Investing

Why Investing in Stocks and Investing in the Stock Market are Two Entirely Different Things

By June 3, 2019 No Comments

Why Investing in Stocks and Investing in the Stock Market are Two Entirely Different Things

One of the great obstacles to investing well with equities is misunderstanding how the parts add up to make the whole.  In this case, the total definitely does not resemble the sum of the parts.  This is why investing in the stock market – through broadly diversified indexes – is completely unlike investing in stocks themselves.  Let me try to explain why.

First, let’s start with the stock market as a whole.  Here, on a log scale[1], is the Dow Jones industrial Average for a period of over 100 years, starting in 1899:

What is notable is the consistency of the progress.  The relationship is pretty linear.  In fact, were you to do a simple regression, you would find that 97% of what explains the returns of the stock market over time is simply time itself.

Why?

Because the market, as a whole, is driven by growth factors that are macroeconomic.  So long as population grows, productivity increases, and even inflation happens, corporate profits as a whole rise.  Provided the average PE multiple stays within a reasonable range, all of this just becomes an endless – and far less chaotic than you might think – march upward.

It is tempting to think that stocks – at least the “good ones” – do something similar.  But they don’t.  They may for a while, even outpacing the market as a whole.  The difference is that individual stocks have a company underneath them, and the fortunes of any company are determined by much more than the economy: their drivers are largely microeconomic.  They have competitors, management, products, strategies, and all sorts of things they may get right for a while.  But eventually they get something wrong, so they never provide 100-plus years of pretty steady growth.

Think of it this way.  For every Facebook, Google, and Amazon of today there was a Kodak, Pan Am, RIM (Blackberry), or Sears of yesterday.  A company like RIM provides an object lesson in precisely how single stocks do not behave like the market as a whole, as this price chart shows:

And, Nokia looks pretty similar:

Some might argue I have picked industries where longevity is not the norm, and more stable “blue-chip” stocks have more opportunity to look like the market.  But that isn’t so, either.  GE was considered a stalwart anchor of any conservative equity portfolio from perhaps the 1950s forward, but look what its actual stock price did over decades – it was one big run-up in the 90s followed by a tale similar to RIM, though played out over a longer horizon:

Another company that used to be a must-hold for “solid” portfolios was IBM.    But the PC cut it down to size (as well as taking out a bevy of minicomputer companies like DEC, Data General, Prime, Symbolics, and many others that had their heyday in the 20 or so years prior to the PC coming out).  Although its performance has a better shape than GE, the annualized return over the 4 decades shown is only about 3.5% annually:

Now, I know that someone will say “then the way to beat the market is to spot those trends and be in those stocks when they are on their steep appreciation course.”  I’ll address in another post why that is harder to do than it seems.

But my point here is a bigger one, and stems from an old field called Organizational Ecology.  Adherents of this framework believe that companies get big often by getting lucky – being in the right place and doing the right things at just the right time, giving them a natural boost and momentum that they can ride for quite a while (after all MySpace was there before Facebook – so why did Facebook win?  And why can’t anyone take Facebook down quickly?).   It’s hard to believe -given the competition it later faced – that in the 1970s the Justice Department was looking at breaking up IBM: at the time IBM was earning (according to some) over 70% of the profits of the entire computer industry.  This was a possible “natural monopoly” and a seemingly insurmountable challenge for any potential competitor.  Yet, today, IBM is a shadow of its peak self.

Organizational Ecologists tend to be pessimists.  They largely believe that companies become geriatric quite quickly, and just don’t change very fast, if at all, after initial success.  If a company has built an enormous success on mainframe computers, all of its management, structures, strategies, and plans are built around mainframe computers: the organization has what it has come to know as leading to success deeply embedded in its DNA.  The world then evolves around it, and it has a terrible time repurposing.

These firms ascend when they are fit for purpose of their times, then ossify, and eventually fade.  I don’t believe a single company from the original Dow Jones index is still in business today.  Kodak tried to become a digital imaging company, but it was a bridge too far.  And I have no doubt that Google (Alphabet) and Facebook will, in time, be over their own hump and become dinosaurs that will be taken over by newer companies of the future, their carcasses being picked over for prosaic assets like customer lists and patents with a few more years on them.

And this is my thesis.  Companies live and die based on their timing, strategies, management, competition, and huge numbers of other factors.  There is a Darwinian battle for first existence and then growth.  But across the economy there is a Schumpeterian orgy of creative destruction, whereby new entrants bring out products and services that provide even greater value or convenience to consumers at equal or lower costs.  The wealth then switches from the older players to the new ones.

But the market as a whole – or a broad index fund on it – never sees these “internal” events.  Rather, it captures the totality of growing demand of all goods and services, coupled with the productivity and value growth that drives much of the inner dynamics.  The market (and broad index funds based on it) differ from companies in a huge way: the market has no competitors, no CEO, and no strategy. But it always holds all the winners at all times.

So let me recapitulate the very first chart for you, because it shows what no stock, as far as I know, has ever done: delivered amazingly consistent value growth for over 100 years with exceedingly low volatility.  It never has huge run-ups, but like a well-tuned and powerful diesel engine it can keep on cranking and deliver consistent returns that can compound mightily:

Quite simply, it is probably easier to make money owning the racetrack than it is to win by betting on the horses.

 

[1] See my prior post here on why this is a good idea: https://www.leekranefuss.com/2019/04/why-you-should-use-logarithmic-scales-to-make-investment-decisions/