The Fundamentals of Financial Data

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This video was recorded on Jan. 22, 2022.

Ayal Cusner, Investing AI & Automation lead at The Motley Fool, joins CEO and co-founder Tom Gardner to talk about the data that can give you more peace of mind when the market goes sideways.

In this episode they discuss:

•  The math behind stock volatility.
•  The fundamentals of owning growth-oriented companies.
•  The potential long-term rewards of going on stock investing's wild ride.

Tom Gardner: They're reinvesting and there's a lot of debate about whether they're going to succeed or not. Their stock, like Netflix, is rising and falling dramatically. Netflix up more than 500 times since coming public, but its stock fell more than 70% five separate times. If you want those amazing returns, you've got to go on a wild ride.

Chris Hill: I'm Chris Hill and that was Motley Fool's CEO, Tom Gardner. This episode of Motley Fool Money is all about the math in your investing journey. But don't worry, you will not need a calculator. Ayal Cusner heads up our investing AI and automation team, and today he's joining Tom to talk about numbers, including why it's a benefit to understand the math behind diversification, what the historical data can teach us all about a stock market downturn, and a fundamental advantage that investors like you and me have over Wall Street firms.

Tom Gardner: It's only natural to think that an individual investor like you would have no hope whatsoever of outperforming professional investors. They work with teams of analysts. They manage billions of dollars and some of them wield automated trading platforms, powered by sophisticated algorithms with the capability and even legal clearance to actually step in front of your trades, buy before you, then sell those shares to you, taking a lick off your ice cream cone in the process. You can't win, no chance. Yet many individual investors systematically outperform the market decade after decade. It's just as Peter Lynch, the former head of Fidelity Magellan, who generated over 25% per year at that fund. It's just as Peter Lynch said would happen, that individuals have a genuine long-term advantage as investors. But in order to win consistently throughout our lives and to go well beyond just a lucky stock or two, we, as investors, need to understand the basic numbers of how to win. It's like a sport or a game, or a puzzle, or a problem set. There are some basic numbers that explain how that is won or lost, how you are correct or incorrect in your approach, and those numbers are actually relatively simple, more like fifth-grade math than Greek alpha numerics. That's where we find ourselves here in the third of our four classes designed to help you invest successfully forever the Motley Fool way. We are guided by our visiting instructor, Ayal Cusner, the team lead of investment intelligence across all Fools the universe over. Ayal, thanks for being here today.

Ayal Cusner: Thank you for having me, Tom.

Tom Gardner: Let's talk about the first thing that I think many investors encounter that shocks them when they invest, and that is volatility. We may be accustomed to making the first purchase of an apartment, let's say, and we don't quote the price of our apartment with any frequency, we don't have any idea whether that apartment is worth more or less a year after we have made that purchase. But when we invest in the stock market, we're getting information every second, every minute, every day, every hour, as frequently as we want to know what it's worth now versus what it was worth yesterday at this time, we can find that out. Let's start with the basic data around volatility and how to understand that as investors.

Ayal Cusner: Let's do it. Before I get into the numbers, I should probably mention that learning about volatility for me when I first started about investing was a big eye opener, because I came from engineering and I thought that the world works very much like a formula where you put something in and you get something out. If something fails, maybe that's a problem, but we shouldn't expect that to happen. When I came over to learn about investing, I had some hard realities to take in because I was looking for equations for everything like we have in engineering, and what I learned is that in many cases, investing is like a coin toss, and in every case, if you can be right say two-thirds of the time, 75% of the time, you're Warren Buffett. That was a big shock to me and it required me to recalibrate, and so I'm hoping that after we go through the data, everyone who's interested in having that experience can walk away feeling similarly. Volatility is part and parcel for investing. There's a source of the volatility that we have to come to terms with. I'll ask you a question, Tom, do you know where the source of volatility comes from? Why are stocks risky?

Tom Gardner: Human emotion.

Ayal Cusner: That is exactly correct. Human emotion, the processing of information, uncertainty, and specifically when it comes to stocks as an asset class, it's uncertainty about the unique characteristics that make stocks different from any other asset class and that is growth. Volatility really does come from hopes of growth and the risk of achieving that growth. The reason why that's important is because if you understand that volatility goes hand-in-hand with growth, you'll understand why we need to lean into volatility in order to get the returns that we're all searching for in this problem. With that, let's go ahead and jump in and start setting some bounds right off the bat. Volatility is something that a typical stock will demonstrate at a level of about 30-40% per year.

