Investing is relatively simple if you really think about it.
First, you take a quick cursory look at the basket of available stocks out there – let’s round up and say there are currently around 9000 stocks trading on U.S. stock exchanges. Each of these stocks represent an equity stake in a vast variety of different companies.
Some of these companies are traded on large stock exchanges that are monitored heavily by the financial world and require filing of regular audited financial reports while others trade over the counter on the pink sheets system which has no regular filing requirements. These companies may be large-caps, mid-caps, small-caps, micro-caps and even nano-caps depending on the value of the company in question.
These companies produce products or offer services or try to create the next big thing that will forever change the world or at least some of them do those things. Others are probably just wasting away tons of money and resources on products and services that will be outclassed by the hundreds of other companies vying for market share in the same industry. Companies are born and die almost every day – values explode and crater every day based on market sentiment, financial performance, industry headwinds and a dozen other factors that may or may not be public knowledge today.
And all you have to do as an investor is wade through this jungle of options and figure out which of these companies, large or small is currently under priced by the ever moving force known as the marketplace and pick it up at a low price before everyone else gets in and sends the price soaring into the atmosphere making it overpriced. Then you sell, make your hearty profit and repeat the process one more time and then again and then again and then again and then again.
Sounds easy right? It’s such a simple formula, buy low then sell high, rinse and repeat. Investing is relatively simple if you really think about it but the reality here is much more complex.
There are three truths to the stock market as far as I see it. History has vetted these and we can see them in action almost every day. They are;
The market goes up in the long run
You’ve likely heard the term ‘the trend is your friend’ and it holds true when we talk about the market as a whole. The long term trend with stocks is up which is why most people rich or poor who want to increase their wealth look towards stocks as one of the best vehicles to do that. The problem with this trend is that people don’t realize that the market means the entire basket of stocks and the long run means an extended period of time. There has never been a 15 year period where stocks lost money and while that might not sound particularly enticing to a novice investor – it’s quite likely that you’d need some real bad luck to be stuck within that long a period without a positive return.
Now this certainly doesn’t mean that stock A from our basket of 9000 stocks will never lose money if you look at it over a 15 year period. It doesn’t mean that at all. In fact, I would wager that if you look at the basket of 9000 stocks available today, a small but not inconsequential portion of them(especially the small pink sheet penny stocks) will not even be around 15 years from now. That means if you paid $1000 to buy their shares today, you’d likely be out $1000 in the future if you held that long. But you wouldn’t have done that right? You’d have sold out long before it started its often rapid downfall as you my friend are a great investor who can predict these types of trends long before the marketplace knows about them because….
The market is efficient
Computers do a lot of amazing things including buying and selling securities by the thousands in the few seconds it took you to read this sentence. That’s why any newly digested information is often reflected in the stock price faster than you can blink.
If the earnings of a company you were following come in better than expected or forward earnings guidance is great then the price is already $5 more than it was three seconds ago because that information is now known by the marketplace. That’s what market efficiency means and you can see it in action every day if you follow the financial news at all.
That’s not to say that all information is perfectly reflected in the price of a specific security or that it’s impossible to actually buy something and make a profit off of it because…..
The market is not always reasonable
There are a variety of analysis techniques that people use to determine the fair value of a specific stock and not one of them works perfectly. There are stocks out there that look like a great value, have great fundamentals and then lose 20% right after you buy it.
There are also stocks out there that look vastly over priced but keep rising and rising with almost no ceiling in sight. The market is often fickle and stocks will see big inflows and outflows based on more than just fundamentals. There are hard to quantify things that go into pricing that are impossible to predict accurately. It’s quite hard to figure out which industry will suddenly become loved by the marketplace because of potential growth and which one will be vilified because of potential risks. There may be moves in both directions that seem to be based on nothing more than pure emotion.
So…investing…pretty simple right?
I guess the question now is – what does this have to do with the title of this post.
