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Dividend Mantra
Dividend Mantra
Articles (242) 

Equities: Unlimited Upside With Limited Downside

May 26, 2013 | About:

I'm a huge fan of investing in stocks, as you can probably tell by my almost 100% allocation to the asset class in my Freedom Fund. More specifically, I'm very enthusiastic about investing in ownership stakes with high quality companies that have a history of rewarding shareholders by paying out a portion of profits via dividends. Furthermore, I stick to an even narrower universe of these high quality companies that not only pay these dividends, but raise them on a regular basis (at least annually). I've discussed before why I'm such a huge fan of this strategy, known as dividend growth investing. But today I'm going to reveal one of the biggest reasons I'm so enamored with investing in stocks as an asset class, and this can be broadly applied to stocks that pay dividends or do not pay dividends.

With investing in stocks, one needs to consider that the potential upside is almost unlimited while the potential downside is limited to only your original capital investment. You can invest $1,000 with "Company X" and this equity stake can only do one of three things: it can appreciate in value, it can depreciate in value or the value can stay static.

Obviously the least desirable of these three outcomes is that the value depreciates. But this is the true beauty in investing in stocks. Your stock can only depreciate to $0, but nothing more. A stock cannot go below $0. Therefore your biggest downside is losing all of your capital. If "Company X" goes bankrupt and your entire equity stake becomes worthless (actually highly unlikely in reality) you lose all the capital you initially invested. In this case you lose $1,000.

But what if the company becomes wildly successful?

Let's say you hold your equity stake in "Company X" for 20 years and the company increases in value by a factor of 10. That means your $1,000 investment becomes $10,000. That's a capital gain of $9,000. And if "Company X" pays dividends your initial investment has a gain that is even larger than this (especially if you're reinvesting the dividends). You risked $1,000 and gained $9,000 in this case. Think it doesn't work like that? Doesn't happen in real life? Think again.

Let's take a look at a real-life example.

You could have invested $1,000 in Altria Group Inc. (NYSE:MO) (then known as Philip Morris) on 5/25/1983, which would have bought you 16.88 shares (closing price $59.25). That was 20 years ago. Those shares are now worth $15,023.80 on a split-adjusted basis (you now have 405.06 shares). That means you only put $1,000 on the line, but received over $14,000 for a gain of 6,390.83%. In this case the downside was 100%, but the upside turned out to be over 6,000%. (Source)

Obviously this is cherry picking a name from the past, but the point remains: your downside to investing in stocks is limited only to the capital you invested, while the upside is theoretically unlimited. Therefore, I feel the reward to investing in stocks far outweighs the potential risks. And this risk can be mitigated further by diversifying your capital into many different companies. I personally plan to have equity ownership stakes with at least 40 different companies by the time I'm done investing fresh capital and living off my dividend income.

This risk/reward relationship is one of many reasons I personally prefer stocks over every other asset class available.

For comparison sake, let's take a look at some of the other popular asset classes available:

With bonds, this upside/downside relationship does not exist in nearly the same manner. Your upside is limited by the coupon (yield) the bond gives you, as well as any potential capital appreciation that may exist by way of interest rate changes which could make your bonds more valuable if yields on new bonds fall (obviously unlikely looking forward as we are in a low interest rate environment). Bonds do not allow you to share in the growth of a company, however, so potential appreciation on your bonds is much less than stocks. The downside of bonds is a bit more limited than stocks, though, as bonds have a higher ranking in the capital structure of a business, meaning that if a business goes bankrupt bond holders are first in line to get reimbursed. However, the risk of capital depreciation is still there, and bonds are more sensitive to interest rates. Bonds have a tighter upside/downside spread in my opinion, meaning the downside and upside are both more limited than stocks. But I don't want limited upside. I want unlimited upside. Bonds, in my opinion, are much better for capital preservation, rather than capital growth.

