Investors Often Make Less Than the Stocks They Invest In
Did you know that many investors’ returns are a lot less than the returns of the stocks they invest in?
That’s why you see graphs like this:
[Source]
That graph shows us that “average investors” in 1993-2013 gained far less than practically anything they might have invested in.
More recent studies show that little has changed since then.
[Source]
When I first saw charts like these, I thought it was impossible: After all, everyone’s money is somewhere, and the charts list practically every place it could be. How could the average investor underperform everything?
Well, if you look closely, there’s one giant asset class not listed: Cash.
So what the graphs really tell us is that many investors hold lots of money in cash, which earned little during 1993-2013 and today earns even less.
And that brings us to the difference between investor returns and investment returns.
Investor returns are what you, as an investor, actually receive.
Investor returns differ from stock returns in this way: Investor returns take into account your own behavior.
Remember in DGI Lesson 12: Run Your Investing Like a Business, we said:
You are the founder, CEO, and Chief Investment Officer of your business. You want to run it well. Every well-run business has:
• a primary goal;
• strategies designed to achieve that goal; and
• tactics, programs, and activities to execute the strategies.
Running your investments like a business helps remove behavioral quirks and emotions from your investment decisions. That way, your investor returns will more closely match the returns of what you hold.
That’s what we want, because in general, studies have shown that investor returns usually trail investment returns, often by large amounts. The reason universally identified by these studies is that investors trade too much and time their trades badly.
Specifically, they sell out in fear during market downturns (going to cash), then they wait too long in cash to get back into the market when it’s going up. Their money earns nothing in cash.
Why do investors behave like this?
• Fear. Selling in a panic when the stock market drops.
• Greed. Buying when the market has been going up or topped out, based on short-term euphoria (recency bias).
• Impatience. Short-term view rather than long-term view. Hopping around from idea to idea rather than giving an investment thesis time to play out.
• Lack of discipline and over-emotionalism. Being triggered into action by today’s news, especially breathless stock-market reports. Trading based on tips or superficialities.
Dividend Growth Investors Have Another Behavioral Factor
Dividend growth investing (DGI) includes all of the above factors that could negatively impact investor returns.
But with DGI, there’s another factor as well: Dividend reinvestment.
We saw the math behind dividend reinvestment in DGI Lesson 5: The Power of Reinvesting Dividends.
But reinvesting dividends is a behavioral issue too: Dividend reinvestment is controlled by you, the investor. You have to decide to do it, and then you must execute your decision(s).
If you owned a business like a construction company, much of your success over time would result from how you allocated capital. Capital comes into such a business via payments for jobs completed, business loans, and the like. What you do with that capital is called capital allocation.
As a stock investor, running your stock-investing business, you make capital allocation decisions too. You decide what stocks to buy in the first place, how to manage your portfolio, and what to do with dividends.
Thus, your investing operation is itself a growth business. That is true even if you invest in slow-growth dividend-paying companies.
To see this more clearly, break down the sources of return to the stock investor. There are more sources than simply the growth of the businesses that you own.
The Layers of Returns for The Stock Investor
Viewed from the perspective of the investor’s investing business, here are the five components of return.
1. Results of trading in and out
We saw above that many investors sabotage themselves by trading in and out of stocks, trying to catch high points and get out at low points.
That usually backfires, because no one has a crystal ball. Sells made at perceived highs often cause the investor to miss still higher highs that come later. And buys made at perceived lows often cause the investor to be stuck in cash, rather than invested, when the market reverses and the stock’s price starts going back up. By the time the investor decides to re-enter the market, much of the runup has been missed.
So the first layer of investor returns is under the investor’s control: Don’t trade too much, and don’t try to time the market.
2. Earnings growth
It is axiomatic in stock investing that stock prices follow earnings.
But a footnote to the axiom is: But not always and not consistently. Let’s be sure we understand the relationship between a company’s earnings and its stock price.
Stock prices are determined in the market. The market is an auction house: Potential buyers make bids, and potential sellers set their asking prices.
The stock’s multiple – price divided by earnings, or P/E ratio – reflects this fact. Market participants place a value on earnings and the expected growth of earnings. The market’s valuation of a stock is reflected in the P/E ratio at any given time.
As I write this, Johnson and Johnson (JNJ) has a multiple of 24.59, circled below.
JNJ is one of my favorite stocks for illustrating investment principles. One reason is that it suffered through a strange flat period in the 2000s where its price hardly moved for a decade even though its earnings increased steadily.
The following chart shows July, 1999 through March, 2009. JNJ’s earnings rose every year, a total of 180% (see the orange line), while the stock’s price (blue line) hardly changed for a whole decade.
During that decade, the market did not reward JNJ’s continual earnings increases by upping the share price. JNJ was called “dead money,” and investors were often advised to avoid the stock.