What I’m trying to show here is that investing in individual securities is a lot harder than most people think. Yes, the basic idea is to buy low and sell high but who the hell knows whether Stock A is low today or if it’ll be lower in two weeks. There are many reasons why active trading strategies often fail and it isn’t just due to the fact that it’s quite difficult to pick the right stock, not to mention the right time to buy and the right time to sell for optimal profit. It also has to do with the kind of decisions that type of mentality brings and the added costs that come with an active trading strategy.
I am a passive trader – I believe that buying securities should be based on a long term plan because I don’t think that I can effectively predict the movements of securities in a way that will allow me to earn greater returns than a buy and hold strategy after accounting for trading fees and taxes. On top of that, I believe that a long term mentality will also allow me to weather a downturn a lot more easily than an active trader who may see a downturn mid way through the process, sell out to avoid losing any more money and then get back in well after the bottom has been set missing out some if not all of the subsequent rise.
There was a study done in 2013 that showed a long term market return of the S&P 500 index from 1983 to 2013 as 8.4%. However, just missing five of the best days the market had during those years would torpedo your annual return to 6.85%. That’s a massive difference and shows exactly why timing the market can be so detrimental to your future returns. Humans are emotional creatures who feel the brunt of losses much more than the feel the joy of gains so it is quite easy to see why we might be less than trustworthy when it comes to making solid decisions when the market starts to move downwards.
Ask yourself this – if you had a lot of money in the market and you saw a 10% fall one day one, would you sell? What if you saw a 10% fall the day after and then another 10% the day after? Would you stick it out and continue buying or would you sell? The point is that its hard to predict what one would do in situations like these but I think a firm belief grounded in the fact that the market will eventually rebound will mean you are more likely to weather such a down swing than a person who believes they can predict future movements with any sort of certainty because if you do happen to sell and buy in too late after the market rises, you could have a substantial effect on your overall return as the study above shows. Most big jumps in the market happen after a market crisis and it is important that one does not miss those big jumps as they have a huge huge impact on overall return. Missing the 25 days in the market brings that 8.4% annual return across 30 years I mentioned above down to 3.3%. That’s a big difference guys.
Now I won’t say that timing the market is impossible. I think there are often values out in individual stocks that I like to take advantage of but most of my money is in passive index funds because the data shows that while it is possible to time the market, it is quite hard to do that even when you’re a professional.
86% of active mutual fund managers failed to beat the benchmarks in 2014. These are professionals who have dozens of people analyzing individual securities and their success rate is 14%?
That means that if I paid someone to manage my money, I’d only have a 14% chance of having better returns than if I just put my money in a cheap index fund that tracks a similar benchmark of stocks. This isn’t a one year trend either, if you look back 5 years, nearly 89% of professional managers under performed their benchmark. Look back 10 years and it’s 82%. Look back further and it’s the same situation.
If professionals have such a terrible rate of success then what chance does the regular investor have?
The point of it all is this.
If your strategy is grounded in the long term idea that the market will keep going up and you stay invested through ups and downs then you are almost 85% more likely to do better than professional managers employing a market timing strategy. That makes sense when you account for the fact that there are multiple expenses they have to account for like management fees, trading fees and taxes whereas your long term buy and hold strategy beats them on all three accounts. That means that their pre-tax returns have to be much higher than yours to beat you on a post-tax basis which is what matters. Some of these funds have 1-2% expense ratios whereas a vanguard index fund will have expenses ratios in the 0.1% range meaning they have to beat that index by 1-2% just to account for the expenses. That’s not easy when you look at the all things they have going against them.
This passive strategy is grounded in the three things we know about the marketplace; the long term trend is up, the market is efficient and the market is not always reasonable.
Why do these things matter? They matter because they make a stock picking strategy hard to pull off consistently and successfully for the reasons mentioned above. And on top of that, the passive strategy wins because when you buy and hold, you minimize transaction fees and you minimize taxes.
So what does an investor do with all of this? What does ‘time in the market beats timing the market’ mean?
It means that if you have money now, put it in the stock market and don’t worry about day to day price fluctuations and whether or not the stock market is overpriced right now or if it will be two weeks from now. It means that the easiest way to go about your investing journey is to find a low cost index fund like the ones offered by vanguard that tracks the whole market and put your money in there and sleep soundly knowing that you’ll be beating 85% of the people out there who are working real hard to under perform the lazy investor.
