By Dr. Jim Dahle, WCI Founder
I occasionally see questions on internet forums, including the WCI Forum, the Facebook Group, the Subreddit, and comments on blog posts that are well-intentioned but reflect a lack of understanding regarding some of the fundamental principles of investing in the stock market.
It can be difficult to make a quick reply (much less actually answer their questions) because it requires a lot of teaching about how the stock market works (and doesn't work) in order for them to understand why the question is not a very good one. The simple asking of the question tells those “in the know” that the questioner doesn't actually understand and makes them look uninformed.
That's okay, we've all been ignorant at some point in the past and there are no stupid questions, but I'm hoping this post will help those people understand why their question is dumb (and give me a post to link to when they ask it).
Let me show you a few examples of what I'm talking about:
Marijuana stocks are a favorite these days it seems.
Yup, even companies that have paid dividends sometimes cut them.
Ah…the eternal dilemma, does a dropping price mean buy or sell?
Not enough income to even have to pay taxes. Doesn't seem like a winning strategy.
Would the original 30 stocks in the Dow qualify as kings? Because none of them are in the Dow any longer.
The conversation below I post not because the question is particularly terrible, but because the answers become even worse than the question. Truly a case of the blind leading the blind.
The whole conversation is cringeworthy once you understand a bit about picking stocks. So today, I wanted to explain a few things about stock market investing, the proper way to do it, and WHY that is the proper way to do it. Then I will address a few common “rebuttals” to my arguments.
#1 Professionals Can't Pick Stocks
There are thousands of professionals out there whose job it is to pick stocks. These folks manage mutual funds, pension funds, hedge funds, family offices etc. They have advanced certifications and degrees like MBAs and CFAs. They have dozens of smart people working for them and the most advanced computing resources available on the planet. It turns out that if you actually analyze how good they are at doing the job they purport to be doing, that they are terrible at it.
In reality, their job is gathering assets and charging a fee on them, not outperforming the market. If you think you can hire a pro to outperform the market, you are sadly mistaken. It isn't because these people are stupid. It's because they are so darn smart and there are so many of them. They become the market and their opinions on what market prices should be, dictate the prices at which stocks are bought and sold.
Despite their best efforts, on average these folks underperform the simple approach taken by a well-run, low-cost index fund that just invests in all of the stocks in a given market. This is not a matter of opinion. This is fact. Well-documented fact. Fact that is documented again every year. Take a look at a document SPIVA puts out every year. Here's the edition for 2018.
Spend just a second here and look at what this is saying. It is saying that over a 15 year period (2003-2018), 89% of actively managed funds underperformed the stock market. For any given asset class, that number ranges from 79% to 97%. And this is after only 15 years. Over your investment horizon of 50-60 years, those numbers would be even higher. But wait, there's more. This doesn't even account for survivorship bias. The worst funds close and drop out of the dataset. The winners certainly don't close. So how many of those funds closed over 15 years? Let's take a look:
Over 15 years, 57% of the funds simply disappeared out of the data set. And 60% changed their “style” i.e. gave up on their original goal and started pursuing another one.
It isn't just limited to US stocks either.
Or even just to stocks:
Yes, there are some funds that outperformed a comparable index fund over this time period. But identifying them in advance is just as difficult as choosing the stocks that will outperform the market in the first place. And the outperformance is usually minimal while the underperformance is often dramatic.
To make matters worse, much of the outperformance that does occur is simply due to luck. The question isn't why some people managed to beat the market, but why more of them did not do so. Statistically speaking, random chance should have led to more outperformance than is seen in the data. By the time you can prove a manager is skilled instead of just lucky, that manager has likely already retired.
But wait, there's more. This data only applies inside a retirement account. Once you move into a taxable account, the advantages of an index fund over an actively managed fund become even more substantial. By their very nature index funds have very low turnover and are very tax-efficient. Almost all the dividends are qualified, almost all the distributed capital gains are long term, and very little capital gains are distributed in the first place.
But what about hedge funds, that only the truly wealthy can get into? Do they do better than all of these silly mutual funds for the masses? It turns out they do worse, especially after paying the higher fees!
The pension fund managers aren't much better.
Consider the return for the total stock market index fund over the last 10 years is 16%, almost twice as much as the pension funds. Even the Vanguard Balanced Index Fund (60% stocks, 40% bonds) managed 11.22%.
#2 You Can't Pick Stocks Either
So if the pros, with all the resources they have, cannot do this successfully over the long-term, imagine the hubris it takes for a doctor with no financial training, no staff, and no advanced computing resources to think he can do this in between patients. Pretty co*cky right? When you're buying and selling all those shares of stock, who do you think is on the other side of the trade? You're not trading with Randy down the street. 90%+ of trades are institutional trades. You're trading against pros with far more information and resources at their fingertips.
Now, I'm not saying you cannot beat the market, even in the long-term. It is entirely possible that you are one of those rare possessors of this skill and discipline. But this skill is so rare and so valuable that if you really do have it, it makes no sense whatsoever for you to be doing anything else with your life other than picking stocks for the benefit of hundreds or even thousands of other people.
