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THE STOCK MARKET offers limited downside and unlimited upside. That might not seem like a big deal. But this asymmetry has huge implications for how we manage our money—and, for prudent investors, it should be a great comfort. How so? Consider five key implications.
No. 1: The most a stock can lose is 100% of its value. Sound grim? There’s a silver lining. Assuming you own your stocks outright, your potential loss is limited to the sum you invested. By contrast, if you sell a stock short, sell put or call options, or buy stocks using margin debt, a bad bet could threaten the rest of your portfolio.
The fact that a stock could lose 100% of its value is the most-pressing reason to diversify broadly. How often do stocks become worthless? Historically, they’ve done so with surprising frequency.
Consider the 2018 study by Arizona State University’s Hendrik Bessembinder, who analyzed the roughly 26,000 U.S. stocks that traded over the nine decades through 2016. Of these, 4,138 stocks were still trading at the end of the period, 12,560 had been merged, exchanged for other shares or liquidated, and 9,187 had been delisted by the exchange. This last set of stocks—some 35% of the total—lost a median 92% of their value over their lifetime.
That brings me to a frequent and ill-founded complaint. Have you heard investors heap scorn on dividends and stock buybacks? They shouldn’t. If a company doesn’t eventually start returning cash to its investors through dividends and buybacks, it could disappear without creating any overall value for its shareholders during its corporate lifetime.
What if a company does pay a dividend? We should think long and hard before reinvesting those dividends back into the same stock. If almost all companies will eventually disappear—and at least some will end up worthless rather than, say, being acquired by another company—you want to take dividends from your individual stocks and reinvest them across a broad array of companies, rather than plowing that money back into the same stock.
I knew an investor who owned Washington Mutual. It was easily her largest individual stock holding and a hefty percentage of her portfolio. She merrily reinvested dividends, and also made additional cash investments, through the company’s dividend reinvestment plan. Remember what happened to WaMu? The bank collapsed in 2008—and the investor I knew lost everything.
No. 2: The most a stock can climb is far more than 100%. How much more? The potential gain is infinite, though that’s a tad too optimistic. Companies can grow faster than the overall economy for a few decades, driving their shares to impressive gains. Think of companies like Alphabet, Amazon.com and Apple. But eventually, that growth must inevitably slow, or the company and the economy would become one and the same.
No. 3: Most years, the stock market’s gain is driven by a minority of stocks. Welcome to what’s called skewness, in this case the result of stocks’ limited downside and unlimited upside. Every year, a small number of stocks post huge gains—sometimes 100%, 200% or more—and their results skew the market averages higher, so typically a majority of stocks end up with market-lagging results.
Many investors are captivated by these highflying stocks and assume their best bet is to hunt for the next big winners. But just the opposite is true. If you try to pick the next big winners, the odds suggest you’ll end up picking turkeys. Instead, the only sure way to own the next big winners is to own the entire stock market—by purchasing total market index funds. Any other strategy runs the risk of delivering market-lagging results.
No. 4: The global stock market is highly unlikely to lose 100%. During late 2008, with the Dow Jones Industrial Average plunging below 10,000 and the index regularly losing 500 points in a single day, I’d joke to colleagues that, “Another 19 days like this and it’ll all be over.”
Yes, it was gallows humor—but with a point: The Dow wasn’t going to zero. If it ever did, it would be game over. It would mean something truly dreadful had happened to the world, causing the economy to cease functioning. At that point, it wouldn’t matter what you owned. Bonds and cash investments would also lose all value because borrowers wouldn’t be able to make their interest payments and, no, nobody would be interested in buying your bitcoin or gold bars.
What if the economy doesn’t cease to function? Even if some companies and even entire national markets shed all value, a globally diversified portfolio of stocks would eventually recover and start notching new highs. In other words, investing is a coin flip where “heads” means diversified stock market investors win, and “tails” means all investors lose. That’s why, to me, stocks are the only logical choice for long-term investors.
It’s also the reason I happily buy stocks whenever there’s a major market swoon. Yes, there’s a risk that a 20% decline might become a 40% or 50% drubbing. But it’s highly unlikely to become 100%. Stocks will ultimately recover, though it may take far longer than any of us would like.