That’s what I do and that’s what most investors these days are starting to do because it’s easy and it works.
That’s not to say that you should never buy individual stocks. I think there’s plenty of room for that if you’re diligent enough to do research and find companies that are good long-term plays at an affordable price but for most investors, just getting in the market through a large scope index fund NOW will mean better returns in the long run.
Investing in the market is really simple if you think about it. If you can beat almost 85% of active investor with a simple passive strategy, why not do it? Active investing isn’t impossible but it is harder than most people think it is. One top of that, people are wired to over inflate their achievements as well so we don’t often see our failures as clearly as we see our successes.
That super successful stock trade you made recently might be fresh in your mind as you tell yourself that you can certainly beat the market – you just did it now – you bought when the market was pessimistic about a stock and hit it out of the ballpark with a huge profit in a short amount of time. That sort of trading success happens and it can happen to you but the long term statistics don’t lie. You have so many things working against you; whether it be taxes or transaction costs that eat into your return or panic selling when the market starts to slide down in a big way. These things can eat into your long term returns severely. Missing just one or two great days by buying back in too late after panicking and selling can have a big effect on your overall return. Even a medium term active trading success can lead to an inflated ego and years of great gains can be erased in one fell swoop with a few bad speculative trades that may turn against you even though the fundamentals and your research are very sound. The market is fickle and the only way to avoid the risk that comes with that fickleness is to be in it long term.
Buy early and buy often but buy with the intention of holding for the long term. Buy cheap index funds or etfs that track a large basket of stocks and have low expenses ratios and provide diversification and limit single stock risk. If you’re buying individual stocks, do a ton of research and make sure it’s a company you believe in for at least the next 5 to 10 years – make sure the financials are sound and if it is a dividend payer – make sure it can sustain that dividend or even increase it for the next 5 to 10 years. There are no sure things in stocks but there is a lot of information out there that can make sure you’re limiting risk while maximizing upside but you have to be willing to do that research in order to succeed.
I myself own only a few individual stocks – despite a background in finance. I buy them only when I feel like the market is undervaluing them due to some short term information(like an earnings miss) that I think will even out in the long term. I buy companies that I feel will be in existence twenty years from now and ones that will likely return cash back to shareholders via dividends or share buybacks in that same time period. I don’t speculate and if I have money to invest and don’t see a stock that’s a particular value at the time, I’ll just purchase an ETF that tracks the broad market because I believe in the long term growth of the market.
This strategy has worked well for me. I started investing 7 years ago right when I got my first job earning 45k/year. My family is not rich, we are first generation immigrants who had zero money to our name when we came over here twenty years ago to make a better life for myself. My father still works the same blue collar job he first had when we came over here so my starting point when I got out of college was nothing and yet through this method of saving – through a passive approach based on the idea that time in the market beats timing in the market – I’ve grown that zero to over 300k in net worth all through investing in stocks in about 7 years. I’ve never made a ton of money and I still don’t and I certainly benefited from a great bull market that started after the the 2008 crash but all that savings wouldn’t be possible without the passive approach I took.
There are certainly other avenues for guys like me to make money – to try to reach financial independence like starting their own business or real estate but I think stocks offer the least difficult way to get there. You can just be passive and watch your money grow – watch those dividend payments start to ramp up as you put more and more money into an inexpensive index fund that just tracks the market. If you find it interesting and have the background in it, you can do research on individual companies and buy them at an attractive valuation with a plan to hold them long term. This is the path that has worked for me – there are other paths out there for others but this is the one I chose and plan to stick to because I firmly believe that passive investing is the easiest way to get there.
I don’t have to spend hours upon hours doing stock research if I don’t want to; I can just put my money in there and let it roll doing some minor re balancing here and there if needed. I’ll talk more about my strategies in future posts but in this one I just wanted to share my overall investing belief and I think most of it is wrapped up in that simple phrase.
Time in the market beats timing the market. It’s like that old Ronco rotisserie commercial said. It’s easy, you just ‘set it and forget it’.
Happy investing guys.