When we're talking about volatility at 30%, for example, what that means is that a stock has a decent chance of being up either 30% or down 30% over the course of a year. If we want to know how likely those outcomes are, we can think of a typical bell curve or normal distribution and what that would tell us is a stock with a volatility of 30% would see those performance outcomes about two-thirds of the time. If you're holding for a year this year, holding for another year next year, another year next year, it's probably safe to think that about two of those three years, you're going to see swings in your portfolio that hit those 30% up or 30% down bands for a stock that's got a 30% volatility. There's some interesting math about how that happens. It doesn't quite increase at the rate that the time goes on for, so if you wait one year and see 20%, you won't necessarily see 100% volatility to your portfolio on a five-year basis. But you should expect that volatility to increase as you hold longer because you're just allowing for more time for stocks to move up and down and get further away from wherever they started in your portfolio.

Tom Gardner: So if I put $10,000 into an S&P 500 index fund for five years, I shouldn't be surprised if at some point during that five-year period I'm down 25%?

Ayal Cusner: You should expect to be down 25% at some point. Actually, if we take a look at the performance of the S&P 500 over the last 30 years, and we look at every year's performance over the last 32 years is what I'm staring at here, we can see that on average, the S&P has returned 12% per year, which is actually a little better than the long-term history of the market, and we know that the market has done very well for us over the last few decades. If we look at the maximum drawdown in that year, which is how far the S&P fell from its highest point in every year down to its lowest point, you see that on average, that drawdown is about 14% per year. We can expect in a given year, what we've experienced over the past year is about 12% return per year with that pain that you feel when you go from being at the top of the world to being at the bottom, about 14%. Putting that all together, if you like the feeling of making about 8, 10, 12% return on your investment each year, you've got to get used to that feeling of losing about 14% at some point over that year, and that's the average number. You should really embrace yourself for big drops at some point in time, it's part of playing the game.

Tom Gardner: That's a little bit of the rollercoaster ride that we all know, we all experience as investors. Any long-term investor knows this and newer investors need to understand this and thank you for that. Now let's take a second fact. We've talked about volatility. How about time? We've talked about within a year and we talked a little bit about five years, but stretch it out and explain to us what happens when we think as investors over a one-day period, a one-year period, a five-year, one decade, two decades, what happens to volatility and performance as we look at it over different periods of time?

Ayal Cusner: As we mentioned, volatility and performance go hand-in-hand. They're almost two sides of the same coin. When we think about the time that we hold stocks and what that means for the volatility we're going to experience and the opportunities that we're going to benefit from, what we see is the more time you are willing to take, the more volatility you will experience. But the more likelihood that you'll actually make money over that time period. Conversely, if you want to spend less time in the market, you will experience less volatility to your portfolio because in the game less, you're not staked, but at the same time, you stand to make a lot less money. To put some numbers around that, your odds of making money, if you hold the S&P 500 for a day, 57%. Fifty-seven percent of all days were positive days, going all the way back to 1928. That's like a coin flip. We want to do much better than 57% outperformance in our portfolio or positive gains in our portfolio over the long term. If we are willing to hold 20 years, that number goes to 96% historically. You basically go from a coin flip to making money, to essentially guarantee. Trade-off is you have to be willing to pull the market for a longer period of time, which means you have to take risk and you have to experience volatility.

Tom Gardner: Let's leave in a second variable, or a third variable. We've got length of time and then we've got plus or minus, make money or lose money over a day all the way forward to 20 years. Now, let's talk about the size of the gains available to you within a day versus a 20-year or a 10-year or a five-year return. This is the most beautiful thing about investing, really. It's not simply that your odds move from random to near guarantee, it's that the size of the returns move from infinitesimally small and meaningless to transformative.

Ayal Cusner: Exactly, Tom. If you're willing to hold longer and experience more volatility, not only will you increase your odds of making money, which might be important to some investors who aren't comfortable taking as much risk, but you also earn more gains over that time. If you're willing to hold longer, you could double your portfolio in five years. There's no way you will be able to double your portfolio in five days, let's say.

