Equities: Unlimited Upside With Limited Downside

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 30 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. (MO) (then known as Philip Morris) on 5/25/1983, which would have bought you 16.88 shares (closing price $59.25). That was 30 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 potential for 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 (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

Thanks for reading.

Photo Credit: Stuart Miles/FreeDigitalPhotos.net

Edit: Corrected timeline for MO investment

Comments

  1. says

    Thanks again for the great post. I think that you are quite the opposite of a madman investing in shares. You are the wisdom itself, but people are so afraid for their money that they invest it almost always in the worst vehicles. A salute !

    • Travis says

      Ha, that need to be Jason’s new tagline:

      “Dividend Mantra – Quite the opposite of a madman investing in shares.”

      I like it.

    • says

      Aspenhawk,

      Thanks! Glad you enjoyed the post, and I appreciate your opinion that I’m not a madman. :)

      I agree that fear is one of the primal emotions that keeps a lot of people from earning the kind of money they should. Fear is what keeps people out of the stock market and forces them to put their money in their “safe” savings account, all the while actually losing value on their capital to inflation. Fear and greed are quite powerful, and it’s difficult at times to toe the line. I try to keep my emotions in check, and this blog serves as a platform for that.

      Keep in touch!

      Best wishes.

  2. says

    The limited downside is very true, provided that you’re working off of some kind of investment plan. On the few stocks I’ve sold on bad news, my losses weren’t that great. Some of the decline decline in stock price was even offset by dividends.

    But this was when I am now more educated about investing. Previously, when I had no specific investing plan other than “make money” I lost more money on stocks. It’s easy to see stock investing having a big downside (and little upside) if you practice strategies like buying high and selling low or chasing hot trends that you don’t understand.

    Real estate is both local and personal. I don’t have a family or some hobby that requires lots of space (eg carpentry or pottery) so I can’t really justify buying a house. Both the purchase price and the annual upkeep costs (maintenance, property tax) of houses here are really high. If one or both of those things change, I’ll probably look into buying a house.

    • says

      MFIJ,

      I agree – it’s important to have a plan. Limiting losses is easy when they are only paper losses. The money doesn’t actually leave your hands until you realize that paper loss and take a hit.

      I’m in the same boat as you in terms of real estate. It is something that serves one better if you have a family or need a garage for your tools or hobbies. I find that owning a home is more a lifestyle/quality of life decision than anything else. Although they’re typically not a fantastic investment, for many people that’s not why they’re buying a house. It’s to raise a family or provide a yard for kids/pets to run around in and grow old in. I think that’s fantastic in that regard, but I was simply discussing the financial side of it.

      Best regards!

  3. Onassis says

    Great and very long article, Jason! :-)

    I prefer and love real estate to inhabit them myself and shares!
    And I hate bonds, gold, (and cash on the current account)!

    At the moment I have 6 different shares in my portfolio. But I want to get up to 40 or 50 companies like you. That gives me a feeling of safety.

    Because I have traded with options and futures, I don´t have afraid of shares and high volatility.
    The larger the market downturn, the greater the chance to get an 5-, 8, or 10-bagger!

    At the present time, the market only listens to the FED and the cheap money from there. But like last week, the people react very quickly if they think, the FED will reduce the cheap money…
    And then the market can fall down very quickly for 5, 10 or 20 percent (or more… ;-) )!

    Onassis

    • says

      Onassis,

      I’m totally with you on the asset allocation. I dislike gold strongly, and cash is only good to have in large amounts when the markets are falling. Otherwise, I prefer to have equity positions in wonderful companies working for me.

      I agree that the market is high on easy money right now. When the Fed exits QE there is no telling how the market will react. Many suspect quite negatively because there is no easy way to exit the easing, as it’s really historically unprecedented. We’ll see, but I do hope for at least a 10% drop.

      Best wishes!

    • says

      RO,

      Thanks for stopping by! Hope all is well.

      Glad you enjoyed the article. I think the upside/downside relationship with stocks is so understated and very, very attractive.

      Take care!

  4. Spoonman says

    The scalability of stock investing its most attractive characteristics. I didn’t have to wait until my principal was at a certain amount before being able to invest. I was able to build my current passive income by slowly making contributions with zero overhead costs.

    I feel the same way as you about the other asset classes.

    It’ll be a very long while before bonds become a viable investment vehicle for me. The yields are too damn low and poised to go higher any day now. One day it’ll make sense for me to buy bonds, but that day isn’t here yet.

