Wall Street thrives on perception. For the beginner or even novice investor, there seems to be a perception versus reality gap when it comes to investing.
I am often reminded of this when smart people tell me: I don’t know the first thing about investing, so how do I start trading? The first mistake is thinking trading is going to get you anywhere. If you are a beginner, the first step is to expunge the “T word” from your vocabulary. There are some people who consistently make a living trading, many of these people however, either do research as their full time job or they are trading someone else’s money and executing orders. The dream of consistently making money by trading everyday is a myth that brokerages have sold the public to reap commissions.
Maybe you don’t want to trade but you have seen stories on the news of how employees have gotten rich off of company stock like here. Maybe you have read the hypothetical articles, which seem to be popular now, about how much you would have now if you have just invested in Amazon in 1997. Or the stories of someone who became fabulously wealthy overnight in the stock market, most of which turn out to be a hoax like this one from The New York Post. Always keep a skeptical eye on the media, when the reporting turns out to be false, it threatens the legitimacy of the news source so they are not in a hurry to advertise sloppy and false reporting. They also don’t want to give their mistakes the same headline space they did the original story, that’s why retractions are usually buried at the end of an update or deep into a website or newspaper days later.
You can’t get distracted by the hype. You have to keep in mind that for every Apple, there are tons of losers. Stocks that people thought would be the next big thing that never caught on. Investors in those companies lost a lot of money or lost it all, but nobody wants to hear that story, losers aren’t newsworthy. So betting on one stock is risky, so why wouldn’t I just hedge my bets and buy a few I think will be winners? I’m bound to do well with one of them right? Maybe, but the fact of the matter is doing this is already starting to engage in a diversification strategy and you likely won’t beat the market. If your goal is to get the best return you can get, your best bet is the boring old index versus buying one or even a few stocks and I’m going to explain why below.
Why Choose the Index
1. You take less risk. Yes, you can beat the market with one stock or even a few, in the short run, say over 1-5 years, this is relatively easy. I did so over short periods with shares like Wells Fargo, Lowe’s, Bank of America etc. most of which I bought during the crisis, but the value in stocks is the very long term. About 10 years after the crisis, I went back and compared my returns on individual stocks and an investment I made in the index which I discussed in this post. What I found was that my index investment was now beating many of my awesome picks because it captured the tech rally. Also, if I included my loser picks from the crisis like some emerging market stocks and Telefonica, the index beat the return of my total investment from that time.
This is commonplace, and my example is a good one, most people do much worse than I did. The problem is, many people don’t look back and evaluate their mistakes and how they could have done better. When portfolios as a whole are examined, most people fail to beat even the return of bonds over a long period of time. Just take a look at average investor performance over a 20 year period below and you get an idea of the cost of not just following the index and if you are wrong.
Source: resilientam.com
This leads us into the discussion of why the time horizon makes a huge difference.
What if you had to pick a stock that would beat the market over 20 years? You would be much more cautious and realize there is a high probability you would be wrong like I was over 10 years? This is where diversification becomes important. Even the best investors get a 20 year call wrong and even when they do they have to have the humility and mental discipline to change course, an attribute which is often in short supply on Wall St. Besides picking a good stock, this is the less talked about talent of a Warren Buffet, just look at how he switched into Apple stock and Amazon after many years of shunning tech. Not only did he change course, he went hard, making Apple his biggest holding. This is a psychological and mental discipline advantage that is very tough to emulate. Also consider the downside and the cost of being wrong versus the benefit of being right. If you are right, let’s say over 20 years you beat the market return by 4% annually. Let’s say the market grows 10% over 20 years while you find a stock that grows 14% over 20 years. At the end of that period, if you started with $10,000 you ended up with $60,727 for the market portfolio and $137,434 for the stock you hold. However now you are taking much more risk because the likelihood that something goes wrong and crashes one stock is much more probable then everything going wrong in an economy and crashing thousands of stocks like those found in an index that tracks the entire stock exchange. Even if it was a good 20 year ride, would you want to bet the next 20 years that the company will keep this up without anything seriously damaging the company? 40 years is a long time for a company to go without some sort of scandal. Trust me, even if you’ve beat the market over a long period, you’ll still sleep easier if you just roll that winning investment into the index and go on vacation. That leads into my other point.
2. Indexing reduces market induced stress dramatically. If you have a day job that doesn’t involve investing or even if you do and don’t want to have to do more work when you get home, set it and forget it is a much less taxing way to likely retire comfortably than evaluating earnings calls, market appetite and corporate strategy. Not to mention evaluating management versus accounting metrics and secular shifts in preference and tech disruption. All this has to be done to keep up with a stock and with a company. When you talk about the really long term, you need to make an educated bet on the fortunes of a company, isn’t it easier to bet on the likelihood that some company will do good rather than gambling your savings on one?
Often, we see stories in the media of someone who bought stock x long ago and held onto it forever or added to their position over time and now they are millionaires. However, usually these people aren’t investing experts, they were regular people with a different skill but happened to take a risk and it paid off. In essence, without knowledge, they took a big gamble and it paid off. Some people play poker and it pays off in millions for them. But if you know any poker player, the average one maybe is just making ends meet or slowly losing money. The media loves a winner but they focus on these winners because their story is unique and rare. By definition that means it is not easily or likely repeated, which means that you at home watching have a very low chance of repeating this success. With diversified investing and discipline though, there is a very high chance that it will pay off in the long run, so which bet would you rather take?
People Still Dream of the Lotto
Source: Toronto Star
Unfortunately even when presented with this question, many people choose the low probability, high payout option. This is why people play lotto, even though the statistical return is negative, people still buy lotto tickets based on the hope that a fabulous payout will make them rich one day. The fact of the matter is, if you buy one lotto ticket everyday for 40 years at $2 each there will still be a low chance of winning. In contrast, if you were to take a different view of it and invested that $2 in the market over 40 years you could have $333,003 dollars at the end. In essence, if you have the knowledge and the discipline, even some of the poorest people in the US could amass more wealth than the median middle class family has right now. Unfortunately most people do not do this.
A Reason for Optimism
This doesn’t mean however, that all hope is lost. Saving and investing is a habit that can be learned. The key, as I have been stressing for a while now, is to gain control of the psychology that revolves around savings and risk taking. Once even the poorest and most indebted person has the right mindset and psychology when it comes to money, you can climb out of almost any hole and have a fantastic financial life. Just keep steady and resist the temptation of the single stock myth of getting wealthy.
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