At the Motley Fool, we have a free service called Motley Fool CAPS. In CAPS, you pick the stocks you think will beat the S&P 500 Index (also known as “the market”). In my case, 57% of my stock picks in CAPS beat the market, which means that 43% of my stock picks fail to beat the market. In essence, I am wrong 43% of the time.
That’s a spectacular failure rate. If I did that in school, I would get an F on my report card. And yet in CAPS I am in the top 1% of stock pickers. So that’s fascinating, right? How can I be wrong so often and still crush the market?
The main reason is the miracle of compound returns. In a year, one of my stronger stock picks might double or triple. That’s a gain of 100% or 200%. But over time, if a stock continues to outperform, the rewards escalate. It might go up 1,000% or 10,000% or 30,000%. And what happens is that your investment in this winner (if you don’t sell along the way) becomes larger and larger on a dollar basis.
The math is on your side
It’s hard for people to understand this, but if you make a bad investment and a good investment on the same day, the bad investment is irrelevant. Say I invested $3,000 in Amazon in 1999 and $3,000 in Pets.com in 1999. That means one of my two initial stocks was a complete washout. I stink, right?
No, actually. A $3,000 investment in Amazon in 1999 would have made you rich. The money you lost in Pets.com would have been mostly irrelevant.
The key is to make at least one really strong investment, maybe two or three really strong investments, and to hold on to your shares. If you do that, you will be rich — or your children will be rich — regardless of how badly your other investments perform.
If you avoid margin debt and simply use cash to invest in stocks, the most you can lose is 100% of your investment. That’s a hard stop. You invest $3,000 in Pets.com, it goes out of business, and you’ve lost $3,000. But there are no limitations on the positive side. Your $3,000 investment in Amazon can double 100%, or triple 200%, or run up 10,000% higher. In other words, every wrong investment can cost you a little, while every right investment can win you a lot.
A $3,000 investment in Amazon at the beginning of 1999 would be worth over $1 million today. (The company had two splits in that time frame, so this chart actually understates your returns.)
When you have one amazing winner, it doesn’t actually matter how many bad stocks you bought over the years. In fact, you could have made 40 awful investments, losing $3,000 in each one. But you’d still be a millionaire thanks to that one right investment you made back in 1999.
Small caps and large caps
The S&P 500 is filled with America’s largest, most successful companies. These are the biggest winners in our economy. An investment in these winners is considered “safe.” And many people think that the safest thing you can do is simply buy an index fund, which is a small investment in all 500 of these winners.
Since the S&P 500 focuses exclusively on large-cap American stocks, you can beat it by finding powerful small-cap stocks. One of the most fun ways to beat the index is by finding and buying the top dogs and first movers in important emerging industries. At the Motley Fool, we call these stocks Rule Breakers.
Back in 1999, Amazon was such a company. It was the leading internet portal for e-commerce. If you wanted to shop online, you would go to Amazon. The company was unprofitable but growing fast. And nobody knew how big it could get (not even Jeff Bezos). It was a risky investment — but the upside was unlimited.
Part of what made Amazon such a spectacular investment was how small the company was back in 1999 and how large its market opportunity turned out to be. When you invest in smaller companies (under a $10 billion market cap), you give yourself a stronger opportunity to find stocks that jump 10,000% or more.
Since these are smaller companies, your failure rate will be higher. But your overall returns will be greater, as your big winners will stomp the index over time. The goal is to buy small caps that become large caps. You want to own the future stocks in the S&P 500.
That’s why my family owns Silvergate Capital, a bank that’s focused on servicing the crypto space. And it’s also why we own Doximity, the networking portal for doctors and other healthcare workers, as well as Innovative Industrial Properties, the financing arm for the marijuana industry. These are all small companies, but they are leaders in their space, and their market opportunity is profound.
Will all of my picks crush the market? No. I expect 40% of them to underperform. Some of them might even lose money. But all you need are a few big winners to create serious wealth over time.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Taylor Carmichael owns Amazon, Doximity, Inc., Innovative Industrial Properties, and Silvergate Capital Corporation. The Motley Fool owns and recommends Amazon, Doximity, Inc., and Innovative Industrial Properties. The Motley Fool recommends Silvergate Capital Corporation and recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.