Saturday, June 8, 2013

Equities: Unlimited Upside With Limited Downside

I'm a huge fan of investing in stocks, as you can probably tell by my almost 100% allocation to the asset class in myFreedom Fund. More specifically, I'm very enthusiastic about investing in ownership stakes with high quality companies that have a history of rewarding shareholders by paying out a portion of profits via dividends. Furthermore, I stick to an even narrower universe of these high quality companies that not only pay these dividends, but raise them on a regular basis (at least annually). I've discussed before why I'm such a huge fan of this strategy, known as dividend growth investing. But today I'm going to reveal one of the biggest reasons I'm so enamored with investing in stocks as an asset class, and this can be broadly applied to stocks that pay dividends or do not pay dividends. 

With investing in stocks, one needs to consider that the potential upside is almost unlimited while the potential downside is limited to only your original capital investment. You can invest $1,000 with "Company X" and this equity stake can only do one of three things: it can appreciate in value, it can depreciate in value or the value can stay static. 

Obviously the least desirable of these three outcomes is that the value depreciates. But this is the true beauty in investing in stocks. Your stock can only depreciate to $0, but nothing more. A stock cannot go below $0. Therefore your biggest downside is losing all of your capital. If "Company X" goes bankrupt and your entire equity stake becomes worthless (actually highly unlikely in reality) you lose all the capital you initially invested. In this case you lose $1,000.

But what if the company becomes wildly successful?

Let's say you hold your equity stake in "Company X" for 20 years and the company increases in value by a factor of 10. That means your $1,000 investment becomes $10,000. That's a capital gain of $9,000. And if "Company X" pays dividends your initial investment has a gain that is even larger than this (especially if you're reinvesting the dividends). You risked $1,000 and gained $9,000 in this case. Think it doesn't work like that? Doesn't happen in real life? Think again.

Let's take a look at a real-life example. 

You could have invested $1,000 in Altria Group Inc. (MO) (then known as Philip Morris) on 5/25/1983, which would have bought you 16.88 shares (closing price $59.25). That was 20 years ago. Those shares are now worth $15,023.80 on a split-adjusted basis (you now have 405.06 shares). That means you only put $1,000 on the line, but received over $14,000 for a gain of 6,390.83%. In this case the downside was 100%, but the upside turned out to be over 6,000%. (Source)

Obviously this is cherry picking a name from the past, but the point remains: your downside to investing in stocks is limited only to the capital you invested, while the upside is theoretically unlimited. Therefore, I feel the reward to investing in stocks far outweighs the potential risks. And this risk can be mitigated further by diversifying your capital into many different companies. I personally plan to have equity ownership stakes with at least 40 different companies by the time I'm done investing fresh capital and living off my dividend income.

This risk/reward relationship is one of many reasons I personally prefer stocks over every other asset class available. 

For comparison sake, let's take a look at some of the other popular asset classes available: 

With bonds, this upside/downside relationship does not exist in nearly the same manner. Your upside is limited by the coupon (yield) the bond gives you, as well as any potential capital appreciation that may exist by way of interest rate changes which could make your bonds more valuable if yields on new bonds fall (obviously unlikely looking forward as we are in a low interest rate environment). Bonds do not allow you to share in the growth of a company, however, so potential appreciation on your bonds is much less than stocks. The downside of bonds is a bit more limited than stocks, though, as bonds have a higher ranking in the capital structure of a business, meaning that if a business goes bankrupt bond holders are first in line to get reimbursed. However, the risk of capital depreciation is still there, and bonds are more sensitive to interest rates. Bonds have a tighter upside/downside spread in my opinion, meaning the downside and upside are both more limited than stocks. But I don't want limited upside. I want unlimited upside. Bonds, in my opinion, are much better for capital preservation, rather than capital growth.

Physical real estate certainly has the potential for significant upside, but real estate is hyper-local meaning that values on real estate are specific to a geographical region. Also, real estate is much different from a business. A business produces revenue, and therefore profits, via products or services that it sells to the public or other businesses. Real estate is simply shelter. It doesn't actually produce anything. Real estate can produce rental income for the owner, however, so income can be squeezed from this asset class. For the most part, residential real estate valuations are tied to incomes. If incomes fall, residence values fall in kind. If incomes rise, people can afford more luxurious abodes, and therefore usually bid up the prices of local real estate. Also, it's much more difficult to diversify with physical real estate as real estate holdings typically tie up a large amount of capital due to the costs of one physical holding. It's relatively easy to pay $7 to buy $1,400 worth ofChevron Corporation (CVX) stock. You can't really do this with real estate. The transaction (friction) costs are much higher, and in most cases you're not talking about fractional ownership like you are with publicly owned companies. You also have ongoing maintenance and tax costs. Because of this, I would more likely prefer to own real estate via Real Estate Investment Trusts (REITs) that behave and trade much more like stocks.

Overall, the upside/downside relationship with real estate is mixed. Your downside is not as great as stocks, because the odds of a property going to $0 in value is almost impossible. However, you could purchase a property that needs unforeseen repairs fairly quickly that can drain any available spare capital you have, and local markets could make it difficult for the asset to appreciate appreciably over the rate of inflation. Also, the odds of physical real estate appreciating at the rate of a group of wonderful companies with fantastic products/services and ones that operate with sufficiently high margins is very unlikely. This opinion is backed by the Case-Shiller Home Price Index which shows that home prices as an aggregate havebarely appreciated over the rate of inflation going back over 100 years. Also, this doesn't take into account the value of your time, as physical real estate tends to be more hands-on than stock ownership. Overall, I view the downside of real estate more limited than stocks, but the upside also not nearly as attractive as what stocks have potential for. Also, the difficulties of diversification, high transaction costs, hands-on nature and need for local market knowledge are traits that make real estate as an asset class less attractive than stocks (in my opinion).

I'm not even going to discuss gold or other physical metals. I've revealed my distaste for gold before. Upside and downside are completely dependent on what the next guy down the line is willing to pay for your unproductive metal.

And cash is obviously unattractive for many reasons. It will only depreciate over time, as inflation eats away at its purchasing power. So, you're guaranteed to slowly bleed money while your upside is basically non-existent. Cash is useful, however, when there are few attractively valued opportunities out there. When markets fall, bringing assets back into valuations that are near historical norms, cash can be useful to take advantages of opportunities. Cash is only good when you're turning it into an appreciating asset at attractive valuations looking out over the long-term. 

Some people may think I'm crazy to put almost all my wealth into stocks. But I don't think I'm crazy at all. I think stocks represent the best possible opportunity to build wealth in a capitalist society. Owning pieces of high quality companiesand reinvesting the profits they send you via rising dividends is simply a fantastic way to build your wealth over the long haul. Picking a great group of high quality companies that pay, and increase, dividends while allowing time and compounding to work its magic will almost certainly provide you the greatest risk/reward relationship available. Your downside is limited only to original capital you've invested, while the upside is limited to the potential of the company you're investing in, the price at which Mr. Market is willing to pay for your ownership stake in said business, whether or not you were reinvesting dividends and your own emotional limitations (trying to time the market). Buying and holding quality companies for the long-term whileignoring the noise will eliminate almost every single potential drag on your investment upside.

How about you? Do you enjoy this upside/downside relationship in stocks?

Full Disclosure: Long CVX, MO

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]

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