Will you have what you need when you need it?

Let's say I told you of a company whose stock posted the best 15-year return of any Fortune 500 company between 1965 and 1995, earning more than 18.5 times the return of the S&P 500. Had you invested $10,000 in this company at the beginning of that magnificent run, your stake would have risen to $1.8 million.

But I hope you would have sold that stock within the next few years — because today it's worth zilch.

This is the sad tale of electronics superstore Circuit City. The stock's amazing run earned it a spot in Jim Collins' blockbuster business book Good to Great, published in 2001. However, the greatness was not “built to last” (the name of another popular Collins book). In 2008, Circuit City declared bankruptcy.

A few months ago, Alan Wurtzel, Circuit City's CEO from 1972 to 1985, visited Motley Fool HQ to discuss his book, Good to Great to Gone, an obituary and autopsy on the company his father founded as a mom-and-pop appliance shop in Richmond, Va., in 1949. One of the biggest causes of its demise, according to Wurtzel: arrogance.

It's a cautionary tale for business owners, executives and investors alike. Past success can certainly be an indicator of extraordinary talent, skills and foresight, but it's not a reason to believe in a permanent Midas touch. For every incredibly multiplying stock like Google, Panera Bread and Amazon.com, there are plenty others like Enron, Polaroid and Eastman Kodak — stocks that created fabulous wealth as the underlying businesses innovated and led industries. But the companies couldn't keep up, or they were just outright frauds, and the people who invested in them — people who at one point probably thought they were exceptionally skilled — paid the price.

Think back to when you were a kid. Which retailers did you visit? If you're of my vintage (roughly mid-40s… but I am still tops in my zumba class), your parents dragged you to Sears, JCPenney, and Kmart. They're mere shadows of their once industry-dominating selves. Others, like KB Toys and Montgomery Ward, no longer exist.

And here's an interesting tidbit from the Circuit City saga: Take a guess which company considered buying Circuit City for $1 billion in 2008? Blockbuster Video. You don't see as many of those stores as you used to.

I don't mean to dance on the plummeting stock prices of these companies. Many people lost their jobs, and many investors lost a lot of money. But Circuit City's history has many lessons, starting with this: A “buy and hold” strategy doesn't mean “buy and ignore,” especially when it comes to individual stocks. Another lesson is the value of diversification and not betting your retirement on too few companies, or even too few types of companies.

The true meaning of risk

When it comes to your money, there are lots of ways to define risk. But it really comes down to one thing: Will you have the money you need when you need it?

If you absolutely, positively need a certain amount of money by a certain date, you can do it with not too much uncertainty. Just put it in cash and use a savings calculator to help you estimate how much you need to save each month to reach your goal. Of course, you won't earn much interest on that money — which means you'll have to save quite a lot — but you can be pretty sure it'll be there. For example, if you need $100,000 in 10 years (and assuming a 1 percent interest rate, though we hope that'll be somewhat higher in 10 years), then you need to save $800 a month.

What if you can't save that much each month? Then invest in something that might pay a higher return. If you could earn 8 percent a year on your money, then you'd need to save just $550 a month.

But now you've introduced risk into the equation, because you can't get a surefire 8 percent these days. To get that type of return, some people turn to the stock market. According to Ibbotson Associates, the best 10-year annualized return for the S&P 500 was 20.1 percent (1949-58) and the worst was -1.4 percent (1999-2008). Your $550 a month could have turned into $212,219 or $62,028 (much less than the $100,000 you needed). You have widened the range of possible outcomes.

But what if instead of investing a diversified portfolio of stocks, you invested in just one stock? Well, now you've really broadened the range of returns. Check out this Yahoo! Finance chart that shows the five-year performance of Apple (blue line), the S&P 500 (red line), and AIG (green line, which you can barely see).

That is quite a divergent range of outcomes! The S&P 500 almost looks flat by comparison, yet we know that it most certainly had its ups and downs; you can barely tell from this chart that it dropped 50 percent from April 2008 to March 2009. That's because, compared to Apple and AIG, the volatility of the S&P 500 looks like a stroll in the park.

Obviously, Apple was the stock to own… though it's down 40 percent since September. Also, while these days it seems so obvious that Apple would be worth so much, given all the iTunes songs we listen to on our iPhones, it wasn't always such a sure thing. On one day in September 2000, the stock dropped more than 50 percent.

My point: The more risk you take, the wider the range of future outcomes. As you go from cash to bonds to diversified stock funds to individual stocks, you increase the chances that you'll have more than you need or less than you need when you need it.

