Mark Hebner / Mary Brunson

IFA's Quote of the Week - 9 (Merton Miller)

"If there's 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that's all that's going on. It's a game, it's a chance operation, and people think they are doing something purposeful...but they're really not."

Merton Miller, Nobel Laureate and Professor of Economics,
University of Chicago, Transcript of the PBS Nova Special,
"The Trillion Dollar Bet"

For investors who seek the rewards of equity investing, there’s no surefire way to avoid occasional erosion of equity values. Case in point, the S&P 500 Index declined from its peak of 1,565 reached on October 9, 2007 to its recent closing low of 1,310 on January 22, 2008. This 16.27% decline is the price of risk.

Market declines are natural, unavoidable, and they are the reason why we can expect to earn a return that is commensurate with the level of volatility we are willing to accept. In fact, the flipside of the market’s recent decline is the benefit of that same risk that rewarded investors in the S&P 500 with a 101% return for the 5-year market increase that began on October 10, 2002 until October 9, 2007’s closing high. Returns for non-US equities for the same time period were higher still.

Investors cannot realistically expect to enjoy the profits of a market increase, but sidestep inevitable declines. This is because free markets respond to news as it occurs. Sometimes the news is good, and sometimes the news is bad, but we simply cannot know in advance the news that will move the markets. This concept is precisely why we call it “news”, as opposed to "olds". The only solution is to buy and bear as much risk as your risk capacity allows, expecting that stock markets will ebb and flow in the short term, but will result in an upward march over time due to the average profit-making attributes of capitalism.

Some investors, however, will argue that there are always good stocks for the times. In fact, an entire industry thrives on recommending a handful of “stocks to buy now”, leading investors to believe they can enjoy appreciation when the market rises, but avoid profit erosion in a market decline. 

The firms listed below are widely considered to be industry leaders. As such, they have been included at some point among the top ten "Most Admired Companies" in Fortune's annual survey. These companies are most certainly considered to be successful investments, and on many stock pickers’ “short lists”.

As you can see, not one these stocks outperformed the S&P 500 Index’s 101% gain for the five-year period from October 9, 2002 to October 9, 2007. In fact, the share price for Wal Mart lost nearly 11%, while Pfizer was lower by more than 14.5% and 3M gave up a whopping 17% for the same five-year period that enabled double-digit growth for a simple US equity index.   

The chart below reveals the real problem with stock picking. This comprehensive chart shows risk and reward data for the 20 IFA Index Portfolios, the IFA Indexes and the 30 individual stocks that make up the Dow 30 for the 20-year time period from 1987 through 2006. As you can clearly see, despite their highly regarded status, these 30 individual stocks are inefficient when it comes to return in exchange for risk. Not one of the stocks in the Dow achieved returns in excess of the risk they took. On the other hand, an investor who purchased an efficiently diversified Index Portfolio and held it had a high probability of achieving the returns of the market, minus taxes and costs. This investor would also avoid uncompensated risk in the form of concentration and/or speculation. The only question that remains is how much risk is right for you? Click here to take the Risk Capacity Survey to learn which Index Portfolio is right for you.

TO VIEW THIS CHART IN DYNAMIC FORM, CLICK HERE