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.