I'm not saying you shouldn't own individual stocks. I own many myself, as well as actively managed mutual funds and index funds. As a general rule, I don't think most people should have more than 5 percent of their net worth in one company; this would have been a good rule for a friend's mother, who had 90 percent of her portfolio in AIG. Many of my Motley Fool colleagues feel that having more than 5 percent in one stock can be smart since a more concentrated portfolio is the way to better returns. And for some investors, that can be the right strategy. But don't get too cocky, and always have some part of your portfolio that hedges the risk that your spectacularly performing stock becomes a spectacular failure before you need to turn it into cash.

So go ahead and invest in diversified stock mutual funds if that's right for you, and perhaps even buy some individual stocks. Who knows, you might invest in a young startup that produces a return six times better than the S&P 500's — as has CarMax has since its initial public offering. A funny thing about CarMax: Did you know that it was actually the brainchild of another company, which at one point owned 80 percent of its stock? And can you guess which company that was? Yep, Circuit City.

More about...Investing, Planning, Retirement

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TB at BlueCollarWorkman
TB at BlueCollarWorkman
7 years ago

5% — thank you! I’ve been looking for that number for awhile. I want to be “diverse” in my stocks but I don’t know how diverse I’m supposed to be. It’s nice to have a number, which I can tweak as time goes on depending on what I think and learn.

And I always keep a bunch in savings or just cash. Because that’s not going anywhere, it’s really important to have something that’s as safe as can be.

My Financial Independence Journey
My Financial Independence Journey
7 years ago

I invest in individual stocks rather than mutual funds. I make a point to diversify my portfolio across not only companies but also sectors. If all your money was in banks, you would be left without much money after 2008. But if your money was spread around, your portfolio would have been almost fine by now. I build diversification slowly as I get new capital to invest. And I am aiming to have only 3-4% of my portfolio in any given company and ideally 10% per S&P500 sector – although I’m not certain if utilities and telecom deserve that much.… Read more »

Anne
Anne
7 years ago

I don’t get “if all your money was in banks you would be left without much money in 2008”. Actually, wouldn’t the opposite have been true after the stock market melt down?

Johanna
Johanna
7 years ago
Reply to  Anne

I think “in banks” means invested in banking company stocks, not deposited in bank accounts.

Jane Savers @ The Money Puzzle
Jane Savers @ The Money Puzzle
7 years ago

I thought I was pretty safe investing in two different Canadian banks but they area both down this month. I will be holding on to them for another five or eight years and then everything will be in GICs (guaranteed investment certificates) for my retirement.

Ramblin\' Ma\'am
Ramblin\' Ma\'am
7 years ago

Right now my only investments are in a 401(k). I don’t have any individual stocks, just mutual funds.

Also, as a general comment, I always find Robert’s articles to be helpful and interesting.

Bill
Bill
7 years ago

Personally i’d invest in different portfolios, so, by the time am Retiring, i’d be much more safe and secure. It all goes down on how much you diversify your investments.

Jenny @ Frugal Guru Guide
Jenny @ Frugal Guru Guide
7 years ago

The funny thing is how long successful companies can coast before they crash. I’ve been baffled by Best Buy’s success for 10 years now. Who would go into such an overpriced store, with pushy and ignorant sales people, when they can buy the same thing for less and get good research online? But it’s only been the past 5 years or so that Best Buy has begun to flag.

Circuit City was the same way. For many years before its eventual demise, I could not figure out why people would want to go there anymore.

Johanna
Johanna
7 years ago

Mathematically, I don’t see the point of “investing” in individual stocks. As the article explains, stock index funds are riskier than savings accounts, and they have a better average return: You’re compensated for taking a greater risk by getting a greater expected reward. It’s not just the best possible outcome that’s better for index funds than for savings accounts; the middle-of-the-road outcome is also better. Individual stocks, on the other hand, are even riskier than stock index funds, but the average return is the same. (After all, the index fund’s return is just the average of all the stocks in… Read more »

Matt Becker
Matt Becker
7 years ago
Reply to  Johanna

This is a great comment! Diversification does not decrease your expected return. It keeps it exactly the same. It just decreases the range of possible returns. So by investing in individual stocks, you’re increasing the amount you could possibly earn, as well the amount you could possibly lose (an index fund could theoretically go to 0 I guess, but that’s not a realistic scenario). But you’re not increasing your EXPECTED return, which is really what you should be worrying about. Index funds give you the same expected return with less risk and less cost. Since you really can’t control the… Read more »

William Cowie
William Cowie
7 years ago

Warren Buffett is not that much of a fan of diversification, BUT he backs up his choices with an extraordinary amount of research.