No. 5: There’s no limit to the stock market’s potential gain. As I’ve written in earlier articles, I’m happy to over-rebalance when the stock market nosedives, shifting a higher percentage of my portfolio into stock funds than my written asset allocation calls for.
But the opposite isn’t true. When stocks soar, I sell shares to get back to my target percentage—but I would be loath to underweight stocks. Why? While the potential loss on stocks is 100%, the potential gain is far more than 100%, and underweighting stocks could mean I’d miss out on big gains.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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My question is similar to that of parkslope. If the goal is to have x number of years of living expenses in short term bonds funds why do you want to state your portfolio allocation in percentage returns. Why not let your stock portfolio grow without restriction. As long as you have your safety net in short term bonds it seems the % of your portfolio in stocks is irrelevant. History suggests you will maximize your returns in the long run by investing more in stocks.
Anyway that is what I do. I keep 4 years of expenses in very safe fixed income investments and everything else in stocks regardless of my overall % of stocks. Basically I want keep as much as possible invested in stocks for as long as possible. I learned a long time ago that I’m even worse at picking market tops then market bottoms.
This is exactly why we love self cleansing indicies.
WaMu, Enron, WorldCom, Lehman, SVB — if a management is committed to taking too much risk, or engage in fraud, and hide it from the shareholders, there’s little chance of avoiding those bombs, whether you own them individually, or in an index.
Further, if one is not comfortable reinvesting 2% to 3% more in a company annually by reinvesting dividends, should one own the stock at all?
According to Dr. Robert Shiller’s data, the Average Annual return of the S&P 500 since 1971 without dividends reinvested was 7.58%, and 10.51% with dividends reinvested, for a 38.6% greater average annual return.
I’ll take the risk of reinvesting dividends in companies I like and trust — whether owned individually, or collectively in an index — rather than forego the appreciable power of compounding that dividend reinvestment brings.
I’m all in favor of reinvesting dividends in an index fund. The question is, is it wise to reinvest dividends back into the same stock?
Hi Jonathan. I think the result is known in the end, isn’t it? If one is burned by bad management like your example of the WaMu investor, it looks foolish. Reinvesting Apple dividends looks pretty smart. I think it’s a matter of risk tolerance, but I’d rather take the risk of reinvesting dividends in an apparently good company, than miss out on the compounding that dividend reinvestment offers.
No. 3 is just the flip side of a part of No. 1, where a “… set of stocks—some 35% of the total—lost a median 92% of their value over their lifetime.”
No. 3: “Most years, the stock market’s gain is driven by a minority of stocks.”
One entails the other, and it always been this way.
Thank you Jonathan for this thoughtful article. When I started investing I did a lot of foolish things like buying individual stocks and reinvesting dividends in the same stocks. I learned my lesson and consoling myself that it was all part of the learning curve. Now I am investing 70 percent of the funds allocated to stock market in the total stock market index fund and index ETF and 30 percent in total international stock index fund and reinvesting the dividends in the same funds. I am planning to convert these funds to total world index fund as Jonathan is doing.
Some knowledge of the stock market history is helpful. At the turn of the century (that is around 1900) largest markets in the world were Russia and India. The Russian market disappeared entirely in 1917 with the Bolshevik revolution and the Indian market survived but performed anemically since. This is the reason I want to change everything to total world stock index fund and reinvest in the same fund as Jonathan is doing. I am hoping that the index fund will survive even when individual stocks and individual markets perish. A large part of my assets are in Roth and traditional IRAs so there will be no tax consequences. I have to think more carefully about non IRA assets.
Jonathan,
I read your article but it does not apply with my equity investments 100% in index funds. However, one practice I’ve followed for about the last 10 years is on my taxable accounts I do not reinvest my dividends. On my tax exempt/deferred accounts, I use automatic reinvestment of all dividends. The cash distributions allow me an opportunity to rebalance along the way in the taxable accounts and give me liquidity as I continue my path to full SS at 70.