An over-reactive investor might have followed such triggers and sold the stock. As we’ll see, that would have been a mistake.
Why didn’t JNJ’s price rise with its earnings? Because for 10 years, while JNJ’s earnings rose every year, the market steadily devalued those earnings. JNJ had a high P/E ratio at the beginning of its dead-money era, but that ratio fell for 10 years even as the company was growing its earnings.
At the beginning of the period, JNJ’s P/E ratio was over 40. At the end of the decade, it was under 11.
A stock’s P/E ratio is determined by the market, not by the company. Why did the market devalue JNJ’s shares when the company was doing such a great job?
Markets can be irrational. We can surmise that at the beginning of the period, owners of JNJ had bid up its price “too high,” cresting in a euphoria of over-valuation. The valuation of JNJ was irrational at 40.
But the market self-corrected, as it often does over long periods of time. A decade later, JNJ’s shares were, if anything, undervalued at 11.
Then the market turned around and reversed itself again. Over the next few years, JNJ’s price climbed back faster than its earnings grew.
If you look at enough price charts, you’ll see that that is typical behavior for stocks, although market irrationality it rarely lasts for 10 years. Stock prices often climb above fair value, then fall back below fair value, then climb back up again. A stock’s price is rarely right on its fair value.
Over the long term, the stock’s price will approximately track its earnings growth. Over shorter time frames, its price might do anything, including move in the opposite direction of earnings.
Here’s my point: The axiom that stock prices follow earnings is true in general, but sometimes it takes years for the thesis to play out.
In any event, that is the next layer of returns: Stock prices directionally tend to mirror growth in earnings over long periods of time. This layer of returns is not in the investor’s control: Earnings are a function of how the company is performing.
3. Multiple expansion or contraction
We just saw that over long periods, earnings and stock price tend to correspond to each other. But we also saw that over shorter time periods, they often do not.
Many times, a stock’s P/E ratio is around 15, and that is often viewed as a fair valuation estimate for most stocks most of the time.
But the exact P/E ratio changes constantly in the market, as buyers and sellers complete transactions.
Let’s look at JNJ again, this time using FASTGraphs. On the following chart, the orange line is drawn at a constant P/E ratio of 15. That provides us with a generic fair value for JNJ’s stock. It moves with earnings, because it is a constant multiple of earnings.
The black line is JNJ’s actual price, reflecting what traders are actually doing in the market. This chart covers more than 20 years.
You can see that over that long a period, JNJ’s price has sort of generally followed its steadily rising earnings. Its price has stayed within about 50% of the orange line at all times, indeed wandering through it in both directions a few times.
I put maroon dots at the beginning and end of the 10-year dead-money era on this chart. Note that from one dot to the other, JNJ’s fair price (orange line) went up steadily – due to JNJ’s earnings success – but its price zig-zagged up and down, ending up just about where it began.
The orange fair-value line is nice and smooth (drawn at a constant P/E of 15), but the black price line is volatile and has sudden directional changes. Note also that at the beginning of the dead-money decade, JNJ’s price was quite a bit above its fair price (orange line), but by the end of the decade, it was quite a bit below its fair price.
For the JNJ investor, the outcome was this: During its dead-money decade, the JNJ shareholder did not receive price returns commensurate with JNJ’s earnings growth. Even though JNJ was steadily increasing its earnings every year, the market was relentlessly reducing the value that it placed on those earnings.
But then, in 2011-12, the market’s devaluation of JNJ’s earnings reversed, as investors began to value JNJ’s earnings more highly, and JNJ’s P/E ratio steadily rose. The result has been that in recent years, JNJ’s price has grown faster than its earnings.
So while JNJ’s really long-term shareholders have received price returns that roughly correlated with JNJ’s earnings growth, the degree of correlation has varied markedly over shorter time periods.
So that is the third source of stock returns: Market valuation. As an investor, you have no control over the market’s raising and lowering of the stock’s P/E ratio. You just have to accept it.
And also note that if you tried to trade in and out of JNJ, it would be all but impossible to time your trades correctly. The price line simply zig-zags too much. If you are truly a dividend-growth investor, my advice is simple: Don’t do that.
4. Dividends
Dividends are cash sent to you by the company. (See DGI Lesson 1: What Is a Dividend?)
Dividends are added to price returns as part of the return equation. Your return from a stock in a given period = price change + dividends.
So while dividends do not represent growth in the company, they certainly represent growth to you as an investor in the company.
Over time, in the whole market (as measured by the S&P 500), dividends contribute about 30-40% of the stock market’s return, although that varies by year and by era.
[Source]
Dividends are the fourth layer of shareholder returns. You have no control over dividends. Dividends are declared by the companies themselves.
5. Reinvestment of dividends
The chart just above does not account for the reinvestment of dividends. The 30-40% contribution of dividends to investor returns only accounts for receiving the dividends.