Tom Gardner: You even factor in taxes and you start to see the impossibility of winning over the short-term versus the high-probability efficiency and also the reduction of anxiety, which we'll be talking about in next week's class with Morgan Housel, author of The Psychology of Money. How do we relax our mind in our central nervous system? It's not going to happen when we compress and force all of our attention into the here and now and the high hopes for low volatility and high returns in the short term, it just doesn't happen. Let's talk about allocation, Ayal, and the different types of stocks. Now we know how to assess volatility. We've got a good basic number there and we've got, the time horizon matters. I have a much greater chance of making money the longer I hold and a much greater chance of making significantly more money if I hold. Now, how about the difference in the types of stocks that we put into a portfolio?

Ayal Cusner: That really is starting to get to the key of becoming a great investor. Is understanding that stocks are different, they're different in idiosyncratic ways, that's a big word for meaning ways that are just specific to them. Every company has got a different CEO, every company is trying to do different things, every company has got a different set of almost personal circumstances. But then there are a lot of common factors between stocks that are common sources of risk. The better you get at identifying those common sources of risks, the better you'll get at removing them from your portfolio with proper diversification. That's really where you start to see the benefits because one of the only free lunches we get in investing is the opportunity to reduce the risk of our investments by diversifying our bets. When we say it's a free lunch, what we're actually saying is the market is expecting us to take advantage of it. The way that the stocks are priced in the market are based on an expectation that all market participants have that those who go out to build portfolios off of those stocks are going to do it in a way that efficiently reduces risk. The sources of those risks are many, and they start from very common source of risks. There's a risk that every stock shares, and it's the risk of being a stock and being subject to the exposure to the economy. It's very hard to diversify that risk. The way we diversify that risk is by putting cash in our portfolio. That's generally how we do it. But then there were other risks that we want to make sure we do a good job of accounting for. We do that by having proper portfolio allocation. We can look at a lot of risks that are linked to industry effects or certain investing styles that might be popular in certain areas, less popular at other areas, what we try to do there is build the best portfolio that balances those risks to our liking so that when one part of our portfolio zigs, another part might zag in just the right way. We don't have to think too much about it. All we really have to do is understand that companies are fundamentally different and they are exposed to different opportunities and different risks. We want to make sure that we span our portfolio with all those risks because, by taking lots of risk, by doing it in a diversified way, the total portfolio is going to come together and give us a great risk-return profile.

Tom Gardner: We're going to close this class with a conversation about the Motley Fool way. What we've learned from the data of our investment performance going back a decade, two decades more. Company has been in existence for almost 30 years and we've been investing throughout and learning from our members, meeting management teams, learning from our mistakes. We've gathered that information into a methodology that we share with our members and that really forms around a couple of key factors like the number of stocks to achieve diversification, the length of time that we think that these should be held in order to put the odds of making money and compounding that money to significant amounts. How long do you have to hold it for? How many do you have to hold? What might the journey look like along the way? What will the highs and lows look like? So, put it all together for us in a Motley Fool plan, if you will, about how to think about what is a diversified portfolio, what is the right time horizon, and how high will the highs and how low will the lows be along the way?

Ayal Cusner: When we look at the stocks that we'd like to recommend at the Motley Fool, we see a couple of unique characteristics. We see that they tend to be much more focused on achieving growth and we love that because that tells us that they're really shooting for capturing as much market share as they can. It lets us know that they're capable and encouraged to go out there and become the biggest companies that they can be. What that means for us though, is that we also have to expect that they're going to come with high volatility. What that means for the portfolios that we would want to build with the stocks that we tend to favor, that diversification is more important than what we would be recommending for an average stock portfolio. I would even go so far as to say if you were just going to buy one stock, you probably shouldn't buy a stock that we like. You should buy a nice stable stock that already looks like a portfolio. It's probably got a portfolio of products, it might be a utility company and that's what [...].

Tom Gardner: Berkshire Hathaway B.

Ayal Cusner: Perfect. There you go.

Tom Gardner: You've got candy, you've got insurance, you got railroads, you got Apple. You've a lot of Apple. You've got a portfolio in that one company.

Ayal Cusner: Exactly. But the trick here is if you are willing to diversify, if you're willing to buy more stocks, then that allows you the opportunity to go buy riskier stocks. Find the riskier stocks that have great businesses, great growth potential but that the market is still trying to figure out what may become of them. Many other investors might be reluctant to invest in those stocks. If you're willing to diversify and hold for the long term, that is going to be the surest path to success that you can rely on. Of course, you're going to have volatility in that scenario. I cannot recommend anything. I wish I could. I wish I could offer some solution that would deliver great performance without volatility. What I would offer instead is if you're comfortable taking the volatility, the gains over the long term should definitely be more than worth it.

