If you owned stocks during the final months of 2018, looking at your portfolio and investment account statements was almost certainly an exercise in pain management. Essentially, we all took ugly haircuts. Then came 2019, and for reasons that were no better than the ones that drove prices down, shares recovered for the best January since 1987 (incidentally, another year investors don't recall with fondness).
Now, if you know anyone who is actually living off their portfolio at this point -- or maybe that describes you -- you know that sharp drops like these can lead to panic selling, and a retrenchment away from those risky, volatile, I'm-too-old-for-this-market equities. Respectfully, allow us to say that's the wrong lesson to learn. In the Feb. 5 Motley Fool Answers podcast, hosts Robert Brokamp and Alison Southwick will lay out five simple reasons why everyone -- from those at the start of their careers to retirees -- should have a major slice of their portfolio in stocks. Long story short: It's the best way to earn bigger returns, and you're going to need them.
But first, in the "What's Up, Alison?" segment, Southwick enrolls us all in the Elizabeth Holmes & Billy McFarland School for Deceptive Leadership, where she will impart five lessons on the art of committing massive frauds, based on the stories of the Theranos founder and the Fyre Festival entrepreneur.
A full transcript follows the video.
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This video was recorded on Feb. 5, 2019.
Alison Southwick: This is Motley Fool Answers! I'm Alison Southwick and I'm joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool.
Robert Brokamp: Hello, everybody!
Southwick: In this week's episode, we're going to talk about why you should always own stocks -- even in retirement -- and I'm taking you to school. Fraud school! All that and more on this week's episode of Motley Fool Answers.
Brokamp: [laughs] So what's up, Alison?
Southwick: [laughs] Let's see how long I can just stare at you until you remember that was the one thing you need to say for the next six minutes. Well, Bro, I have been surrounded by fraud lately. Both Netflix and Hulu have released documentaries about the Fyre Festival. There's a new podcast out called The Dropout. It's all about Elizabeth Holmes and Theranos, so I've got fraud on my mind.
It occurred to me that while both of these frauds are different, they're also very similar and there are some lessons to be learned so that you, at home, can commit your very own fraud! Or identify fraud when you're faced with it at work or life. Today I'm going to offer five lessons for committing fraud from the Elizabeth Holmes & Billy McFarland School for Deceptive Leadership.
Brokamp: How exciting!
Southwick: I know! As I talked about Theranos and Elizabeth Holmes in an earlier episode, you probably already know the gist, but basically Elizabeth Holmes lied about inventing a device that could test for many medical conditions using just a pinprick of blood. She took in millions -- hundreds of millions -- from VC investors and lied for over a decade that the technology existed when, in fact, it did not.
And then here's the background on the Fyre Festival. Bro, you don't know anything about it? Not really?
Brokamp: Ever, ever so little.
Southwick: OK, sit back. It's fun. So Ja Rule -- yes, Ja Rule, the rapper -- and a random guy from New Jersey named Billy McFarland were buddies. McFarland was a budding entrepreneur. He created a couple of companies, but his most recent company I guess you could describe as an Uber for booking celebrities. If you want to have Ariana Grande (but probably not someone as big as her) at your bat mitzvah, you go onto this app and you're like, "Here's who I want at my party."
Brokamp: Is it the same one that allows you to have Lou Ferrigno call you up on your birthday to say, "Happy birthday?"
Southwick: I didn't know that was a thing!
Brokamp: It was this whole service where you could hire people who maybe are past their prime in terms of their careers to call up someone that you love and say, "Happy birthday" to you.
Southwick: Did someone do that for you?
Brokamp: No, but I sent it to someone. Someone who's a Lou Ferrigno fan.
Southwick: OK! So like that but not Lou Ferrigno. I mean, maybe you could book him through this app. I don't know. So anyway, McFarland and Ja Rule got to talking while they were on a trip to the Bahamas and they decided that they wanted to throw the most millennial, luxury music festival ever on a private island formerly belonging to Pablo Escobar. We all watch Narcos, right?
Yes, I want to party like Escobar where we feed snitches to hippos -- no! -- but there will be tons of supermodels; at least, that's what attendees were promised. A bunch of supermodels I've never heard of were paid to be part of a coordinated ad campaign on Instagram. To post pictures of themselves and yap about how amazeballs the Fyre Festival was going to be.
The promotional video for the Fyre Festival showed footage of private planes and again, more models. Blue water. Yachts. It was described as, "an immersive music festival ... two transformative weekends ... on the boundaries of the impossible." The boundaries of the impossible! Foreshadowing!