Physical real estate certainly has the for potential significant upside, but real estate is hyper-local meaning that values on real estate are specific to a geographical region. Also, real estate is much different from a business. A business produces revenue, and therefore profits, via products or services that it sells to the public or other businesses. Real estate is simply shelter. It doesn't actually produce anything. Real estate can produce rental income for the owner, however, so income can be squeezed from this asset class. For the most part, residential real estate valuations are tied to incomes. If incomes fall, residence values fall in kind. If incomes rise, people can afford more luxurious abodes, and therefore usually bid up the prices of local real estate. Also, it's much more difficult to diversify with physical real estate as real estate holdings typically tie up a large amount of capital due to the costs of one physical holding. It's relatively easy to pay $7 to buy $1,400 worth of Chevron Corporation (NYSE:CVX) stock. You can't really do this with real estate. The transaction (friction) costs are much higher, and in most cases you're not talking about fractional ownership like you are with publicly owned companies. You also have ongoing maintenance and tax costs. Because of this, I would more likely prefer to own real estate via Real Estate Investment Trusts (REITs) that behave and trade much more like stocks.

Overall, the upside/downside relationship with real estate is mixed. Your downside is not as great as stocks, because the odds of a property going to $0 in value is almost impossible. However, you could purchase a property that needs unforeseen repairs fairly quickly that can drain any available spare capital you have, and local markets could make it difficult for the asset to appreciate appreciably over the rate of inflation. Also, the odds of physical real estate appreciating at the rate of a group of wonderful companies with fantastic products/services and ones that operate with sufficiently high margins is very unlikely. This opinion is backed by the Case-Shiller Home Price Index which shows that home prices as an aggregate have barely appreciated over the rate of inflation going back over 100 years. Also, this doesn't take into account the value of your time, as physical real estate tends to be more hands-on than stock ownership. Overall, I view the downside of real estate more limited than stocks, but the upside also not nearly as attractive as what stocks have potential for. Also, the difficulties of diversification, high transaction costs, hands-on nature and need for local market knowledge are traits that make real estate as an asset class less attractive than stocks (in my opinion).

I'm not even going to discuss gold or other physical metals. I've revealed my distaste for gold before. Upside and downside are completely dependent on what the next guy down the line is willing to pay for your unproductive metal.

And cash is obviously unattractive for many reasons. It will only depreciate over time, as inflation eats away at its purchasing power. So, you're guaranteed to slowly bleed money while your upside is basically non-existent. Cash is useful, however, when there are few attractively valued opportunities out there. When markets fall, bringing assets back into valuations that are near historical norms, cash can be useful to take advantages of opportunities. Cash is only good when you're turning it into an appreciating asset at attractive valuations looking out over the long-term.

Some people may think I'm crazy to put almost all my wealth into stocks. But I don't think I'm crazy at all. I think stocks represent the best possible opportunity to build wealth in a capitalist society. Owning pieces of high quality companies and reinvesting the profits they send you via rising dividends is simply a fantastic way to build your wealth over the long haul. Picking a great group of high quality companies that pay, and increase, dividends while allowing time and compounding to work its magic will almost certainly provide you the greatest risk/reward relationship available. Your downside is limited only to original capital you've invested, while the upside is limited to the potential of the company you're investing in, the price at which Mr. Market is willing to pay for your ownership stake in said business, whether or not you were reinvesting dividends and your own emotional limitations (trying to time the market). Buying and holding quality companies for the long-term while ignoring the noise will eliminate almost every single potential drag on your investment upside.

How about you? Do you enjoy this upside/downside relationship in stocks?

Full Disclosure: Long CVX, MO

About the author:

Dividend Mantra
Trying to retire by 40 by investing in dividend growth stocks and living frugally, valuing time over money.

Rating: 3.1/5 (15 votes)


Seanickson - 4 years ago    Report SPAM
I agree for the most part. Although i dont think a large equity percentage is for everyone. Be prepared to lose 50% of your portfolio from time to time to time as it will happen but long term the overall results for equities are very good.

I think your take on real estate is a little lacking. Yes the price of the real estate likely wont do much better than inflation but thats because all the earnings are distributed to the owner(about 30% in stocks). Lets say after costs you can collect rents of 5% of the value of the property and this amount and home value keeps up with inflation, youve earned a real return of 5%, add a little leverage and you will do a little better.
AlbertaSunwapta - 4 years ago    Report SPAM
I have next to nothing in bonds now as I see them as very risky instruments. However, my ability to see the future is non existent. I have built up cash levels quite high having moved from mostly equities for the last few years. I am making some short term assumptions and "bets" on the near future as I see the probabilities - not as the probabilities really are.

