Feb. 11, 2020
Stocks provide an ownership stake in a company. They provide access to company earnings based on its future performance. Companies can pay dividends to their stockholders to return profits to the owners, or they could reinvest profits into the firm to lay the foundation for better performance and even larger dividends to owners in the future.
The stock price can be driven up when investors anticipate stronger future performance than previously anticipated, and this can serve as a source of capital gains for stocks owners who sell shares. However, there are no contractual protections to receive either capital gains or dividends. In the ownership structure, stockholders are residual claimants, meaning that their rights to receive firm earnings or assets fall behind most other claimants like bond holders or lenders. Companies could underperform relative to expectations, and the stock price could decrease in anticipation of a reduced ability for the company to pay dividends in the future. The returns from a stock over a specified holding period are the dividend payments it makes plus any capital gains or capital losses. For owners having to sell shares after a price decline, stocks could underperform relative to bonds.
The value of a stock can be estimated as the present value of its anticipated future dividend payments. This relates to our bond pricing discussion, as bonds can be priced as the present value of their future cash flows. Except that, again, there are no promises supporting anticipated dividends. Projections of company performance can change over time, leading to fluctuations in stock prices. With this price volatility, funding retirement expenses by selling stocks can be risky as stock prices may be in decline at the time they need to be sold, requiring more shares to be sold to meet an expense.
Mutual funds and exchange-traded funds (ETFs) provide a simple way for household investors to diversify across a broad range of company stocks. These same investment vehicles exist for bonds as well. With stocks, these investment vehicles provide a collection of stocks that help to reduce the individual risks of companies by diversifying across a broader range of companies. By limiting exposure to individual companies, this also limits exposure to that company’s specific risks. If company specific risks are independent from one another, then this diversification leaves investors exposed to the overall systematic market risk for the collection of stock holdings, while diversifying away from the company-specific risks so that overall volatility is less.
Our analysis treats stock and bond investments in terms of overall index returns, which implies that the funds in question are index funds. Index funds are passively managed holdings of the components in a market index, and they are generally offered with lower expenses than mutual funds driven by active management decisions about which companies to hold. Actively managed funds attempt to outperform the overall market either by identifying and selecting mispriced securities or by forecasting broad market trends.
Actively managed funds may charge higher fees in part to pay investment managers and researchers to select securities they believe will outperform the overall market index. Whether such active management can provide increased returns net of the investment management fees and taxes, after accounting for the fund’s risk relative to the overall market, is a subject of continued debate. Generally, though, the conclusion of academic research is that there is no reason to believe than an actively managed fund will outperform an index fund when considered net of investment fees, taxes, and risk. Investment fees tend to be higher for active funds to compensate a larger team of individuals working to select stocks, and active funds tend to generate high taxes through their turnover of investments that passes capital gains to the fund owners on an ongoing basis even if shares are not sold.
In a market equilibrium, higher return investments must be viewed as riskier in terms of there being greater volatility in the returns. If higher returning investments were not viewed as riskier, demand would increase and the price would be pushed up immediately, reducing the potential returns for subsequent owners.
This is the basis for the efficient market theory, which says that stock prices incorporate all of the known information regarding market performance. New information about a stock is processed quickly through price adjustments. Good news, reflecting better future performance prospects, will lead those with the information to purchase the stock immediately, driving its price up, and vice versa. Current prices reflect the aggregate expectations of all market participants. An implication of this is that stock price movements should follow a random walk as new information, either good or bad, will arrive in a random and unpredictable manner. An implication of stock prices quickly incorporating information from all market participants into their prices is that it is not feasible to systematically beat the market through active decision-making. A lower cost passive strategy based on index funds capturing the broad-based returns for different asset classes can capture the overall market returns in the least costly and most tax efficient manner when market prices behave efficiently.
Passive strategies can be supported with less fees because they are not paying analysts, and the reduced turnover of holdings helps to manage transaction costs and creates greater tax efficiency by avoiding the realization of capital gains. Regarding taxes, index funds can be more efficient because they have less turnover for the assets held, which in turn can help reduce the creation of short-term capital gains that are taxed at income tax rates. At the very least, actively managed funds introduce another type of risk called tracking risk, which relates to how the returns might vary from the index returns over time. Because our analyses are based on assumptions for market indices, it is easier to think about our investments as index funds rather than actively managed funds.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.