So, what should you do if you think you may have this skill? Well, the first thing to do is to find out if you are right. How do you do that? You meticulously track your returns (and perhaps even have them audited by an outside firm so you can prove your rare ability to your future investors). Be sure to include all costs including taxes and the value of your time.
If after a couple of years you find out that you are right and that you are at least lucky if not highly skilled, you can open up a hedge or mutual fund and start cashing in on the big bucks. If, like most, you realize within a few months or years that your crystal ball is just as cloudy as everybody else's, then you can quickly abandon the effort before it dooms you to a lifetime of investing underperformance and join the rest of us as index fund investors.
#3 Newsletter Writers Can't Pick Stocks Either
But what about newsletters? Can they pick stocks? Well, the first question you should ask yourself is “If I had this very rare, very valuable ability to predict the future and choose the winning stocks and avoid the losers, what would I do?” By any measure, the answer should be something like:
- Tell no one, leverage up everything you own and can borrow and get very rich, very quickly, or
- Start a mutual or hedge fund, gather billions in assets and charge a percentage of it and get very rich, very quickly.
In no circ*mstance does it make sense to sell a newsletter for $15 a month (or even $500 a month) to other people and share that information, much less give the information away for free.
So, what does that tell you about the ability to pick stocks of those who sell newsletters? That it is all a clever masquerade in order to make a few bucks. Is that what we find when we look at the data? It sure is. Consider this article by Paul Merriman that discusses Mark Hulbert and his life's work — to track the returns of investing newsletters.
Imagine that you're publishing an investment newsletter. How do you attract attention and get people excited enough to subscribe? You certainly don't do that by recommending buying index funds and holding onto them.
Almost by definition, you have to do something different: Something that appears to be “the right thing.” Something that gives your subscribers a reason to think you have something special.
Sometimes that “something special” is a massive amount of data along with a bit of analysis and some predictions….
Other times, the “something special” is a system, either subjective or mechanical, for knowing when to get into and out of the stock market. Timing the market is an enormously appealing idea, and once in a while it works very well. But very few investors do well with this approach over the long haul.
Hulbert tracked a dozen timing newsletters, with returns ranging from 0.1% to 8%. The average was 4.3%. [The market return over this time period was 5.6%-ed] That 0.1% return, by the way, was from the most famous market-timing letter in the industry, Successful Investing, published by Doug Fabian.
All of the returns in that article, of course, do not include the cost of the newsletter, the cost of the trades, or the taxes due from the often frequent trades. Those returns would be even lower.
Don't Look Dumb
So, now you know why you look ignorant if you're talking about picking stocks (or sectors) for yourself, choosing actively managed mutual fund managers, or talking about investing newsletters. You're broadcasting to the better-informed investors out there that you have no idea what the empirical data actually shows about how these investing methods have worked in the past and are likely to work in the future. To make matters worse, you are taking on risks that the index fund investors aren't taking on. You're taking on manager risk (that a manager could retire, die, or lose his touch) and uncompensated risk when picking individual stocks (you will not be compensated for risk that can be diversified away).
Some Objections
Okay, now that we've listed out the basic information every stock investor should be aware of, let's get into the objections that some people still have to just investing in index funds.
Objection #1 – The Market Isn't Efficient
The first objection that usually pops up is data showing that the market isn't perfectly efficient at pricing securities. That's probably a true statement. The issue, of course, is that it doesn't matter. While not perfectly efficient, the market is efficient enough that assuming it is efficient is still the right course of action and the market is getting more efficient all the time.
Objection #2 – I'm Picking Small or Value Stocks
The idea behind this objection is the data out there suggesting that small and value stocks had higher long term returns in the past and there are many good reasons why this trend should continue in the future. Great. So buy a low-cost, broadly diversified small or value or small value index fund. You capture that investing “factor” and if the premium shows up, you will get it without running uncompensated risk or wasting your time following newsletters, monitoring mutual fund managers, or picking your own stocks.
Objection #3 – I'm Small and Agile
This objection relates to a complaint you occasionally hear Warren Buffett talk about. He recommends investors invest in index funds (rather than the stock of his own company) because he feels it would be very difficult for him to outperform the market given how much money he has to invest. His investing fund is just too large so he can only invest in the biggest companies out there. Since those are also the most heavily analyzed, it is tough to get an edge there. In addition, when he buys and sells with that enormous sum of money, he actually moves the market price–the more he buys, the higher the price goes. A mom and pop investor doesn't have this problem, the argument goes.
Well, the issue here is that there is a lot of room between having $5K to invest and having $350 Billion to invest. A typical actively managed mutual fund may only have $100 Million in it or at most a few Billion. Surely you could still manage a lot more money than you have while still being able to invest in small stocks without moving the market so much that it eliminates your advantage. Even if you just managed $500 Million at 1% a year you could still collect $5 Million a year in fees.
