1: How you invest is far more important than what you invest in
Most investors believe that the job of a investment advisor (or a personal investment strategy) is to look at the thousands of securities (stocks and bonds) and pick “winners” rather than “losers.” The better an investor’s talent at picking “winners,” the faster his portfolio grows. Other investors think the market or economy has predictable cycles, which one can take advantage of to earn superior returns.
The reality is that the vast majority of both amateur and professional investors cannot pick stocks or time the market any better than random chance. In fact, randomly picking stocks will usually provide a higher return than professional management.
2: Amateur intuition is a terrible guide to investing
Most amateur investors who pick stocks significantly underperform the market. 90% of people who pick “winning” stocks do worse than if they picked them at random. There are many reasons for this: (1) your emotions will work against you — you will be tempted to buy high and sell low, (2) even if you correctly identify a good stock, it is much harder to evaluate if it is already priced too high and (3) unless your have exceptional talent, the collective wisdom of the market will be superior to your predictions.
It is possible to outperform the market, but it’s not a simple or quick process:
- Sort through thousands of companies to find securities that trade for less than their intrinsic value using fundamental analysis.
- Buy and hold those stocks for years (or decades) until you achieve a return in your investment
- Monitor those companies and sell stocks if their fundamentals change.
- Repeat the process with several dozen stocks so that you’re not overly exposed to any one company
This “buy and hold” strategy is more profitable than frequent “active” trading, but it requires hundreds of hours of study, more risk, and a lot of practice. Even if you do everything right, you will only earn slightly more than picking stocks at random. A “set it and forget it” strategy of investing in broad indexes is far easier.
Furthermore, even if you think that you have a superior understanding of market fundamentals because of your economic theory or insider knowledge of your market, that’s no guarantee of superior returns:
For example, if you follow Austrian economics, you might think that your understanding of why business cycles happen would lead to superior returns. However, you may have noticed that most Austrian economists are not millionaires. That’s because the results of most macroeconomic policies play out over decades, and simply staying out of the market because you think it may crash in the next 5, 10 or 20 years is worse than keeping your money in the market. The timing and severity of crashes is impossible to predict, and most are followed by a sharp recovery. The best strategy is usually holding on for the long run.
Likewise, even if you understand an industry well enough to pick winning technologies, there’s no guarantee that the first mover will execute them best. It’s possible to be a great futurist at predicting future trends and yet completely fail at predicting the companies which will profit at exploiting them.
3: Expert stock-pickers won’t do better than you
There are at least four reasons why the average small-time amateur investor can get a better return than by delegating the job to a professional manager:
1: The more effort is spent on an actively managed portfolio, the more that manager has to be paid: whether it is a mutual fund or a personal broker, the more work the manager has to do, the more he’s going to charge you for it. Since he’s unlikely to do much better than the market, he’s just as likely to hurt your total returns as to help.
2: The more popular a fund becomes, the more difficult it is to outperform:
The more popular a fund, the larger its value. For example, Fidelity Contrafund (FCNTX) has a net worth of $80 billion. A manager of an $80B portfolio cannot bet on a few promising startups because investing billions into a small company will drive up the stock too much. He’s forced to invest in large S&P 500 corporations and dilute his strategy investing in many companies. The larger a fund becomes, the more its performance tracks the overall market.
3: A consequence of getting too popular is pressure to match the index: high returns require taking bigger risks. A small fund can afford to do that, but an $100B fund is too big to fail — there will be too many angry investors when $20 billion of shareholder value is wiped out. This forces fund managers to insure against underperforming their indexes and discourages risk taking.
4: Unlike hedge funds, mutual funds are required to disclose their holdings, so anyone can copy the strategy of a successful fund. While some funds might be unusually successful because of innovative strategies, investors can’t be sure of that until they have a proven track record, by which time the market has copied and diluted their advantage.
Thus, a common pattern is:
- A managed fund outperforms the market
- More and more people buy into the fund and copy its strategy
- The fund becomes too big and stale to profit from its original values
Studies show that the overall effect after taking costs into account is that managed funds slightly underperform indexes. By investing on your own in cheap index funds, you can keep your costs low and match your target asset class.
4: High-performing investment categories are not legal unless you are already rich
So far, I’ve presented a pretty pessimistic view on the notion “beating the market.” If you can’t do better than the experts or actively trading on our own, is there any way to get superior returns?
There are investment vehicles which may outperform the market, but they are only available to accredited investors – those with over $1 million in assets or $200K in yearly income. You must be an accredited investor to invest in venture capital, hedge funds, angel investments, and other alternative investments such as financial instruments based on loans, legal settlements, and crowdfunded real estate.
Alternative investments might return above market returns and they can offset risks from investing in the market through because they are allowed to short the market, etc. Unfortunately, most western countries have decided that non-accredited investors lack sufficient financial sophistication to understand and take on the risks.
Small-time investors seeking superior returns do have a way to seek superior returns: you can become an entrepreneur by starting your own business or buying property. If that does not appeal to you, it’s best to resign yourself to buying in for the long run and getting rich slowly.
5: Sound investing is fundamentally about managing risks, not picking “hot stocks”
There is no particular stock, bond or industry which can predictably be counted on to return above-average returns. In other words, you’re likely to make just as much money investing in high-tech startups as plain old boring utility companies. However, if one looks at broad asset classes, one can see a certain pattern. (Asset classes are categories such as domestic vs international stocks, large vs. small companies, or value, growth, or income stocks.) Research shows that over the long run, all stock-based asset classes earn similar rates of returns.
There is no free lunch in investing. Higher returns come with with higher risks (year by year variability). Some asset classes (such as stocks) historically have higher returns than others (such as bonds), but usually with higher risk. An investment strategy should match your values and financial goals – not guarantee a particular rate of return. Given a particular tolerance for risk, your portfolio should maximize returns while minimizing variability.
A diversified portfolio (one which invests in securities of different kinds to minimize their correlation with each other) will give annual returns mostly consistent with the overall market, but with less variability. As a rule of thumb, no single security should be worth more than 5% of your portfolio.
In short: don’t stress too much about what you invest in – just don’t put your eggs in any one basket: spread your investments over many securities in different asset classes.
Below: my portfolio is diversified by market sector, asset class, and capitalization (not shown).
6: It doesn’t matter if you are up or down
Even experienced investors can get caught up in the emotional rollercoaster of markets: markets move up and down in unpredictable swings, and individual portfolios reflect that trend. On average, the entire stock-market gains 5-7% per year – that’s what you would earn if you picked stocks at random. When evaluating how your stock asset-class is performing, it is important to compare it to the stock-index rather than the absolute number. If the market is up 15% in a year, a 10% return is not actually that great. Vice versa, if you lost 10%, but the market crashed 15%, your portfolio might be OK. Similarly, other compare each of your other asset-classes to a relevant index.
Judge your performance by comparing it to the indexes of the asset classes that you are targeting: for example, a portfolio split between the S&P 500 and international equities should take the average of both when evaluating how well it performed. If you are keeping up with your benchmark index, consider yourself lucky — most investments underperform. If you are losing money when markets make a positive return, it may be time to change your strategy. Only if you consistently out-perform your target index can you conclude that you’ve picked a superior strategy.
- Don’t try to pick “hot” stocks or time the market
- Build a diversified portfolio by investing in individual stocks in diverse asset classes, or index funds which track the market
- Minimize costs by avoiding managed funds, investing in low-cost ETFs, and trading infrequently
- Buy for the long term: don’t sell your investments until you need the money
- Live a frugal, minimalistic lifestyle so you have some money to invest!