In 1990, both cities got access to the rest of the money. Any guesses on how much the other half grew to? How about 20 million bucks and that’s for each city. So that’s 200 years of compounding the remaining $2,500 that was bequeathed to each city.

And the annual rate of return required to turn that ‘tiny’ sum to 20 million bucks? 4.6%. Again, pretty average. In fact, that’s below average historically and yet the result, extraordinary.

And when you are dealing with 200 years of compounding, a tiny change in the rate of return makes a big difference in what you get at the other end. Go ahead, pull out that spreadsheet and give it a try.

So time truly is magical. But the first step to compounding is to have something saved to compound. You could be the greatest investor who ever lived but zero dollars will still be zero dollars regardless of the rate of return. So save.

And to find out how much your savings will grow to at some future date, you can use this little bit and the only bit of math here and ever.

FV = PV (1 + r)^t

FV is the Future Value of your savings

PV is the Present Value

r is the rate of return

t is time

I love playing around with this by trying out different values for the rate of return and time. Let’s try one. Say I had 100 dollars (PV) saved and I bought an investment with an annual rate of return of 6% (r) and I invested that money for say 5 years (t), I’d have a total of $134 at the end of that 5 year period. Just plug the numbers into the equation and solve for whatever you are trying to find out. In this case, we want to find FV like below.

FV = $100 (1 + 0.06)⁵

But compound interest is slow and boring…at least at the start.

And here’s what I mean. Say you are 20 and you start setting aside $500 each month and invest that at an 8% rate of return each year and you do that for 45 years (till you are 65), this is what you’ll have…

But just look at these numbers…

• 20 years in, you invested $120,000 and you earned $176,538. Big deal but then, no big deal.
• 40 years in though, you invested a total of $240,000 but you earned $1,438,686. Now that’s something.

This compounding thingy really starts to become fun only after a couple decades.

Here’s another more fun example. Say at 15, I start a business and I clear $3,000 in profits that year and I do that for 5 years. Now a saver that I am, I don’t spend nothing all those years so at the end of five years of toiling, I accumulate $15,000 in total. And say that’s all the savings I’ll do through my life. Not likely but let’s assume that. And I don’t need the money because I get to live and eat and have fun for free (how? that’s a secret). So then what do I do? I go to my dad to ask for advice and since I don’t need the money for a long, long time, he recommends investing the entire amount in a global portfolio of stocks.

My sister on the other hand, in her attempt at imitating me, does the same exact thing. She starts a business when she turns 15 generating the same amount of profits each year. But a spendthrift that she is, she spends it all. At 25, she gets to have a peek at my account and she realizes that she is falling behind in terms of all this savings thingy so she starts and continues saving till she is a grand old lady at 65.

And like me, she also seeks advice from our dad on where and how to invest her savings and THE dad that he is, recommends the exact same portfolio. I started 10 years earlier and I saved and invested only $15,000. My sister started 10 years later but she saved and continued investing till she reached 65. So she invested a total of $120,000 (40 years x $3,000 each year). Who wins? Of course I do.

Because I got a 10 year headstart, my little sis could never catch up with me even after saving 6x more. That’s the secret I was talking about.

Thank you for reading.

Bye.

Cover image credit – iheitlager, Flickr