It was fun interviewing my colleague, fellow Investment Committee member, and Atlas’ Chief Investment Officer, John Ogle. John came to Atlas in 2014, a little over a year before I came aboard, and helped me quite a bit as I became acquainted with Atlas’ investment approach. John has had a long, investment career before joining Atlas, and you can find out more about his professional background here.
I would encourage you to listen to full interview of this episode of ‘Planning on Call,’ the podcast, here:
Follow the links below to listen to The Atlas Advantage on Apple Podcasts, Spotify and Libsyn:
THE WHY…
I sat down with John to discuss the basics of investing – to explore the essential concepts to know as young doctors contemplate investing on their own. To get the conversation rolling, we started out exploring the fundamental question of, why individuals should invest their money? John highlighted two main reasons people invest. The first reason is to maintain the purchasing power of their money. This means keeping up with the natural rate that prices increase over time, also known as inflation. It is very important to understand that by just holding cash in traditional savings alone, an individual will essentially lose money in the long-run as the annual percentage yield for a savings account increases at a slower rate than the price of most goods. For historical context, from 1913 through 2020 the US has averaged an approximately 3% rate of inflation.[1] If this continues in the future, that means a $30 tank of gas or bag of groceries could cost almost $75 in 30 years. The other, more common reason for investing, is to grow assets at a rate higher than inflation. In essence, this is ‘putting your money to work’, so that you could make larger purchases in the future than your traditional savings vehicles would allow for. With this type of investing comes risk, and typically more risk has the potential to yield a higher return over the long run. This tradeoff between risk and return forms the crux of modern investing.
Before moving on, it is also important to bring up one basic principle of investing – compounding. Compounding in financial terms refers to the power of layering returns on top of each other over a relatively long period of time. In other words, compounding is the power of earning interest on interest. The easiest way to think about this is with a very simple example: let us consider an investor that invests $100 and expects a 10% rate of return. In year 1, that return would yield $10. At that point, they would have $110, so in year two a 10% yield would return $11 – more than the previous year’s return even though the rate of return has not changed and a person has not contributed any more money. If we extrapolate upon this example over a longer period, it can be very powerful. By year 30, assuming that 10% yield stays constant for the entire period, a $100 investment could potentially have grown to approximately $1,745, which is over 17 times the original investment and now yielding approximately $175. This ‘power of compounding’ is an extremely important principle to understand when considering why investing over long periods can be so impactful. For more information and examples of this principle, check out an article on the concept from the St. Louis Federal Reserve.[2]
These principles are the main reason it is so important for young physicians to start investing early. Plenty of health care workers may feel that they absolutely want to get rid of all their debt before anything else, but in some cases (depending on the specialty) that could mean they are not investing until they are nearly 40! Due to the power of compounding, people need to begin saving early, even if it is only small sums of money.
THE WHAT.
Given these important principles and rationale for investing, you need to know what you are actually buying when someone tells you to ‘invest’ your money. John outlines that there are three main asset classes to consider when initially investing – cash and cash equivalents, bonds, and stocks.
Cash is exactly what one would think (currency held within various account types such as a bank savings account), and cash equivalents are debt securities with maturities of less than 90 days including ‘Money Market Funds’ or. Essentially, cash and cash equivalents refers to short-term, readily accessible funds. This means, cash and cash equivalents as an asset class has the lowest risk of losing money, but also the lowest potential for appreciation and therefore the highest risk of losing purchasing power due to inflation.
Bonds, sometimes also referred to as ‘fixed income’, is really just a loan, typically to a company or government entity. Once an investors’ loan (funds) are in the hands of a new entity, it is up to the business or government entity to determine how best to spend it. As compensation for borrowing the funds, the entity will pay income (an ‘interest rate’) to the investor, the loaner of funds. The interest rate an entity will pay is dependent upon economic factors including the credit quality of the company or government entity and the length of the bond, and this rate is usually locked in over the life of the bond. This means the performance of a company over that time, unless the company goes bankrupt, does not affect the return of the investors’ bond. This limits downside but also upside, especially in comparison to stocks.
Buying stock, in a company, means buying a share of a company… simply put, it means that a person owns a proportional piece of that company. As John notes, “with a stock you own and with a bond you loan”. As an owner, if shares of that company become more in demand (more people want to buy into the company), the price of the investors’ pro-rata piece of that company can increase (or decrease with less demand). They can therefore participate in future growth or shrinking value of a company. This means that in some cases a person could have near limitless upside potential, but it is important to note there exists quite a bit more downside potential than the other asset classes noted.
SUBCLASSES…
Within the main investment asset classes, there are subclasses of stocks and bonds.
Investors distinguish stocks in several different ways, but the two most significant that John discusses are by market cap (market capitalization) and by style. Market cap refers to a company’s market capitalization or the total value of all outstanding shares of stock. Companies with a market cap of over $10 billion are known as ‘large-cap’, companies with a market cap of $2 billion to $10 billion are known as mid-cap, and companies with under $2 billion are known as small-cap. Large-cap, in general as a subclass, are going to tend be a little less risky than the subclasses of mid or small-cap companies due to the relative stability of larger companies. Historically, large-cap companies tend to underperform small and mid-cap companies over the long run. [Placeholder – add content about relative risk of large-cap subclass v mid or small-cap subclasses] John notes that as companies grow it becomes harder and harder to sustain growth rates, or as companies grow they may have less headroom to get larger.
