The Mathematics of Getting Rich By Investing in Stocks

The Reason Index Funds and Buy-And-Hold Stock Investors Do so Well

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One of the interesting things about investing is the oft-repeated truism: It only takes one great investment, held for a very long time, to change your family's destiny forever. Great fortunes aren't built from risking everything on a single stock that triples in a year.

They more frequently arise from decades of holding ownership in extremely profitable firms that generate ever-growing earnings. Some refer to this approach as business-like investing.

A Simple Math Example

Imagine it is March 13th, 1986. The typical new car retailed for around $10,000 that year. But instead of buying said car, you decide to purchase a block of shares in a new company called Microsoft. At the end of 2014, you'd be sitting on $5,526,749, of which $4,532,922 came in the form of Microsoft stock sitting in your bank vault and $993,827 came from cash dividend checks you've deposited over the years.

The interesting thing about the math is the power of a single good investment to overcome a lot of disasters. Go back to 1986, only this time, assume that you divided that $10,000 into 10 different investments of $1,000 each.

You somehow manage to construct the single worst, awful, statistically improbable portfolio humanly imaginable and nine of your 10 holdings immediately go bankrupt the day after you acquire them. Such a catastrophic thing has never happened in the stock market, but it has taken place in this alternate universe.

How would you have fared? Fantastically, believe it or not. At the end of 2014, you'd still be sitting on $552,675 or so, representing a compounding rate on the portfolio as a whole of somewhere around 14.8 percent. One superstar investment can do all of the heavy lifting.

Whether it's a beachfront property acquired in Malibu 50 years ago or shares of Coca-Cola bought in the 1960's, a well-constructed portfolio can tolerate incredible doses of failure while still generating satisfactory returns.

Avoiding wipeout risk is key. As long as you can hang on and survive recessions, depressions, and liquidity crunches, things have historically worked out nicely.

Long-Term Investing

The problem? Many academic studies on individual investor behavior have shown that most people wouldn't have held their Microsoft for those nearly three decades, nor would they have been likely to have added Microsoft in the first place as opposed to one of the other IPOs that year, all of which did far worse.

A doubling or tripling of their money and they'd have bailed. This explains why index funds are so useful. Although they miss the early growth, which mitigates returns drastically, the index fund tricks inexperienced investors into ignoring the underlying components. They don't see the specific businesses going bankrupt or skyrocketing to the moon. It's amalgamated into a single quotation of net asset value, by-passing the evolutionary quirk that causes a lot of folks to manage their money sub-optimally.

This mathematical reality underlies the reason most secret millionaires who are uncovered following their death tended to be buy-and-hold investors, rather than stock traders.

Few have owned index funds but they nearly all, to a person, behaved very much like index funds in the way they acquired and sat on ownership stakes. The difference leads to superior outcomes more often than not if the portfolio itself had even a modicum of conservatism.

Meanwhile, those who don't have it suffer. Warren Buffett is fond of pointing out that there have been four separate times over the past 50 years in which shares of Berkshire Hathaway collapsed by more than 50 percent.

Yet, over that same span, because underlying net income and book value were increasing, the shares climbed from $7 to $222,250 each. It was a bumpy road, with a lot of pain. Many owners, who didn't understand GAAP or the nature of equity investing, sold after seeing their brokerage account decline. It plays out as a tragedy and a tax on economic ignorance.

A Large Loss Scenario

What if someone wasn't lucky or skilled enough to spot a Microsoft? It's a fair point, which leads to more good news: Great businesses, especially boring ones, can carry a lot of the water.

There are three things you need to do:

Imagine that same day in 1986, instead of buying Microsoft, you decided to divide your portfolio into two piles. In one, worth $5,000, you pick up shares of five of the bluest blue chips in the United States; companies that everybody knew, that had strong balance sheets and income statements, that had long been part of the index, that were household names, and had been in business for generations, if not nearly a century, and that paid dividends.

You select a random list based on the darlings of the day: McDonald's Corporation, Johnson & Johnson, Hershey, Coca-Cola, and Clorox. You use the other half, also worth $5,000, to speculate on high-risk penny stocks you choose yourself that you think have huge payout potential.

You promptly lose that $5,000, meaning from day one, you are sitting on a terrible 50 percent loss of principal. Now, you're left with the so-called "grandma stocks" that look like the portfolio of a Mad Men-era window. How'd you fare? Did these boring, ordinary names that promise a complete lack of sex appeal, excitement, or nightly news stories let you down? Hardly! The chart below shows your total return on investment from 1986 to 2014.

  • Hershey: Your $1,000 grew to $24,525.92, of which $20,427.75 was stock and $4,098.17 was cash dividends
  • Coca-Cola: Your $1,000 grew to $25,562.42, of which $19,574.04 was stock and $5,988.38 was cash dividends
  • Clorox: Your $1,000 grew to $20,668.60, of which $16,088.36 was stock and $4,580.24 was cash dividends
  • Johnson & Johnson: Your $1,000 grew to $40,088.31, of which $31,521.17 was stock and $8,567.14 was cash dividends
  • McDonald's*: Your $1,000 grew to $16,092.36, of which $12,944.39 was stock and $3,147.97 was cash dividends
  • Total Value: Your $1,000 grew to $126,937.61, of which $100,555.71 was stock and $26,381.90 was cash dividends

Despite losing half of your portfolio at the outset, a failure rate that would make you one of the worst investors imaginable, you still watched your $10,000 blossom by 1,269 percent+. Your overall portfolio enjoyed a compound annual growth rate of 9.16 percent. Though what really happened was half your portfolio compounded by 11.8 percent, and the other half went bust.

Geometric math does some crazy things. You multiplied your money by large proportions, and did it without lifting a finger or ever again glancing at your portfolio, just as if you were an index fund, doing nothing for 29 years except letting the time value of money work for you.

Even better, this assumes you spent the $26,381.90 in cash that was mailed to you along the way. Had you reinvested the dividends, you'd have ended up much richer.

The McDonald's calculation assumes you did not take any Chipotle shares during the 2006 split-off. If you had, the returns would have been significantly higher and made it one of the best-performing stocks in the portfolio, returning many, many times the amount shown here as the burrito chain rapidly expanded across the United States.

The Takeaway Philosophy

What is the takeaway of all of this? Investing is simple and takes very few good decisions, properly structured, to make up for bad decisions. The key is to allow time to heal the wounds, be selective about what you buy, rarely sell anything, focus on real companies selling real products or services for real cash rather than pipe dreams that promise instant riches, and go about your life.

Historically, that recipe has produced more millionaires than almost any other behavioral pattern. Stock trading and market timing (attempting to predict whether stock prices will be higher or lower in the future) may make for some interesting diversions but they aren't where the real, sustainable money is made.