Tom Gardner: So when we look at the data going back almost 20 years across our membership services, what we find is that a member who had purchased 25 stocks or more and held them for five years had a 98% likelihood of profitable results. That moved that one-day near-coin flip to a five-year very high likelihood of a positive return, but it required 25 different investments and many of those investments, the Motley Fool way are growth-oriented, reinvesting their business, they have an R&D line that's filled up on the income statement because they are trying to find the new solutions of the future and to win large market opportunities, so they're reinvesting and there's a lot of debate about whether they're going to succeed or not. So their stock, like Netflix, is rising and falling dramatically. Netflix up more than 500 times since coming public, but its stock fell more than 70% five separate times. If you want those amazing returns, you've got to go on a wild ride with the stock price while that business is performing, carving out a new market that didn't exist before. So 25 stocks, five-plus years, and a volatility that we shouldn't be surprised if the portfolio is down 15 or 20% in any given year en route to stretching that time horizon out and putting the odds in our favor of a profitable return. What would you change about that, if anything?

Ayal Cusner: Honestly, I think those are pretty good rules to abide by as you're building a portfolio. Every unique situation might be a little different, 25 stocks might be more than enough diversification for one type of portfolio, but not for another. What I would encourage everybody to do in that situation is to think about the constituent companies in your portfolio and ask yourself, do you think they're really competing for something unique? If you could see them at some point being a market leader, because if you fill a portfolio with a bunch of companies that individually are very risky, but also individually could become market leaders in their own respects, you are going to make sure that you are building that diversified portfolio. I don't know if there's a data-driven process that can even capture how much diversification you're getting from taking that approach. The other thing that I would encourage everybody to focus on, if they're willing to take this approach of buying very volatile stocks, but making sure that they diversify them, making sure they are great quality companies, first and foremost, that come with high volatility because of a lot of uncertainty about what their futures might be. The reason that I would recommend doing that is because if you're willing to do that, play a diversified, long game focused on individual companies, as opposed to a short-term trading-based strategy focused on stock price movements, what you will be able to do is rely on lots of data about the fundamentals of companies looking at their cash flows, their profits, and their real fundamental operating risks, instead of having to focus on the volatility of the stocks. What you'll get out of that is a portfolio of stocks that are very volatile, but whose businesses are rock solid, especially when you diversify across all of them. It's amazing what you see when you roll up the cash flows of companies and you look at how smooth those are in a diversified portfolio when you pick stocks that we like compared to the volatility of those stocks. That makes me feel really comfortable continuing holding those stocks and investing in that philosophy off into the future, because I feel like I can rely less on the stock price chart that's full of squiggles, a lot more on the fundamental analysis that we do here at The Motley Fool to identify great companies that are going to live on.

Tom Gardner: Ayal, Thank you so much for classroom No. 3, discussion of the underlying numbers, the data that can guide us how to win the game, a very consequential game, the game of investing, in our pursuit of financial independence in our lives. I guess what I'd close with is a reflection on how hard it can be for somebody who starts as an investor and gets hit with that volatility without the expectation or preparation. That's one of the fundamental things we want to do at the Motley Fool for everyone who is coming into the marketplace whether you've been at it actively trading or you've never bought a stock before to actually open all of our eyes to the benefits of long term investment. We heard today about the beauty of moving from a random result in the short term to a result with much higher probability over the long term and not just a higher probability, a much larger gain over the long term, particularly when you defer taxes over the long term and you actually reduce anxiety because you can start to follow as Ayal says, the business performance, the cash flows and those stock prices are flipping all over the place and that portfolio will move relatively wildly with a given year or three-year or five-year period. 

But when you stretch that out as a lifelong investor into rising companies that could someday become market leaders, and you diversify across them, and add capital along the way, you are moving the probabilities so far in your favor of becoming financially independent in your life and we've seen it since starting the Motley Fool in 1993. This all leads into our fourth class next Saturday with Morgan Housel, the author of The Psychology of Money, who's going to help us make sure that we've got our emotions in check. We can take advantage of these numbers and these philosophical principles of why we invest, how we invest, how to have a plan behind all of our decisions and then the numbers that can help us. Ayal Cusner, thank you so much for all the insights this week, we'll be back in the classroom next Saturday with Morgan Housel. Fool on!

Chris Hill: That's all for today, but coming up tomorrow, a conversation for any investor looking to dip their toes into the waters of Bitcoin and cryptocurrency. As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy yourself stocks based solely on what you see hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.