The Fyre Festival was to take place just four months later in April. Tickets to attend were priced between $1,200 and $25,000, although you could easily spend over $100,000 on some of the VP add-ons like yachts and, I don't know. Whatever the kids like these days.
But what people got was far less luxurious and more like a postapocalyptic struggle for survival. It was mass chaos. Instead of luxury, eco-friendly domes and villas, people were put up in FEMA tents -- literally FEMA tents -- that were soaking wet because there had been a ton of rainfall. You got a FEMA tent and a wet mattress.
They ate cold American cheese sandwiches. There was very little water. All of the music acts had bailed and it didn't even end up being on the private Pablo Escobar island. The location ended up being just a rocky construction site on Exuma with a few port-o-pots. And there were no models -- just hundreds of really upset people.
Let's get into some leadership lessons for the fraudulently inclined.
Leadership Lesson No. 1: Tell a good story that people want to believe. And as someone in PR, I can tell you that this is a good idea whether you want to commit fraud or not. Just have your story straight, and have a good story, and people will follow you far and wide, and throw money at you, as you will learn.
But let's look at the story that Theranos created first; a Steve Jobs-esque wunderkind who's easy on the eyes and has found a way to conveniently diagnose people using minimal blood. It's going to change the world and save lives. As John Carreyrou highlighted in his book, "There was a yearning to see a female entrepreneur break out and succeed on the scale that all these men have: Mark Zuckerberg, Larry Page and Sergey Brin, Steve Jobs, and Bill Gates before them. As a young, conventionally attractive woman, Holmes was also able to charm many of the older men who eventually backed her."
And what was the story that the Fyre Festival created? You, too, can party like a celebrity with supermodels. Now, granted, the first story has a little bit more altruism to it than paying for the possibility of doing shots with someone called Bella Hadid on Pablo Escobar's private island, but still a good story. People believed because they wanted to believe, and when you really want to believe you are less likely to listen to reason.
Leadership Lesson No. 2: When faced with a boatload of money, don't let something like a lack of experience get in the way. Yes, fake it till you make it. Yes, nothing ventured, nothing gained. Yes, man who said it can't be done shouldn't interrupt man who's doing, etc. But there is something to be said for knowing things.
Elizabeth Holmes dropped out of Stanford at 19 just before her sophomore year at college. In The Dropout podcast, a professor describes the "plucky" Holmes coming into her office and pitching her the idea for the Edison, and the professor explained to her why it wouldn't work. No matter.
McFarland and Ja Rule had no experience running a music festival. Not only that, they thought they could pull it off in just a few months of planning and it's something that normally takes at least a year. The inexperience also extended to their pilot that we meet in the Netflix doc, Keith. Keith taught himself how to fly a plane using [the video game] Microsoft Flight Simulator.
Brokamp: Oh, my goodness gracious!
Southwick: Remember Keith. He's going to come up later.
Brokamp: All right.
Southwick: Nothing buys bad decisions time to really play out like good, old-fashioned heaps of money. In 2016 and 2017 McFarland raised approximately $7.9 million from at least 43 investors in Fyre Media offerings (that's his app company) and approximately $16.5 million from at least 59 investors into the Fyre Festival offerings. And, of course, Elizabeth Holmes raised upwards of $700 million for Theranos, which allowed her to keep the lights on for over a decade.
Leadership Lesson No. 3: Inspire a small, tight crew of people. A fawning pre-fall of Theranos in an Inc. article is titled 21 Surprising Facts About Elizabeth Holmes. No. 21 is that Holmes is notoriously secretive and while she's been criticized by industry peers as such, she insists she must protect her technology from the prying eyes of competitors. Yes, protect that nonexistent technology.
Holmes and her secret boyfriend/COO, Sunny Balwani, were all about secrets; not just about the relationship but also the truth about Theranos. Holmes arranged the company so that everyone was purposely siloed. Employees weren't even allowed to communicate with each other about what they were working on.
Brokamp: It's a cult!
Southwick: But they were inspired to change the world. It was like a cult!
Brokamp: Like a cult!
Southwick: Paul Saffo was quoted as saying, "There's one cardinal rule in Silicon Valley that most people never realize, and that is never breathe your own exhaust. This is someone who is so deeply self-deluded by her own optimism and faith in herself," he said, "and delusion is contagious."