His view: the lower returns diversification brings is the price you pay if you don’t have the time or inclination to put in that research. (He doesn’t say this to knock diversification, only to point out that higher returns are possible if you’re willing to put in some more time.)

El Nerdo
El Nerdo
7 years ago
Reply to  William Cowie

It’s not just time for research that he has, but access– I bet you he can call any CEO he wants at 3 in the morning, and said CEO will pick up the phone. That wouldn’t be the case with the rest of us. 🙁

For individual investors, Buffet recommends index funds:

http://www.cnbc.com/id/100518304

mike
mike
7 years ago

The #1 lesson is live well below your means and save as much as you can. People who save more will beat people who take on more risk with less savings 99%. Still need to keep money for the present to enjoy your wants. #2 is diversify into different asset classes at the right time. Everybody tells me you can’t time the market, its a bunch of malarkey. You can time it, it doesn’t have to perfect. You just have to capture a decent spread. Buying the dow at 9 or 10k and selling at 13-14k is much better than… Read more »

Simple Economist
Simple Economist
7 years ago

I see it a lot with individuals who work for a company and have stock options or something like there where they end up with lots of stock in one company. I try to hold even less in individual stocks but I still hold some that are small amounts and were given to me as gifts many years ago.

Ely
Ely
7 years ago

We have a little money in individual stocks, just play money really. We bought Starbucks, Marvel, a promising tech company and some green energy funds at the bottom of the market in 2008.

Two of those have turned out really well. One went bust. The others are struggling, but recently began paying dividends, indicating a bright if gradual future. It’s been an interesting experience.

My ‘real’ retirement money is in index funds. I don’t have the time or the smarts to play Warren Buffet’s game; I like the low cost and the range of risk available with index funds.

Alea
Alea
7 years ago

I seem to remember that a year or two prior to Circuit City going bust, they fired all their long term employees -the people who best knew their stores and products. They went ahead and hired minimum wage workers who were more clueless than their customers and surprise, surprise, Circuit City is no more. I have a general feeling that most companies believe their employees bring no value or contribution and a minium wage worker is the answer to higher profits. I feel this is the main reason that wages are stagnat, and we can’t seem to get ahead. The… Read more »

El Nerdo
El Nerdo
7 years ago
Reply to  Alea

Harold Meyerson wrote something very much along these lines in yesterday’s Washington Post, and zeroed-in on WalMart and JCPenney: For decades, U.S. corporations have been told to slim down. Not to abandon corporate jets or cut CEO pay, mind you, but to produce more with fewer employees. The conventional wisdom couldn’t have been clearer: The minimum number of required workers yields the maximum level of profits, all else being equal and the creek don’t rise. During these decades, however, the United States was also shifting to a service economy – a new reality that didn’t always comport with the doctrine… Read more »

Kingston
Kingston
7 years ago
Reply to  El Nerdo

And the New York Times recently reported this:

http://www.nytimes.com/2013/04/04/business/walmart-strains-to-keep-grocery-aisles-stocked.html?pagewanted=all

The problem seems to be that Walmart pays its workers so badly that the company is having difficulty finding people willing to work there. So shelves go unstocked and customers, frustrated, go elsewhere.

El Nerdo
El Nerdo
7 years ago
Reply to  Kingston

Yes, Meyerson refers to those findings in this op-ed. A couple of things to add: 1) I have a friend who lost her job in the recession, and with all avenues closed she went to work for WalMart. Yes, she had tumbled from the middle class into a minimum wage job, so she had to adjust her expectations, but the working conditions as she described them were draconian, suitable only for ex-convicts and the desperate. 2) After I read that Meyerson piece yesterday my wife and I commented how Trader Joe’s is always buzzing with workers. They are everywhere and… Read more »

partgypsy
partgypsy
7 years ago
Reply to  Alea

My sister has worked multiple jobs. She once worked at one of the big box home improvement stores. Among the problems they had, was one had to make quotas each month in sales; she would put in an order for a customer. An employee on a different shift would cancel out the order and re-enter it with their name as assistant to get the credit and nothing would be done about this. Irate customers would wander into her area asking for help for locating or getting items off shelves, so she would try to be helpful, while the workers who… Read more »

chino
chino
7 years ago

Why would I waste my precious time investing in stocks anyway? I don’t have time for stocks, I’m too busy working, saving money and living my life. I don’t have time to baby my investments. I know what my time horizon is (20+), what my risk tolerance is (70/30 stocks) and trust the whole market to do reasonably well. That’s good enough for me

Zach @ Dividend Ladder
Zach @ Dividend Ladder
7 years ago
Reply to  chino

Trusting the market is a risky bet. Putting a little sweat into your investments is one of the foundations of investing.

chino
chino
7 years ago

Actually, that’s wrong. Most managers and traders don’t do better than the S&P 500. There’s nothing blind here: I did the research and decided that finishing ahead of the majority of fund managers with minimal time and fees was good enough for me.