    Real estate? That may be a viable option for me in the future. Right now, however, I’m trying to a eject a condo from my life that doesn’t fit well into my long term plans. The thing about real estate is that it’s very easy to look at near term rental income and feel good, but down the line there’s bound to be problems and repairs.

    • says

      Spoonman,

      Absolutely. You used a great word there – scalability. That’s a wonderful attribute that stocks as an asset class have that makes it relatively easy for retail investors to build a portfolio from scratch. Certainly the advent of online discount brokers has helped our case, reducing commission costs to a level that is very palatable.

      I agree with you on bonds. They make zero sense right now for me. Treasuries used to be risk-free return, and now they’re almost return-free risk. The risk/reward relationship in bonds is skewed way out of line and I’ll continue to stay away from investing in debt until the interest rates make it attractive to do so. This is a far way off. I do think, however, it might be nice to scale back on stock investing as I approach FI (say 1 year away) and start investing in long duration bonds if yields are attractive enough (over 5%).

      Real estate is a mixed bag for me. I can certainly see the appeal of leveraging other people’s money into receiving a very high ROI. But like you said, it’s easy to get blinded by high ROI and solid rental income and lose sight of what you really signed yourself up for. I try to stay realistic.

      I also think it depends a lot on your temperament and what early retirement looks for you. For me I like the idea of travel, and real estate may end up grounding me a bit. The attractive nature of dividend growth investing is that I can manage it from anywhere in the world. The income is completely location independent. Certainly a management company could take care of 99% of the work for you, but that eats into profits and doesn’t completely absolve you of needing to be there. Could you imagine being in Thailand and you have to fly back because there was a fire or theft or something? Yuck.

      Keep up the great work!

      Best wishes.

  5. Chad says

    Are you accounting for the spinoffs of PM and KRFT and now MDZL from the MO stock of 30 years ago? If not, the gains are even more impressive. Still hard to beat the benefits of equities over the long term. Much better than bonds, gold, or cash.

    • says

      Chad,

      I don’t believe that the stock calculator Altria provides accounts for the spinoffs, which goes to show you how lucrative equity ownership can be. I didn’t mention the spinoffs because, as is, Altria is cherry picking the best performing stock over the last 50 years. However, the point isn’t to find the “best”, but just to realize that even if you don’t, your upside significantly outweighs your downside by virtue simple mathematics. Buying quality and holding for the long haul almost guarantees that you’re going to build significant wealth.

      I think stocks are actually underrated. There is no better performing asset class over a long period of time, and yet people consistently want to expose large parts of their wealth to other classes that historically perform much worse (real estate, gold being prominent examples). I understand the necessities of diversification, but I will likely always have most of my wealth exposed to equities.

      Thanks for stopping by!

      Best regards.

  6. says

    I think real estate is entirely too risky and like you would prefer the safety of a REIT. In fact just the other day I heard someone talking about how they couldn’t sell their house so they had to resort to renting it out rather than face foreclosure. Sadly they had bad luck with the renters who managed to flood the place with over 500 gallons of water. The repairs cost them $50,000 !!!

    P.S. – Love the blog, been coming here for a while now. :-o

    • says

      Captain Dividend,

      Cool logo. Digging it!

      Sorry to hear of the troubles your acquaintance had with their house. Always quite unfortunate to hear of stories like that.

      REITs are certainly safer and more convenient than owning property directly, but just know that REITs will likely provide lower total returns than direct ownership. I’d be okay with that as the convenience and relative safety are worth sacrificing some of the return, in my opinion.

      Glad you enjoy the blog! Much appreciated. Best of luck with your dividend investing!

      Best wishes.

  7. gibor says

    I like REIT stocks (Canadian) , yes , they don’t increase dividends frequently, but currently many of them are paying 6-7% yield and didn’t cut dividends for 10+ years (including last big ressession). I personally own some big REIT stocks like CUF.UN, AX.UN, HR.UN and some ETFs (XRE and ZRE)…all those holding split among our 6 accounts….

    @Mantra, when did you buy CVX?! I thought you only hold XOM

    • says

      gibor,

      Nothing wrong with collecting a 6-7% yield that provides some solid current income. That’s better than just about any bond will give you.

      I’ve held CVX for quite a while now. I do not actually own any shares of XOM, but it is high on my watch list right now.

      Best regards!

  8. gibor says

    Ohhh…that’s right :) you was talking that you want to buy XOM because you already have CVX… just forgot….