The other main stock subclass John brought up is style, which breaks into ‘value’ and ‘growth’ styles. These styles apply across all market capitalizations. Value stocks are companies that focus on company fundamentals like book value and cash flow. Value companies generally rely on existing assets vs. prospective assets for profit. An example of a value company John brings up would be a regional utility company.
The other style John discusses is growth companies. These companies rely on products or services that have not yet been developed, and therefore research and development are key. An example of this style of company would be a company reliant on developing new technologies for consumers. There is not much of a historic difference in risk between stock styles, but different styles historically tend to perform better in different economic environments.
As with stocks, there are many different subclasses of bonds. John focuses on major diversifiers – investment-grade bonds vs. high yield bonds. Investment Grade Bonds include companies and government entities within the upper range of credit ratings. Credit ratings are evaluations scored by agencies that rate the financial status of a company. A simple way to think of a company’s credit rating is as a company’s version of an individual’s credit score. What this means is that higher rated companies have stronger balance sheets, cash flows, and financial controls. These companies therefore can pay lower interest rates to lenders, as they have less of a chance of going bankrupt. Investment-grade companies are seen as lower risk, but in turn, have a lower yield (return) as well. High Yield Bonds, otherwise known as ‘junk bonds’, are made up of bonds from, you guessed it… companies with lower credit ratings. They are seen as a higher risk but are also higher yielding.
THE HOW.
A well-constructed portfolio should include a mix of all of these different asset classes and sub-asset classes. The main reasons to spread investments across these varied asset classes is to construct a mix of investments that fits an individual’s desired risk and return level, and to increase diversification. Diversification is a way of managing risk by avoiding an over-concentration in any one asset class or sub-asset class. This is because different asset classes react differently to certain economic and market environments. An extreme example of the difference between stocks and bonds during the ‘great recession’ of 2007 through 2009. In the midst of this crisis, stocks returned a negative 37% over the course of 2008, while bonds produced a steady return of 5% that same year.[3] Simply put, when it comes to investments, don’t put all your eggs in one basket.
Diversification similarly applies to sub-asset classes and individual holdings. The idea is that as a person incorporates investments that are more varied they can mitigate certain types of risk. For example, if someone invests in a single company (stock), that investment carries a fair amount of ‘company’ risk. A myriad of unforeseen problems can arise in a single company that could cause a loss in an investment, such as internal problems like the health of the CEO, or external problems such as a natural disaster destroying a distribution center. To lessen this ‘company’ risk, a person can invest, or hold, in many different companies so that an unexpected problem with one company does not significantly impact long-term goals. This type of risk can even apply to companies across entire sectors of the economy.
Take the energy sector, in which an unforeseen trade dispute can have a large impact on most of the nation’s oil companies. To diversify this risk away, it is important to hold several different sectors as well. The one risk a person cannot diversify away is ‘systematic risk’, or the breakdown of an entire system rather than individual components of the system, what John calls ‘the primary risk to a capitalist system’. Although we have always bounced back from systematic downturns, this is the natural risk associated with investing.
Risk and return are generally inversely correlated when it comes to investments, so lowering risk when building a portfolio focused on long-term growth is not always the only goal. John emphasizes that constructing a portfolio with the right amount of risk and return begins with defining personal goals and the time horizon associated with each of those goals. A good strategy retains a mix of lower-risk investments for shorter-term goals and risk can be increased for longer-term goals.
This means a fair amount of risk can be taken earlier in a career… for goals like retirement. However, a person may want to take less risk if they are saving for things like paying off loans or making a home purchase. As an individual gets older, it is also important to lower their risk as they get closer to their desired goal, whether that be retirement or paying for children’s college.
This about rounds out the ‘Investments 101’ portion of our conversation, but please listen to the podcast for more interesting information as John and I jump into topics like how to understand investment indexes and investing through mutual funds and Exchange Traded Funds (ETFs).
As always, I ended my conversation by asking John for his most important piece of advice to young physicians worried about investing, his answer… the biggest worry is worry itself. Over his decades of investment experience, John has seen individuals do the most damage to their long-term investment goals by making rash, short-term decisions. In his opinion, the biggest detriment to long-term investing is individuals trying to time in and out of the market. He views the key to long-term gains as the ability to ride out the volatility in the short term.
While we provided investment basics in today’s post, there is quite a bit more involved in the actual mechanics of portfolio creation and long-term investing. For more information on how Atlas helps their clients invest, please visit the ‘Resources’ page of our website, where John regularly shares his insight and thoughts on the market. If you would like to learn more about the investment philosophy here at Atlas, you can read our free whitepaper, ‘The Tactical Approach’.
[1] https://inflationdata.com/Inflation/Inflation/DecadeInflation.asp
[2] https://www.stlouisfed.org/open-vault/2018/september/how-compound-interest-works
[3] https://www.thebalance.com/stocks-and-bonds-calendar-year-performance-417028
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