Early on in the planning stages for the Fyre Festival, the team decided they needed more time and $50 million to pull it off, so they wanted to push it back a whole year. But as reported in New York Magazine, "A guy from the marketing team said, 'Let's just do it and be legends, man.'" So people working to make the Fyre Festival happen against all odds talked time and time again about how they believe in McFarland and they wanted to please him. He was infectious with his enthusiasm, but he was lying constantly to everyone, all the time, and he needed everyone who was in on it to lie, too.
McFarland had employees put charges for the festival on their personal credit cards.
When water for the festival was held up in customs, he asked an employee to basically seduce (the nice way of putting it), the customs official to get the water through customs.
Like "If you want to make this happen, you've got to do this." And the guy was going to do it. He says in the documentary he went down to the customs official's office and he was ready to do what he needed to do to save the Fyre Festival. Luckily it did not come to that.
Brokamp: That's good.
Southwick: To special hugs.
Leadership Lesson No. 4: If you can't inspire them, bully them into submission. In Theranos, if you weren't on board with perpetuating the lie about the Edison working well, you had lawyers sicced on you and more. Most of the bullying was done by Sunny Balwani; again, her COO and secret boyfriend. Their tactics actually drove their chief scientist to suicide.
It took more than a decade for someone (the someone specific was Tyler Schultz} to finally blow the whistle on Theranos after working there for seven months, and when he did (this is crazy), his own grandfather, former secretary of state George Schultz, who was an investor and on the board, didn't believe him. He didn't believe his grandson and essentially they stopped talking to each other.
Tyler Schultz was quoted as saying, "Fraud is not a trade secret." He hoped his grandfather would cut ties with Theranos once the company's practices became known. "I refused to allow bullying, intimidation, and threat of legal action to take away my First Amendment right to speak out against wrongdoing." This poor kid -- his parents had to shell out $400,000 in legal fees because of him coming out about Theranos. It's crazy.
The same with the Fyre Festival. If you weren't 100% on board, you were gone. Remember Microsoft Flight Simulator Keith? Keith tells everyone that the deserted island doesn't have the infrastructure to support thousands of people -- toilets, mosquitos, tents. These were all concerns. But they wouldn't hear it, and Keith was essentially forced out because of being such a Negative Nelly.
Over and over again, people who spoke up about how unfeasible the festival was were all ostracized, bullied, fired, or eventually got fed up and left. That's also a red flag, so for those of you who are studying how to notice fraud (not commit it): If you're seeing all the reasonable people leave, then you should probably follow their suit.
Leadership Lesson No. 5: Don't let something like basic human safety get in your way. The disregard for other people extended to employees, their investors, everyone. Yes, it's sad that a bunch of investors were misled, but what's really sad is that McFarland and Holmes had zero regard for the lives they were impacting. People were expecting the Edison to effectively diagnose serious medical conditions. A misdiagnosis could result in unnecessary treatment or no treatment.
And with the Fyre Festival -- not as bad as not getting diagnosed with cancer -- McFarland didn't care that there wasn't proper sanitation, or housing, or enough food. And it's a testament to the millennial generation that the scuffle for FEMA tents didn't become Altamont. Again, side note. Baby boomers -- you need to stop complaining about millennials and maybe ponder the mistakes of your youth. If you really want to commit a great fraud, you've got to check your conscience at the door and be willing to destroy lives.
One fun fact about McFarland. He lied to investors and the SEC about all his assets. He said he had $2.5 million in Facebook shares when he actually only had $1,500 in Facebook shares.
He claimed to own an $8 million island in the Bahamas. Here's one feel-good story, though. Local laborers and vendors for the Fyre Festival were never paid. That's not the feel-good part. One woman in the Netflix documentary brought in at the last minute to cater the festival sobbed on camera in the documentary because she lost her life savings. So someone created a GoFundMe site and the account has raised $260,000 for her.
Brokamp: That's good.
Southwick: Isn't that nice?
Southwick: So, hey! Where are Holmes and McFarland now?
Brokamp: Good question!
Southwick: Fyre Festival attendees were awarded $5 million in damages after suing McFarland, but I'm not sure how he's going to pay them since he was found guilty of wire fraud and will be in prison until 2023. Today Holmes is facing up to 20 years in prison and awaiting a criminal trial for charges of wire fraud and conspiracy to commit wire fraud, to which she has pleaded not guilty. So while McFarland and Holmes can give you some great advice on how to commit fraud, they can't tell you how to actually get away with it. Womp, womp. And that, Bro, is what's up. [...]