I’ve a question re: rebalancing, Jonathan. You talked about selling stocks when they soar to get back to your particular asset allocation. Right now stocks have been doing better than they’ve been for about a year. But bonds, while sort of recovering now, didn’t really act as much of a buffer as they tend to do normally–what with all the interest rate hikes, they’ve gone down quite a bit (over 10%). Presumably, for instance many intermediate-term bonds will take a while to recover, though the new ones the fund adds will pay higher rates. Ordinarily it’s more like a seesaw with either bonds or stocks going up while the other goes down. It didn’t really work that way for the last year or so. With most of my assets in retirement funds, I ordinarily have 70/30 stock-bond allocation goal with +/- high/low bands and right now it’s about 75/25 (which when it went to 76/24 I sold back to 75/25). I’m a little hesitant about selling stocks now since, while they are doing better, they still are about 10% or so off where they were over a year ago as well. Perhaps should I just incrementally over a few months sell off 1-2% stocks into bonds? It’s not like selling a clear winner into an underperformer, which is the more usual way of rebalancing. Thanks.
Whereas you cannot time the stock market, you can sometimes time the bond market. Why would you stay in a bond fund when rates are going up?
Thanks for the question. Three things to ponder. First, investors take all kinds of approaches to rebalancing:
https://humbledollar.com/money-guide/how-often-should-you-rebalance/
Thus, if you’re inclined to wait before rebalancing, that’s not “wrong,” though subsequent events may later suggest you should have taken a different approach.
Second, while rebalancing can help returns — something I’ve discussed elsewhere — the biggest reason to rebalance is risk control:
https://humbledollar.com/money-guide/rebalancing/
Do you feel your current portfolio is too risky? How you answer that question should probably drive whether you rebalance now or later.
Third, I think 2022 is a reminder of why total bond market funds may not be the best investment to balance out a stock portfolio. My longstanding preference has been to invest heavily in stocks while playing it super-safe with bonds, favoring high-quality short-term bond funds.
I continue to question #5 which you have voiced several times. If you are comfortable having a smaller amount of your portfolio in safe investments when the market is down then why aren’t you comfortable with that smaller amount when the market is up?
I assume you’re referring to over-rebalancing, which is related to No. 4, not No. 5. I don’t have anything to add beyond what I’ve said before:
https://humbledollar.com/2022/10/my-investment-sin/
As in 2008-09 and 2020, over-rebalancing in 2022 served me well. I think it’s a valid strategy. But if you think I’m wrong, obviously you shouldn’t do what I do.
No, I am referring to No. 5. When you over-rebalance when the market is down you have a smaller amount of your money in safe investments than you do when the market is up, which makes me wonder why you feel the need to have a greater amount of money out of the market when it is up than you do when it is down. In other words, if you are okay with a smaller amount of money out of the market when it is down then why not simply stick with that smaller amount regardless of what the market is doing?
I think I answered that with my previous reply. My baseline is 20% in short-term bond funds, but I’m willing to use some of that 20% to buy stocks when the market is down, knowing that the global stock market is highly unlikely to go to zero (No. 4) and, if it does, it won’t matter what you own.
I do reinvest dividends in my stock index funds and ETFs, but I also have a few individual stocks and actively managed mutual funds, acquired long ago.
While I’d now rather have all stocks in the form of index funds and ETFs, the capital gains accrued over many years in the other two categories have me hesitant to sell them. But I don’t reinvest the dividends (and capital gains distributions in the case of the funds), so at least I’m not acquiring any more of them!
Diversification by investing in a broad stock index mitigates the risks of number one, allows us to capture a piece of the gains cited in number three, and number five reminds us why should own stocks. You have previously mentioned that once retired, you intend to hold enough cash and short term bonds to fund a certain number of years worth of withdrawals with the balance mostly in stocks.
I would enjoy an update on the concept of “risk”. I don’t view stocks as risky assets per se, at least when owned via a broad index fund, but rather my behavior can introduce risk. Provided I have sufficient cash and short term reserves to guard against sequence of returns risk, I can resist the temptation to sell stocks at low prices. But even then, how many future years worth of withdrawals to hold in reserve now? More when the market seems richly valued, fewer when it is not?