Objection #4 – I Only Care About the Dividends
I've written about the follies of dividend investing before. Focusing on income instead of total return is a good way to have a low return despite high income and it is even worse if it causes you to also run the uncompensated risk of individual stock picking. Dividend investing isn't even the best way to get a value tilt. But if, for some crazy reason, you just cannot avoid investing primarily in dividend stocks, at least use a low-cost, broadly-diversified dividend-focused index fund.
Objection #5 – It's Fun or I Find It Interesting
This one often comes up last after you counter all of the other silly arguments that have been used. “But I really enjoy it” or “it's my hobby” or “I just do it with play money.” Well, let's run the numbers here. Let's say you're investing a million bucks and you're underperforming by 2% a year, which would not be uncommon at all. That's $20K. Do you really enjoy this hobby enough to SPEND $20K a year on it? Because you are. And that doesn't even count the opportunity cost (i.e. the value of the time you are spending doing it). Is that REALLY the best way to drop $20K in an attempt to increase your happiness?
Hey, it's your life and your money, but I would encourage you to think long and hard about this one. Even if the gambling aspect of it is what you enjoy, is that really the most fun way to gamble? Those people in Vegas seem to be having a much better time than you are there hunched behind your keyboard while the sun is shining outside.
Sometimes people like to watch CNBC or read the WSJ or get newsletters because they just find all this news about individual businesses super interesting. However, once you realize most of that “investing p*rn” is completely inactionable as far as increasing your investing success, the interest level usually wears off pretty quickly and you turn your attention to something else.
Objective #6 – Low-Cost Active Funds Work
This objection usually comes from fairly advanced investors who have learned that the main reason index funds outperform actively managed funds is because they keep their costs so low. It isn't that these professional stock pickers can't pick stocks better than the market, it's that they can't do it well enough to overcome the costs of doing so. The data is quite clear that the best predictor of future mutual fund returns is a low expense ratio, after all. So these folks say, “Well, if I just limit myself to choosing from actively managed funds with very low costs, perhaps I can outperform index funds.” Certainly, their chances are better. Vanguard, the low-cost mutual fund powerhouse, boasts that
For the 10-year period ended December 31, 2018, 9 of 9 Vanguard money market funds, 41 of 60 Vanguard bond funds, 20 of 23 Vanguard balanced funds, and 129 of 146 Vanguard stock funds—for a total of 199 of 238 Vanguard funds—outperformed their Lipper peer-group averages.
While that is an enviable record, keep in mind two things. First, 39/238 funds underperformed, that's a 16% chance of picking a real loser that an index fund investor doesn't have to run. Second, Vanguard is comparing their funds to the AVERAGE fund. Remember that according to that SPIVA data, the typical index fund outperforms 85% of funds in their category, not 50%. If you actually compare Vanguard funds to the relevant index fund, things don't look quite so good at all. Consider their Large Cap Value funds for instance:
Three of these are low-cost actively managed funds. The fourth is an index fund. Guess which one outperformed over the last 1, 5, and 10 years?
How about Large Cap Blend?
Of the 8 surviving funds for which we have 10-year data, 5 are actively managed and 3 are index funds. The index funds rank 3rd, 4th, and 5th among those eight funds. You had a 40% chance of picking a winner and a 60% chance of picking a loser. The 5-year data makes the case even more strongly–only 1 of 6 actively managed funds managed to beat the index funds, and that fund isn't even open to investors.
Yes, if you're going to attempt to pick actively managed funds, a major factor should be the cost of the fund. But I wouldn't recommend the practice.
Objection #7 – I'm Smarter or Work Harder
While I suppose it is entirely possible that you may be smarter or work harder than a mutual/hedge/pension fund management team, the question you should be asking yourself is whether that is really the best use of your time. Let's say by applying your smarts and hard work to your portfolio that you can boost the returns on your $1 Million portfolio by 1% per year. That works out to be an extra $10,000. I don't know exactly what that will work out to be on an hourly rate for you, but the likelihood that this is the best place to spend extra time and effort as a physician seems very low to me. I can think of three ways that are likely to have a higher return for your time and effort:
#1 Work More in or on Your Practice
Most docs make $100-300 an hour. $10,000/$300 = 33 hours. For less than one additional hour a week of work, you could generate more of a return on your time.
#2 Put Your Effort into a Less-Efficient Market
Looking for an inefficient market where your efforts can make a real difference in the performance of your investment? Look out your front window. Becoming an expert in your local real estate market is far more likely to generate a higher return on your time and effort than pouring over company reports and bouncing ideas off of others on the internet.
#3 Start a Small Business or Side Gig
This one has worked out particularly well for me, although many docs would be better off just working an extra shift, taking an extra call or extending office hours a bit. Certainly, it is a better idea than trying to beat Wall Street at its own game.
I hope that helps you to understand the best way to invest in publicly traded stocks (low-cost, broadly-diversified index funds) and why people are snickering in the background when you start talking about your newsletters, actively managed mutual funds, and random stock trades.
What do you think? Why are there so many investors who have not yet figured this out? Why do mom-and-pop investors persist in individual stock picking? Comment below!