Note that the chart is labeled “total return.” That’s only half-correct. What the chart depicts are price returns + dividends if you do nothing with the dividends. The label is misleading. (I encourage you to always check what a “total return” chart is actually displaying. There is no consistency.)
You own an investing business. Your business has revenue coming into it in the form of dividends. What you do with them has a great impact on your total investor returns.
If you reinvest dividends, that triggers compounding. Compounding means making money on money already made. The dividends are money already made. If you reinvest them, you position them to make still more money.
Reinvesting dividends is central to the difference between stock returns and investor returns for the dividend growth investor.
Here is a simple generic example of a dividend being reinvested. The dividend is 3.5% yield growing at 6% per year. On the chart below, the blue line shows the growth in the annual dividend if it is not reinvested, while the orange line shows the effect of reinvestment back into the same stock. The chart assumes an initial investment of $10,000.
The blue line illustrates simple 6% per year growth. The orange line shows what happens if you leverage that 6% annual growth by reinvesting those dividends. As you can see, the impact of dividend reinvestment is enormous, especially after the first decade or so.
Here’s the same example in table form. It shows the Yield on Investment (usually called Yield on Cost) of the blue and orange lines. YOI = the current yield calculated as a fraction of the original cost of the investment.
I call the impact of reinvesting dividends the “Multiplier Effect.” It grows every year. If you reinvest your dividends regularly, they grow faster and faster compared to not reinvesting. That is why the orange line of dividends received curves up so much more dramatically than the blue line.
Not only that, the reinvestments buy more shares too. Therefore, the investor gets the benefit of price returns from the “extra” shares as well as the rising dividends from those shares on top of the shares originally purchased.
Just focusing on the dividends alone, the multiplier effect after 10 years is 1.34. That means that the investor will get 34% more dividends in Year 10 than he or she would have received if they hadn’t invested dividends along the way.
The Multiplier Effect does not show up in any chart of the stock itself, unless you find a “total return” chart that includes dividend reinvestment. (Remember that the “total return” chart shown earlier did not include dividend reinvestment. You have to be careful interpreting chart labels.)
The multiplier effect of reinvesting dividends – which is the fifth layer of investor returns – is not the result of anything done by the company. It is the result of decisions made by the investor to reinvest those dividends.
Summary of Layers of Investor Returns
The discussion above explains several ways that investor returns differ from the company and market performance, with emphasis on how your behaviors and decisions affect your returns.
The total return of your investment business is determined by all the layers of returns, not just by what the companies and markets do.
Total Shareholder Returns
That gets us to total returns experienced by the investor, which result from the combined impact of all the elements just described:
• Investor’s behavior
• Company earnings growth
• Valuation
• Dividends
• Dividend reinvestment
Let’s use Johnson & Johnson again as an illustration. Despite its decade-long dead-money period, JNJ delivered positive investor returns during that time because of its dividends, which grew every year throughout that decade.
Not only that, if the investor reinvested the dividends back into JNJ, he or she received more shares, which generated more dividends, in a virtuous circle of rising share counts and dividends.
Those extra shares eventually benefited from the price runups that finally happened when JNJ shook off its market slump at the end of the dead-money decade.
These graphs illustrate the total returns that an investor would have received from JNJ with and without reinvesting dividends over the past 20 years, starting with an initial investment of $10,000.
[Source]
Note that the $10,000 initial investment bought 205.13 shares of JNJ 20 years ago. Without dividend reinvestment, that’s how many shares the investor would still own today. But with dividend reinvestment, the investor’s stash would have risen to 337.83 shares today – 65% more shares.
Since dividends are paid per share, that represents a 65% increase in annual dividends, without the investor having done a thing other than (1) hold on, and (2) plow the dividends back into JNJ.
Plus, those new shares rose in price. Subtracting out the initial $10,000 investment, the JNJ investor who bought, held, and reinvested dividends would have made 38% more profit than the investor who did not reinvest dividends.
Let’s go over the layers of shareholder returns and see how they relate to JNJ’s performance over the past 20 years.
Key Takeaways from This Lesson
1. Investor returns differ from the market returns of the assets invested in.
2. The differences result from investor behavior. There are five layers of investor returns, and investors are in complete control of two of them. The decisions you make in these two layers can have an enormous impact on your returns.
3. One layer that investors control is their frequency of trading. Many investors trade too much, and they often hurt their own results by doing so. Through over-trading, they shoot themselves in the foot from fear, greed, or trying to outwit the market.
4. The other layer that investors control is whether they reinvest their dividends. While some investors need their dividends to live on, and therefore can’t reinvest them, dividend growth investors can significantly multiply their returns by reinvesting dividends.
— Dave Van Knapp
Click here for Lesson 20: My ‘Quality Snapshot’ Grading System
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