Thanks for another thought provoking article!
I second more content on the topic of risk, asset allocation, and withdrawal strategies in retirement. Your mention of sequence risk brought to mind this interesting quote on Kitces, “taking a 4% initial withdrawal rate has an equal (10%) likelihood of leaving all the retiree’s principal left over at the end of retirement… or leaving 6X the starting account balance remaining instead.”
The above shows the asymmetrical nature of sequence risk which isn’t typically focused on in the personal finance community. I find myself quite interested, not on what to invest in, but on how to responsibly manage and withdraw my accumulated assets in retirement.
If you head to this page and scroll to the bottom, you’ll find links to a slew of articles on withdrawal strategies:
https://humbledollar.com/money-guide/four-percent-withdrawal-rate/
And we’ve got another article on the topic coming out on Tuesday….
Glad you liked the article. My plan is to hold five years of portfolio withdrawals in short-term bond funds once I’m fully retired. I’m not sure I’d vary that based on some judgment about the market’s valuations. Instead, I’d look for flexibility on the spending side. For instance, if we found ourselves in a bear market similar to 2007-09, that might be the time to trim spending — fewer meals out, less expensive vacations, no remodeling projects — while you wait for the market to rebound. I think many retirees do this instinctively, and it’s probably prudent.
“Fully retired”? Jonathan, perish the thought!
Fear not: Unless my health becomes an issue, I don’t currently have any intention of fully retiring, though I am hoping to work somewhat less in the years ahead.
I have around 7-8 years worth in reserve with the balance in equities. Your strategy of responding with flexibility on the spending side makes sense, and its what I plan to do. Thank you for your reply!
Another excellent post!
Interesting way to look at it. Way back when, I participated in the Employee Stock Purchase Plan offered by my employer, with dividends reinvested. But then it occurred to me that owning stock in the company that paid my salary, provided medical insurance, and would pay my pension was perhaps excessive, a view reinforced when it flirted with bankruptcy. After that I stopped buying, and every time the stock split I sold the new shares. I still own some, but don’t want to pay tax on the gains (I can calculate the basis, I still have the paperwork…)
Every case is different. I worked for an up-and-coming company for 6 years and never participated in employee stock ownership. I wasn’t confident in the company’s prospects. Later on I invested 100% of my portfolio in one company’s stock (not my company) and have held it for 24 years, and have beat the market by a long shot though that was never my goal. Generalizing and averages are the bane of the financial advising industry. They are invaluable to know, but living by them is another thing.
Great article, as usual! Now, please, could we please have an update on the major remodeling project, the one that made it prudent for you to vacate for a few months? I hope it is going well!
I’ll have an update at some point. Long story short, it’s taking much longer than anticipated because of an issue with permits.
Moved my comment/question to the right place
One popular money magazine touts the virtues of dividend stocks. What do you think about the Vanguard Dividend Funds?
I think dividend-oriented index funds are a fine choice as part of a diversified portfolio, especially if you want to give your portfolio a value tilt and — assuming you don’t plan to spend the dividends right away — preferably held in a retirement account. I think a fund is certainly wiser than trying to pick individual dividend stocks.
Jonathan, I’m curious about the preference to hold dividend funds in retirement accounts, as I’ve heard it elsewhere and wondered about it. I assume this is referring to high dividend yield funds as opposed to dividend growth funds. For the latter, the yield on those isn’t that different from a total market index fund, so is there any real reason not to hold them in a taxable account? Thanks
For example: VYM 3.1%, VIG 1.9%, VTI 1.5%, VT 2.0%
Yes, the reason to hold a high-dividend fund in a retirement account is the yield. A dividend-growth fund would indeed be more appropriate for a taxable account. I imagine there’s some risk of capital-gains distributions if a fund changed its benchmark index, but I suspect skillful use of the ETF creation-redemption mechanism would allow a manager to sidestep that problem.
Thanks. Thought provoking article.
A nice reminder Jonathan and lessons to be learned.