Brokamp: Last year was not a banner year to be an investor. The market actually started up OK in the beginning of the year, but somewhere around September, October, things started falling apart. The market dropped about 20%. Many stocks dropped even more.
This year it's been a little different, so as you may have seen in various headlines, we just concluded a January where the S&P 500 earned 7.9% and the headlines were, "Best January since 1987."
Which struck me as interesting because when you think of 1987, now, it's not known for its awesome January. It's actually known for a brutal October, including October 19th, when the S&P 500 dropped 20.5%. A 20% drop in one day is the worst one-day drop ever.
Whenever you see the type of volatility we saw at the end of last year, but also in years like 1987, people start to wonder [if they should] try to time the market. We get these questions all the time when we prepare for our Mailbag episodes.
With all that volatility and uncertainty, we also get questions from retirees about "How much should I have in the stock market?" Should they have anything in the stock market if they're living off their portfolio and it can drop 20-50%?
Longtime listeners already know the answer and that is no, you should not try to time the market and yes, you should always own stocks, even if you're retired, and I hope to convince you with five reasons why you should own stocks forever, even if you're retired.
Reason No. 1: We're living longer. According to the Social Security Administration, back in 1940, which is the early years of people getting Social Security, the average 65-year-old male would live another 12.7 years and the average 65-year-old female would live another 14.7 years. Nowadays, both of those numbers have moved up 20 to 22 years. We're living a long time, and that's the average. That means half the people live longer than that. You're talking about a one-in-four chance of making it to 90 and a one-in-ten chance of making it to 95.
There's two implications to that. First of all, our investment time horizons are getting longer, which means we have more time to ride out the down times in the stock market. We've talked about this before. The average bear market takes about three years to go down and go up again. Many have lasted longer than that. But if you're going to live possibly to your nineties, you have time to ride that out.
The second thing is the longer we live, the more we need stocks in our portfolio so that our portfolios last as long as we do. If you retire at 65 and you have nothing but cash and bonds, you increase the chances that you will run out of money, and we'll talk about that a little bit later. That's No. 1.
Reason No. 2: This is something we've talked about many times before, and that is, stocks win over the long term. Looking historically over the past, since 1926, according to Ibbotson Associates, over one-year holding periods, stocks make money about 73% of the time; so three in four years you're going to make money. Five-year-holding-periods stocks make money 85% of the time, 10 years 95% of the time, 20 years 100% of the time.
Many people often think of their time horizon as retirement. Like I'm 45, for example, and I retire at 65. I have a 20-year time horizon. But you only have that time horizon for a small portion of your portfolio. You have money you're going to need when you're 70. When you're 75. When you're 80. You're talking decades, and historically stocks have made money and outperformed cash and bonds over most of those periods.
Reason No. 3: Stocks beat inflation over the long term. Investing is all about giving up consumption today in order to have consumption in the future. You're not spending today so you can spend money in the future, usually for retirement. Unfortunately, chances are those future expenditures are going to cost more than they do today, so you've got to make sure that you're investing in something that overcomes inflation or that at least keeps up with it.
And when you look at shorter-term time horizons historically -- like five to even 10 years -- cash, stocks, and bonds actually have about the same success rate. About 75% of the time those investments will keep up with or beat inflation. But once you expand it to 20-30 years, stocks have 100% record of beating inflation. Bonds [have a record of] about 90%, so still good, but not perfect.
The important thing to remember, there, is the other name for bonds is "fixed income," and why is that? Because if you buy a 10-year bond -- say you put $1,000 in a 10-year bond, it pays you 3% every year. Over those 10 years you're going to get the amount of interest every year, and after 10 years you're going to get your $1,000 back not adjusted for inflation. So every year you're losing ground to a certain degree. To keep up with inflation, you've got to have stocks in your portfolio.
Reason No. 4: Stocks pay bigger dividends. Most of the time we think of the stock market as the price movements. Even when you hear the prices for the S&P 500 or the Dow, it's always the price. It does not reflect dividends, but historically, dividends have accounted for about 40% of the return for stocks, and it varies by decade.
According to PIMCO, which is a fund company, in the '90s dividends only accounted for 15% of the return. In the first decade of the 2000s, dividends accounted for 135% of the return. How is that possible? Because the first decade of this century was one of those 10-year holding periods where actually stocks lost money and dividends were able to offset that.