Edward
Edward
7 years ago
Reply to  chino

Amen, chino–you’re doing it right. It’s been proven over and over that the small time investor gets further by setting it and forgetting it rather than actively watching and trading. The vast majority of GRS readers (in my opinion) should simply be doing the preauthorized purchase dollar-cost-averaging of simple, lost cost index funds. …Even though it’s not glamorous or exciting to talk about. “If you invested in a very low cost index fund — where you don’t put the money in at one time, but average in over 10 years —you’ll do better than 90% of people who start investing… Read more »

Jake Erickson
Jake Erickson
7 years ago

This is great advice and well-written article. I thought the most interesting statistic was the highest (20.1%) and lowest (-1.4%) returns of the market over 10 year periods. Many people believe that you could lose everything by investing in the stock market (which is technically true), but even the worst 10 year period resulted in only a 1.4% loss. Now, this isn’t very good, but it definitely would not result in you losing all of your money.

KSR
KSR
7 years ago

Chino, I can appreciate your comment and have nothing to argue (anymore). But, wait, no! AAPL is a case in point and made me what– I can–kind of. I lived there, now–I choose to live in the world of the average givings of the S&P and dividend producers, because I’m lazy, old, and feel a tad out of touch. There’s tons of money to be made with the proper research and the supposition of time. TONS! Dividends, growth, or otherwise. I would despise any intelligent conversation for the go-getters out there…to not go get ‘em! So, yeah. You are right.… Read more »

El Nerdo
El Nerdo
7 years ago
Reply to  KSR

Some day I’d like to hear what you did and how.

KSR
KSR
7 years ago
Reply to  El Nerdo

Oh, I wrote a thorough comment all about it a while back. It was an interesting back and forth. I learned not to do that again– as it became apparent that few could get past the end calculation and my subsequent participation at a place like GRS. So, yeah. I can tell ya where to find it but I’d have to go look for it first.

Mr.Bonner@bonnersbillions
7 years ago

The 5% rule is interesting. That’s definitely something I’ll be taking with me as I look over my own portfolio.

Also, I must say I agree with the other comment above. I quite enjoy Brokamp’s articles. The tidbits about Blockbuster trying to buy Circuit City and Circuit City’s ties to CarMax are fascinating and interesting facts that really elevate the story. Nice job!

Tomasz Gorski
Tomasz Gorski
7 years ago

First of all I would like to thank you for raising such a vital question like ” Will you have what you need when you need it?” and answering it with such details. I second you without any hesitation about the 5% method and follow that sincerely when it comes to managing my own finance.

@debtblag
@debtblag
7 years ago

This is interesting. Thanks. Your graph makes me think I’d prefer to have as much of the market as I can — and the world market, if possible. Individual companies disappear and it’s tough to guess which ones at times, but if the productive capacity of the world disappeared, I’d be upset.

Robt
Robt
7 years ago

Absolutely, that’s the point. Investing is not a big deal as there are various options. But the point is, if the investments will offer returns when we actually need them. That’s why my uncle advices me to back my retirement savings with gold http://www.meritgold.com/ira

Tomasz Gorski
Tomasz Gorski
7 years ago

Thanks for approving my comment… will look forward to more such interesting posts from you.

Buy & Hold Blog
Buy & Hold Blog
7 years ago

“But Circuit City’s history has many lessons, starting with this: A “buy and hold” strategy doesn’t mean “buy and ignore,” especially when it comes to individual stocks. ” This is true for individual stocks. BUT, if you own high quality index funds that are diversified across different market slices such as large cap vs. small caps, domestic vs. international, growth vs. value etc., you probably can “buy and ignore” and let the market do its job during the long investment horizon. Since 1926, I believe S&P 500 has yielded 8% annual returns. So, why shouldn’t you buy, keep buying, keep… Read more »

Matthew D
Matthew D
7 years ago

I couldn’t agree more. There’s a great old book called ‘winning the losers game’. Check it out (it’s a books on tape too if you have an old cassette player). S&P500 and SPY are a smart way to go for most people. And it beats the vast majority of investment advisors (even without considering the 1 to 1.5% commissions which I have paid in the past believe me). For you android users checkout this recent S&P500 app https://play.google.com/store/apps/details?id=com.spytimer.spytimer which gives a nice present value evaluation of S&P500 based on historical trends. One quote in that old book I love is… Read more »

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