I’ve had a few bad experiences with individual stocks. The very first stock I purchased was in a friends business venture, a split-off from the parent company, and it failed, never to regain prosperity. The other was the company where I worked and it filed for bankruptcy due to the 2007-2008 economy. It survived and is a doing well. In fact it just reported the best earnings ever, but I don’t own any shares.
This is one of the best articles I have ever found to convince someone not just to invest, but to put a little faith in a 401k. I train new hires and try to get them to sign up for our Deferred Compensation. Sayings like “The stock market never stays down” & “It’s less risky with ETF’s” usually fail to convince a newbie to fork over some of his/her “drinking money”. However, these 5 items may just do the trick. Even though we have a pension, they are phasing out or capping the pensions in favor of self investing/saving. An early start will make all of the difference.
One day our vice president was lamenting the fact that we had several employees who were not signed up for our 401(k) that matched 100% on the first six percent you contributed. He asked me my thoughts and I said, “You should fire them. If they aren’t smart to take advantage of a 100% match, they probably aren’t smart enough to be working here. He knew I was kidding but it does make a point. Barring some unknown personal issue, it sure is strange when someone skips the match (and the deduction).
Fast forward ten years and I’m training a kid with an MBA from a prestigious university and he’s not contributing to the company 401(k). I always wondered about that MBA program.
Nicely put. I’m interested as to what motivated you to write this article at this time. Has it been percolating for a while? Was it a discussion you had or something you read? A life or economic circumstance? I’m going to share it with a friend.
As with many articles, this one started with a series of ideas — some from long ago — that, it recently occurred to me, might work together to create a cohesive article. The latest idea was the dangers of reinvesting dividends back into the same stock. Obviously, there are companies that pay dividends and continue to be incredibly successful. Think Apple. But as a rule, the payment of a dividend can be seen as an admission by management that they don’t have high-returning uses for the cash, and that the company’s rapid-growth days are behind it. That’s an important signal to shareholders — and a reason they probably shouldn’t reinvest cash back into the same stock.
Jonathan…thanks for this article. Unfortunately I had the same experience with Washington Mutual. My biggest loss ever in one stock. Lost it all except for 78 cents. I remember reporting a $1.00 gain on our tax return.
Have never owned another bank stock since then, except for American Express which is also a card issuer and payment processor.
the only difference between your friend and I, with regard to WAMU, is that I never reinvested the dividends in that stock. Tried my hand with Dividend Reinvestment Plans when they were popular—too much trouble. Now I just wait for a “sale”.
I thoroughly agree with your viewpoint.
An aunt gave all of us kids shares of WaMu when I was in high school. Reinvested divs for years… then boom.
Nice article. It’s the risk of losing all our money that makes stocks’ superior rewards possible. Interesting thought about not reinvesting individual stock dividends though. I’ll have to noodle that.
yes, I’ve always automatically reinvested because of some logic long ago. I, too, will re-think this.
I see the reasoning in regard to an
individual stock. In regards to my holding of a global market weighted index/EFT fund, like VTWAX, there does not seem to me to be the need to not reinvest my VTWAX dividends. The global equity fund seems to self correct the problem of an individual stock becoming worthless and think I will be ok as long as I am willing to accept the risk of the overall equity market and plan to hold long term.
I am still heavy in a S&P 500 index fund that still resides in a former employer 401(k) that I have yet to move and I do not like the alternatives for investment in the investment offerings offered by the plan. I plan to move my S&P 500 fund to my IRA later in 2023 after the FOMC decides it is done raising interest rates. My 401(k) is restrictive on distributions other than RMDs and does not allow in kind distributions and will only snail mail me a one time single check payable to my IRA custodian for the balance above my annual RMD as a direct rollover. I am thinking about turning off the dividend reinvestment on the IRA reinvested 401(k) cash after moving for non global investments. I guess I am guilty of some short term market timing, recent result and home bias on my S&P 500 holdings.
We’ve been taught dividend reinvestment is dollar cost averaging. That’s why we think it’s the right thing to do.
Thank you for another thought-provoking article. It reminds us all about the principles of investing in a volatile stock market, the importance of diversification, and the potential of the market in the long run.
Great, as always, Jonathan!