Dividends are much more consistent, so since 1960 there have only been seven years when the dividends paid by the companies in the S&P 500 were cut, and only one year was that significant, and that was actually during the Great Recession of a decade ago and the cut was like 20%.
So even though stocks go up and down in price all the time, dividends are pretty consistent. And not only are they consistent, but they outpace inflation. For an article a few years ago, I compared what it would be like to invest $100 in something that grows just at the rate of inflation vs. $100 in dividends.
Say it's 1960. You have $100. It grows just at the rate of inflation. By 2015 you had $800. Now what if, instead in 1960, you received $100 in dividends from the S&P 500? By 2015 you had $2,180.
So dividends, on average, beat inflation about 2% a year. That's great if you are saving for retirement because most of us are reinvesting the dividends, which means we buy more stocks, which then pay more dividends, which allows us to buy more stocks. Over a long time you could actually end up with two to three times the number of shares you started with just by reinvesting the dividends.
But it's also good for retirees, because that's great income. It's inflation-beating income, and if you hold it outside of a retirement account, qualified dividends are taxed at a lower rate than ordinary income like the stuff you would get from CDs, bonds, and things like that. So it's tax-advantaged, inflation-beating income, which is just perfect for retiring.
Reason No. 5: Stocks enhance portfolio longevity and withdrawal rates. We've talked before about the so-called 4% rule in retirement. It came first from a study in 1994 by a guy named Bill Bengen. It was validated four years later by the so-called Trinity Study, a study by three professors at Trinity University. The study validated that if you take out 4% of your portfolio in your first year of retirement and adjust it for inflation, in all historical periods that has lasted 30 years. That's where that comes from. It would have lasted through the Great Depression, through the crash of the Nifty Fifty in the '70s.
These days, one of the most well-known researchers in withdrawal rates is a guy named Wade Pfau, and he updated the Trinity Study a few years ago with more recent historical information, looking at the returns of stocks and bonds from 1926 to 2014. He looked at the success rate of different asset allocations for a 30-year retirement -- the success rate being after 30 years you still had some money.
If you look at a portfolio that is all bonds and no stocks, you only had a 42% success rate. In other words, if someone retired and just held bonds, in 58% of historical periods you would have run out of money. What if you add 25% stocks? Well, now your success rate jumps to 87%. It still failed 13%, but you improved. What about if you were 50% stocks, 50% bonds? That's the sweet spot. 100% success rate.
In case you're curious about 75% stocks? A 98% success rate, so still pretty darn good. What's the success rate of someone who retires and holds nothing but stocks? It's 93%, but no one wants to fail, so a 7% fail rate is still something to consider. But the evidence is clear that even retirees should have some stocks and could even stand an allocation up to 65-70% of stocks.
Now there's a lot of nuance to safe withdrawal rates, and we're actually going to have Wade as a guest in our show in a few weeks. He'll give us some other factors for determining the best withdrawal rate for you and how to invest in retirement, but it is clear that regardless of your risk tolerance and regardless of your situation, everyone should own some stocks for the rest of their lives.
The Foolish bottom line, here, is toward the beginning of this episode we discussed 1987 and that has the distinction of being the year with the worst one-day drop in stock market history. But here's the interesting thing. Despite that drop, stocks still made money that year, because it did so well in the first two-thirds of the year. Before that year, the S&P 500 earned 5.7% including dividends. Since then -- since the end of 1987 -- the S&P 500 has returned 1,970% including reinvested dividends, which would have turned $10,000 into $197,000 over that 32-year period.
So the evidence is clear. As long as the future looks vaguely like the past, buying and holding a well-diversified portfolio of stocks is a clear moneymaking proposition.
Southwick: So as an "awfulizer," what is your plan? Obviously it's a super-complicated question.
Brokamp: Here's the funny thing, and I think I've mentioned this before. I'm an "awfulizer," so I tend to be conservative with my advice, but with my own portfolio, I'm very aggressive. It would be very conceivable for me to go into retirement with an allocation of 75% stocks. I will definitely follow that rule of having the five-year income cushion, where I put anything I need -- absolutely need -- out of the stock market for the next five years. But then I can go full stocks after that.
Southwick: That's the show! It's edited fraudulently by Rick Engdahl.
Brokamp: That's what I was going to suggest!
Southwick: I think I've used fraudulently before, but it just makes sense. Our email is [email protected]. For Robert Brokamp, I'm Alison Southwick. Stay Foolish, everybody!