A Short Investment Journey

This is a short story about investing. It will explain how financial assets, like stocks and bonds work. This story will help you understand how to grow your capital and the risks you face with each type of investment.

This is a story about a journey

We will be traveling in a car. The car, the terrain we will be traveling over, and the weather conditions we travel in have some very unusual characteristics. Let me describe them.
 

The Car

The car is called the Capital Car. The initial size of the car represents the amount of capital we want to invest. Over time you want your capital to grow. You want the size of your Capital Car to increase. And when it ascends, it gets bigger and when it descends, it gets smaller. The fuel it uses is your savings. As the car ascends it uses less fuel and when it descends it needs more fuel to stay the same size.

We can add fuel to our Capital Car at any time, which increases its size.

This is a journey through time, so our forward motion or speed is constant. However, we can move the car at will to different parts of the terrain. Now let’s examine the terrain we will travel over.

The Terrain

It is a magnificent vista in front of us. Off to our right is a swift flowing river. It is called the River of Inflation. Sometimes it overflows its banks. Directly in front of us is a verdant field rising slowly toward the mountains off in the distance on our left. The field undulates and rises slowly but continually as it joins the mountain range.

In front of us is the junction of three roads. The first runs along the river. It is level and smooth. It is called the Cash Causeway. The middle road runs through the fields and foothills. It is called Bond Boulevard. It is not as straight or smooth as Cash Causeway and looks a little more adventurous. The last one runs through the mountain range with its steep slopes and dangerous curves. It is called Equity Way.

The Weather

We will be traveling in unusual meteorological conditions. There is a mist that envelops the front of our car that obscures our view of the nearby terrain. However, the mist disappears are we look out to the far horizon. The further we look out of the car the clearer the view becomes. The view is absolutely clear behind us and we can see perfectly.

Let’s Begin

Our car is ready; we have looked over the terrain, and checked the weather. We are ready to begin our journey. You are the driver because it is your car. There are other seats in the car so you can take others such as family members, friends, or advisors like your accountant, but you drive. You have decided the road along the river looks best. It is scenic, the road is smooth, and it looks safe.

So we start off along the Cash Causeway. Time has passed and our car is slightly larger and everything is fine. It is a beautiful day and we are enjoying the trip so far.

You glance out the side window and see other capital cars. There are many traveling with us. Some are on much higher ground than we are and their car is now larger than yours.

What’s wrong? Why are we not the same size? The answer is those cars choose a different road; a road that lead to higher elevation but is also not nearly as comfortable.

You begin to question your decision and wonder why your car isn’t as large as the other cars you see. They are already using less fuel. You are upset and worried you have made the wrong decision.

As we motor along we will see road signs erected to guide us on our journey. We will also put up road signs of our own that will help us, and may help others as they follow behind us.

We must now put up our first sign. It reads:

Measure your performance, the size and elevation of your capital car, in terms of your objectives, not against the performance of other travelers.

You started your journey like most people. You started without deciding what you are trying to do and what you are willing to do to achieve it. You have seen how being on higher ground makes your car bigger.

You need to decide how big you want your car to become and what road are you willing to take. Some roads, like Equity Way, are rough and dangerous. They can make your car both much bigger and much smaller. Are you willing to travel on that road?

You must decide what road conditions are you willing to endure? Since the Cash Causeway was so smooth and easy, you think growing your capital doesn’t seem so hard after all.

You decide to move into the rolling hills of Bond Boulevard. This will increase your elevation and size. Another unusual characteristic of your capital car is it can move from one road to another easily.

You steer the Capital Car onto Bond Boulevard. As we travel you notice the capital car is growing larger as we crest a small hill.

We reach the crest and are now descending into a shallow valley. Your car is now shrinking and you become alarmed. You could not see this valley in front of you as you were ascending up the hill behind us. It is getting smaller and the road is now bumpier. You look at the other capital cars around you and see the same look of alarm on some of their faces that is on yours.

One of your advisors points out the view behind you. It is perfectly clear and you can see the shallow valleys. You see the valleys always give way to another hill and even higher elevation.

You are comforted by the thought this valley will not last long and you decide to put on your seat belt and ride through this period of shrinking capital.