    I hold several Canadian oil stocks, but from NYSE only COP… also was looking to initiate position in CVX or XOM…did some research…both stocks have practically equal valuation and fundamentals… CVX has a little higher yield , but XOM has a litttle higher div growth and was a little lagging comparing to CVX … pretty difficult to decide with what to go.

    • says

      gibor,

      I don’t think you can go wrong with CVX or XOM. I’d prefer to own both. XOM has lagged CVX YTD, as well as the market, but the entry yield isn’t as high as CVX. Both are valued relatively similarly. I’m leaning on buying XOM right now because I don’t own any.

      Good luck deciding! :)

      Take care.

  9. Anonymous says

    Jason, great post!

    The best way to blast away fear is to add some historical context to a company’s dividend record. For instance, ever since General Mills began paying out a dividend in the late 1800s, it has never lowered the payout. Not once. The company has frozen it a couple of times, but it has never declined. Think about the implications of that. WWI. WWII. Yep, General Mills paid out its dividend. If the attack on Pearl Harbor or Hitler streaking across Europe do not cause you to eliminate a dividend payment, what will? Oh, and of course, there was: Cold War, Vietnam, 9/11, etc.

    Turns out, people eat cereal and use flour no matter what is going on in the world. That’s a company I wouldn’t mind owning. Before you know it, a successful investing lifetime only requires finding 20-40 companies just like General Mills. Well, let’s see, we have some Coca-Cola here, Johnson & Johnson there, Exxon Mobil over there, and before you know it, you’ve built your own little Fort Knox balance sheet.

    Great stuff, Jason.

    -Tim McAleenan

    • says

      Tim,

      Hey, thanks for stopping by! Much appreciated.

      Great points there. Sometimes us dividend growth investors focus a little too strongly on the growth aspect of the dividend, but putting a payment streak into context can really open one’s eyes. Paying a dividend through the World Wars, Great Depression, Vietnam, rampant inflation, Cold War, Great Recession, etc. etc. Crazy, huh? I mean the fact that they kept sending out those quarterly payments is really amazing.

      I agree. Building a solid portfolio of wonderful companies doesn’t require one to reinvent the wheel. You don’t need to hit home runs, but rather focus on singles and doubles and rounding the bases over and over again. That’s where true long-term success is found, and that’s what separates the investors who build wealth and those who strike out.

      Thanks again for stopping by! Appreciate the support.

      Best wishes!

  10. Anonymous says

    You mentioned 20 years, but looked at a price from 1983. Maybe you were trying to say 30 years :)

    • says

      Anonymous,

      Yikes! Big mistake there on my part. Thanks for catching that. Altria is impressive all by itself, doesn’t need me to embellish anything. I’ll edit the article immediately.

      My apologies.

      Best regards.

  11. says

    DM,

    Thanks for the great article!

    I agree that stocks are the best asset class for the long-term by a long shot. A good quality company will have high enough returns on invested capital that it can pay out a dividend and use the remaining portion of its earnings to invest in projects that produce future growth. It’s the reinvested capital that keeps earnings and dividends growing and in turn forces share price appreciation.

    No other asset class can compete!

    Take care,

    Dividend Freedom

    • says

      Dividend Freedom,

      Glad you enjoyed the article.

      Excellent points there. A wonderful company will not only have high returns on invested capital and high returns on equity, but also do so consistently. These attributes are hallmarks of high quality companies, along with a number of other factors. These high returns on capital and equity allows a company to reinvest at favorable rates of return while still deploying a significant portion of capital to shareholders. It’s a win-win!

      I agree with you that no other asset can compete. I would say real estate is close because a lot of times it’s highly leveraged and you’re dealing with high ROI because your investment is a low portion of the overall value of the asset, but at that point you’re not comparing apples-to-apples because I’m not talking about leveraged equity investments.

      Best regards!

  12. says

    This is a great point. I love the unlimited potential of stocks, but I definitely would hate to lose 100% of my investment. This is where diversification comes into play. If you diversify yourself properly the chance of losing all 100% is very, very small. I’m with you, though, I love stocks and will be in them for the majority of my life.

    • says

      Jake,

      Losing 100% of your investment is a horrible proposition, but the thought that you’re only risking 100% for the potential of a 1,000% return or more is quite comforting. And diversification will mitigate almost any realistic possibility of losing 100%.

      Glad you’re a huge fan of equities as well! :)

      Best wishes.

