Looking Up and Down

Jonathan Clements

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, 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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