You reach the valley bottom and know your capital car will soon start back up the hill. History tells you this is so. While you are in the valley, you see another road sign erected by a fellow traveler gone before you. It reads:

The time to buy is at the point of maximum pessimism and the time to sell is the point of maximum optimism.

This sign was put up by a famous traveler, John Templeton, whose car grew as he traveled in many hills and valleys and though many mountain ranges. This sign means you must ignore the faces of alarms all around you and put more fuel in your car while you are in the valley. This will increase the size of your car at the point it starts growing again on its own.

You add some fuel to the capital car. Before too long, just as vista of bond hills and valleys we saw behind us predicted, we are on our way up the hill.

At the top the terrain evens out, and you begin to relax. You are pleased with yourself that your car is now much bigger than traveling along the Cash Causeway. And you’re glad you decided to add some fuel in the valley, like the old sign advised. You begin to think, “This isn’t so hard after all”

After some time of uneventful motoring, you notice many fellow travelers have moved their cars toward Equity Way. You look to the mountains and see many cars are joining the road halfway up the mountain. Their cars are getting larger by the minute. You can not resist and decide to steer your car onto the mountain road.

As we approach Equity Way you see another road sign. This sign was but up by another famous traveler, Jack Bogle, the founder of the Vanguard Group. It reads:

If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks."

You are so anxious to get onto Equity Way and you are not sure of what is means, so you ignore it and motor on. The ride is exhilarating. Your car is growing rapidly. You are now using no fuel at all.

You look behind you and see the beautiful mountain ranges. The are steep on both sides and if you look closely and carefully you can just barely see scattered wreaks at the bottom of the mountains. These wreaks look like what used to be a capital cars. You begin to think about what Bogle’s sign means.

But the progress up the mountain is truly enjoyable. As you relax in your seat you see another sign. It reads:

Beware! Area of Falling Equities

The ride has been spectacular; the car is running beautifully, the view behind you has been breathtaking. You ignore the sign.

After some time, you notice the car is no longer getting larger, and you have crested the peak and are starting down the other side. Your capital car is shrinking. You are becoming alarmed and begin to look intently out the front windshield. But the view is just as obscured as always.

We must put up another sign. It reads:

Set realistic performance targets based on your exposure.

Even though your capital car is shrinking it is still larger than it would have been if you had stayed on Cash Causeway. The times you looked out the rear window you saw clearly the performance history of cash, bonds and equities.

The history of equities tells us to expect the performance in some years to be down 20%. It also tells us to expect more years when it is up 20%. Measure your performance against where you have steered your capital car. If you travel on equity way, expect to shrink by 20% at some point.

Equity Way has become very bumpy and uncomfortable. Your car is shrinking and you are very nervous. You remember Bogle’s road sign “If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks.”

Your car has not shrunk but not by 20% yet, and because you are so worried, you decide to move your car back to the Cash Causeway. The road smoothes out again, and you begin to settle down.

It occurs to you, maybe you should read the owner’s manual to the car and see if it offers some guidance on how and where to steer the car. You get out the owners manual and begin to read.

You are startled when you come upon the section that tells you can divide your car into several cars, each smaller than the original. You can then steer each of these smaller cars onto the road you want. You can put a small car on Equity Way, another on Bond Boulevard, and a third on Cash Causeway.

The manual also says you can decide what size you want each car to be. This process is called asset allocation. Most travelers on this journey have more than one car. You can decide, for example, to have your equity car be 50% of your capital, the bond car be 30% and the cash car be 20%. This would be a very common asset allocation.

Before you decide how big to make each car, we need to put up another sign. It reads:

Set realistic objectives for your portfolio based on your personal appetite for risk.

This process can best start with the advice “know yourself”. Before you resume your journey you need to answer to the following questions:

How big do you want your car to be?
How long do you want the journey to take?
How much risk can you comfortably tolerate?

You now have the information you need to set your long term objectives. Once you decide this, you will have the answers to how big each car should be. And you must determine what road or roads you comfortable traveling.

And remember, all good drivers obey road signs.

Happy Motoring!

Mike Williams, CFA

(back to portfolio commentary)