If you owned stocks or a stock mutual fund last year, you are probably pretty happy with the results, but you may also be breathing a sigh of relief. If you are anything like the many we have spoken with over the last 18 months, there is a sense that this market has been and continues to be on thin ice. Investors may feel the need to exit quickly to avoid the next market drop. Simultaneously, every time the Dow hits a new high, FOMO (Fear of Missing Out) kicks into high gear and those same investors don’t want to be sitting on the sidelines. There is data that shows how much investors move in and out of stock and bond funds over time and last year is an example of why many investors are their own worst enemy.
This chart shows money flowing into and out of stock and bond mutual funds and ETFs (Exchange-Traded Funds). As the stock market bounced back in the first quarter of 2019, investors chased those returns by adding more to stock funds. After March, however, they began taking money out of stocks and loaded up on bonds. Those who acted out of fear of recession in the middle of the year missed out on a strong finish for equities.
The psychology of this movement in and out of stocks is very challenging and typically a drag on returns. Most of us know that we need to own stocks to some extent to meet our goals, but we feel a very real need for safety. A good financial advisor will tell you that the solution is some combination of stocks and bonds that helps you sleep at night (and he or she will help you figure out that blend).
Sometimes, we hear from someone who knows they can’t handle all the risk of the market, but rather than embracing diversification, they ask this: “Can’t we just buy safe stocks?”
Do Safe Stocks Exist?
Are there such things as safe stocks? Can we really pick the Goldilocks companies that will go up enough to meet our goals but not go down so much to leave us fearful? The short answer is no, but there are ways to improve the odds of safety as you build a stock portfolio or select a fund.
Let’s approach this with clear eyes. First, the idea of safety is relative and depends on so many emotions and conditions unique to each person. No two ideas of safe are the same. Second, safety comes and goes. It is transient. What kept you safe during the Financial Crisis ten years ago did not help you recover in the decade that followed. It is important to determine whether your need for safety is short-term or long-term. The riskiest stocks, if we are to start at the far end of the spectrum, are those companies with futures dependent upon uncertain outcomes. They might be young and fighting to make it to market with a viable offering. They might be more mature but facing intense competitive forces. The market prices risk for companies every day and rewards those that succeed with higher stock prices. You can see wild volatility in such companies and, every once in a while, one breaks through and attains tremendous success. There also is the risk that a company fails in its growth plans and its share price collapses.
On the other side of the investment spectrum are the stable income earners of the corporate world. They are not glamorous. They are not leading the charge into a brave new world like Beyond Meat, Uber, or Tesla. They are selling soap and electricity. They are moving goods and providing services. They are not growth companies, positioning themselves to capitalize on new products and new markets. They are value companies, earning steady cash to weather the ups and downs of the economy. Can they go down in price? Of course, but they also are typically not bid up sky-high in price by speculation on their future. When the market is racing ahead, they can lag behind. When the market turns down, they typically do not have as far to fall because they have more stable sources of revenue. They also tend to pay dividends which provide income in the absence of a stock going up all the time.
Growth vs. Value
These are the two sides of the stock investing coin. Over long cycles lasting years, these two sides trade leadership back and forth. For many years, as in the 1990s, Growth outperformed Value as the internet economy matured and eventually became a bubble. At that time traditional Value investors like Warren Buffet were notoriously considered dinosaurs. Then the cycle changed and for the decade of the 2000s, Value stocks were the safe haven for those who did not want to be exposed to the widest swings of the market.
That brings us to the last decade and where we stand today. Growth reigns supreme and has for a long time. Many companies have done well in the last ten years, but Growth stocks have vastly outperformed Value stocks since the end of the Financial Crisis. The chart below shows the performance of the Russell 1000 Growth index versus the Russell 1000 Value index. The largest holding in the Growth index is Apple and the largest position in the Value index is Buffett’s Berkshire Hathaway.
Someone committed to Value investing like Warren Buffett might be feeling a bit antsy that they are underperforming some of the market leaders. The key to Buffett’s success, though, has been patience. Patience to know that his margin of safety lies in his investment’s ability to generate cash in the long-term.
Investing in the stock market with an eye on safety is a function of a few factors that are in our control:
- Knowing your unique tolerance for risk: Look in the mirror or hire a mirror. We use a tool called Riskalyze to help quantify each investors risk and the amount of risk in their portfolio.
- Being aware of cycles: Your performance may be lagging behind the rest of the market because you are already invested in value-oriented funds. You should seek to understand how your investments are performing in the current cycle and how they may change as the currents shift.
- Patience: As we saw above, investors bail out of the market and dive in at the wrong times. Being safe is more than picking the right stocks. It means staying with an appropriate blend through the short-term volatility. Easier said than done, but good investing is simple, not easy.
When we talk about safety, we are really talking about alternatives. Is there something different than what I am doing now that will create the same or better result with less risk? The truth is that the grass is rarely greener if you are searching for “safe stocks”. Owning the right blend of Value and Growth stocks can bring diversification and balance to succeed through many cycles.
I enjoy conversations about how we can all become better, more educated investors. If you have any questions, comments, or would like to talk about an issue unique to you or your family, I am always happy to chat.
The information provided in this post is for informational purposes only and should not be construed as a solicitation or offer to sell any particular security.