Say, we go into a deep deflationary global decade or multi-decade long depression, earnings collapse, dividends start getting cut across the board, you lose your job, your spouse loses his/her job, you have kids to support, after a few years social programs start getting axed like never before, war looks ready to break out... You start selling off your equities to survive... (If we're like that once massive capital market, Japan, your equities have declined 60-80%, when you sell.) Those with safer bonds look like geniuses. People like me literally look like bums on the street.
BEL-AIR - 4 years ago    Report SPAM
Actually you are all wrong...

The best way to make and grow wealth from the average person is to own your own business.

Ask yourself this question...

How many wealthy people do you know in your community?

How many of those people made it all in the stock market?

Pretty sure it is none....

In fact most people who you know probably lost more money then they made in the last decade if they dabbled in stocks. Almost all of the wealthy people in your community that you could replicate became millionaires by owning a business of some type, yes a lawyer or doctor would also qualify as a business person since they have their own practice.

Even Gates and Buffett made most of their wealth by owning their own business. They just got bigger and more successful business then most.

The fact is the average person in business I have known over the years including myself can make 20% to 15,000% returns per year on invested capital in their own business, yes they might have to work with their hands or do manual labor in some instances but they are doing it and it is possible. And it is safer and alot more easy for the average person to do than the stock market.

Yes that is not a typo, 15,000% returns per year... (That I know of, in fact I subcontract to dozens that fit into this category and personally know dozens more) All this from a small simple business that any one of you could do.

Now ask yourself another question...

Look at your parents, grand parents and that of your spouses, were did the actually wealth come from that they currently own (Net worth) Most of it would have come from real estate they bought 40 years ago for $30,000 that is now worth $400,000...

Just the facts folks...

Sww - 4 years ago    Report SPAM
@BEL-AIR Before you recommend others to start your own business, probably you should first find out what is the failure rate of small business.

This is one of the first link I clicked on a google search for that,

"... Did you know that recent studies have shown that 50 percent of small businesses will fail within the first year? How about the fact that a staggering 95 percent will close their doors before they hit their fifth year of operation?..."


Stock investing is probably the best investment vehicle for most individuals, given you need to learn how to recognize good company and how to value a business and try to invest in great companies that you would like to own for long time for a good price.

When you put your money into Coca Cola stock say $18/share in 2009 or 50+/share WMT in 2011, or BRK-B when it's below 70 last year or MCD when it's 25 in 2004/5. You do not need to do much (ever) for the every dollar you put in that day (forever). No employees need to hire, no bills need to pay and your business grows 24 hours a day.

Compare to a small business chances that these great companies will lose money is slim to none.

People lose money in stock market simply because they do not know (or want to learn) how to value a business. If you can't value a business then how can you know the price you pay for is good value?

But as Munger said, we tend to be fall into the "To a man that has a hammer, every thing looks like a nail" syndrome, people who make their first pot of gold in small business will swear by it but capital or stock market should be the best bet of the masses.
AlbertaSunwapta - 4 years ago    Report SPAM
Investing in great businesses whether its one you create or one you buy into is hard to beat under most imaginable scenarios. However figuring out what makes a great business is a hard thing for most to figure out.

Then to invest in it at a price where your final return will be satisfactory is another. Plus determining your own cash flow needs from those businesses in the future (due to retirement, job loss, medical crisis, hyperinflation, depression, lifestyle needs, etc) to avoid any risk of your having to sell at inappropriate prices is also a major consideration. Dividends, the ability to sell fractional interests(ie shares) or finance may prove critical to avoiding a forced sale below intrinsic value. You might have a "hold to maturity" price and value in your mind, if not calculated to the penny, but that doesn't mean you will be able to realize that value if near term circumstances work against you.

There are businesses that will survive quite well in all manner of circumstances (well all need to eat and seek medical care and heat our homes, etc. and we need positive influences / entertainment and will always be willing to pay for it) so the share price might collapse by 50-80% but the business will survive and if it pays dividends even if the "market closes for five years", you may do ok in otherwise disastrous circumstances.
BEL-AIR - 4 years ago    Report SPAM
All I am saying is this, I know plenty of wealthy people, most of them made it in their own business.

I do not know, nor have I ever personally met anyone who was able to obtain a great deal of wealth in the stock market alone. But I have met hundreds who have done it on their own in some simple little busines they started themselves small and built up over the years until they were millionaires.

This is how I did it...

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