  13. Anonymous says

    This is what I have although I may have missed something:

    In 1983 $1000 bought you 16.88 shares of Phillip Morris stock, which as you point out, became 405 shares of Phillip Morris due to splits. Renamed to Altria ~ 2003

    In 2007 owners got 0.692024 shares of Kraft for each Altria share they owned. So now you have 405 shares of Altria and 280 shares of Kraft

    In 2008 owners got 1 share of PM for each share of Altria (MO). So now you have 405 PMI, 405 MO, and 280 KFT.

    In 2012, each share of KFT became 1/3 share of KRFT and 1 share of MDLZ.
    Making the totals:
    93 shares of KRFT
    280 shares of MDLZ
    405 of PM
    405 of MO

    405 shares of PM @93.36/share = $37,810
    405 shares of MO @37.07/share = $15,013
    280 shares of MDLZ @$31.28/share = $8758
    93 shares of KRFT @$57.54/share = $5351

    = $66932

    YEARLY dividends would be
    405 shares of PM @3.40/share/year = $1377
    405 shares of MO @1.76/share/year = $712
    280 shares of MDLZ @$0.52/share/year = $145
    93 shares of KRFT @$2.00/share/year = $186

    = $2420/year !!!

    That is without reinvesting the dividends. With reinvested dividends the return is much greater.

    The value of compounding is incredible.

    -BEWARETHETAXMAN

    • says

      Bewarethetaxman,

      Thanks for doing that math for me! I realized that stock calculator from Altria didn’t include the spinoffs after running it again. That’s truly an amazing return. Certainly not every company will provide shareholder returns even close to that, but it’s very, very inspiring to know that the possibilities are out there. The possibilities of getting returns like that in almost any other asset class is completely unheard of. Just one of the reasons I love stocks – the endless possibilities!

      The power of compounding is incredible, indeed!

      Take care.

  14. says

    This is exactly why I love (fell in love) with dividend investing too. Not only your initial investment grows in value, but also if you add dividends to it you can grow your investment even faster. On my blog I recently wrote about my new trade into a monthly dividend payer Realty Income (O). Although the stock has been beaten down these couple of days (as the entire REIT industry along with it) I am still 13% up on capital appreciation and 15% up if dividends are accounted for. And although the current yield of this stock is around 4%, my YOC is already around 5%. This is a greatest beauty of dividend investing. What else would you want from your investments – monthly rising income!!!

    • says

      Martin,

      Dividend growth investing is quite wonderful. Not only do you have the appreciation of the underlying shares, but you have the dividends those shares pay. You then also have the growth of the dividend payouts. When you’re reinvesting your dividends, you’re reinvesting back into a pie that is expanding via the reinvestment of your capital, supercharged by the growth of the future dividends which only fuel bigger reinvestment in the future. It’s hypercompounding!

      O is becoming attractive for me again. If it keeps dropping like this I’ll be very interested in initiating a position.

      Best regards.

  15. says

    Another awesome post Jason! Keep up the great work!
    The return on MO is actually much higher once you factor in the dividends received since 1983.
    Bewarethetaxman did a great job of calculating the new stocks offered to MO shareholders over the years.

    • says

      Kanwal,

      Thanks! I’m glad you enjoyed the article. :)

      Altria sells themselves quite short, don’t they? I do love a humble stock calculator like that. Yeah, you returned over 6,000%. Oh, we forgot about dividends. Oh, forgot about the PM spinoff. And oh yeah – Kraft too. How did we forget about that? You mean Kraft split too? Oh, I guess throw that in too.

      MO is of course cherry picking the best of the best, but the point still remains valid that your absolute loss remains static at 100%, while the upside is theoretically unlimited. Basic math is basically screaming at you that you’re going to do well by investing in high quality companies over the long haul.

      Thanks for stopping by!

      Take care.

  16. says

    I am standing on the sidelines right now for the markets to pull back. I will just build my cash position currently while two of the stocks I hold as a “trade”. As I hold these 2 stocks, I get paid to wait while waiting for my exit point.

    • says

      Investing Pursuits,

      Nothing wrong with building a little cash right now. Certainly some of the consumer goods companies (like PG, KMB, GIS, KO) have been falling lately, which is great. But they are all still a bit pricey for me, so I’m continuing to scan for the best opportunities.

      Happy shopping!

      Best wishes.

  17. Anonymous says

    I always feel better after reading your stuff you need to write a book on keeping a good attitude.i bet you are a nice guy to your friends and family

    • says

      Anonymous,

      Thanks so much. Very kind words there. I appreciate the support and I’m glad you enjoy the blog.

      Maybe I will get around to writing a book one of these days. That would be a dream come true. :)

      Best wishes.

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