Even if you’re an expert, the game is rigged
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MOST people are aware that investing is the only road to wealth. MOST people don’t trust financial institutions. MOST people don’t know how to effectively pick stocks. The intersection of these 3 dynamics should convene around nearly everyone doing the following:
Managing their own finances
Dollar cost averaging (investing at regular intervals to normalize against large unpredictable price fluctuations)
Investing in passive low-cost index funds
Not buying shares of individual companies (especially the company they work for)
While these concepts have gained in popularity, low levels of financial literacy combined with influence by the financial media to make you feel ill-equipped for personal finance has resulted in a significant share of investors who use the exact opposite tactics:
Leveraging a financial advisor
Timing the market
Investing in actively managed funds with high operational costs
Buying shares of individual companies (including the company they work for)
This isn’t necessarily to say that the first set of concepts is always good or the second set of concepts is always bad, but I’m certain if more people educated themselves on the market and its middlemen that they would shift from the latter to the former.
In paying especially close attention to my own financial hygiene over the past few years, here are some of the most important ideas that completely changed my investing mindset to feel in control of my future…
Individual stocks don’t always go up, but the aggregate market of stocks does
People think the stock market is risky. It’s not. Their own behavior of dancing in and out of the stock market is what’s risky. If you take that behavior out of your strategy and simply invest in the market at large, you have effectively removed long-term risk from the equation. For younger investors who came into adulthood during the economic crisis (myself included), it has taken some convincing and a bit of a history lesson to prove this out…
On average on a daily basis, the total stock market goes up a little more than half the time. That’s basically a coin flip on any given day as to whether the market goes up or down. Extend the time horizon, however, and the market ALWAYS goes up. The good companies hang around and the bad companies get replaced. Over the past century, annually the market has gone up about three quarters of the time. Over 10 year periods it has gone up nearly every time, and over 20 year periods it has never gone down (including any 20 year period in or around the Great Depression). With even a modest level of invested capital, it would be impossible not to build substantial wealth in that landscape if you just had the discipline to buy and hold the market.
Speculating vs Investing
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When you own an individual stock, you’re always thinking about when to sell it. If it jumps 5%, maybe shave a little off the top. If it has had a solid year but you’ve lost confidence in it, maybe you dump your entire position to lock in the gains. Or maybe your favorite CNBC show highlighted an ominous trend behind your stock’s 50 day and 200 day moving averages so you get a little trigger happy and unload. This way of thinking isn’t necessarily a fatal flaw, but it’s NOT investing. It’s speculating. Speculation of price movement in one direction or another influences your buying and selling, even when that price is more directly influenced by other investors’ behavior than by the underlying performance of the company.
Investing, by contrast, has a MUCH longer view and a MUCH greater link to the actual health and success of the companies you are buying shares of. Daily fluctuations in the price are no more relevant to an investor than daily fluctuations in the weather. The Intelligent Investor by Benjamin Graham, one of the most influential investing texts ever written, covers this psychological difference at great length. The original book was written in 1949, yet the principles remain surprisingly current, validating the longevity of its perspective through any and all market conditions. Recent editions also provide updated commentary to make it a bit more “contemporary”. It’s the best thing I’ve read to rewire my thinking to control what I can control, and to enact discipline in the face of uncertainty.
It’s the speculators who pick up Uncle Sam’s tab
Even if you’ve had some success picking stocks, Uncle Sam gets his cut when you sell. Sure if you hold the asset for a year, you can reduce that tax from income to capital gains, but that’s still 15% (or higher if you make a certain level of income).
When you invest for the long haul, you likely don’t plan to sell until you stop working, and therefore have no (or minimal) income. This is important because when you find yourself in the lowest income tax bracket, the capital gains tax is ZERO. Your assets can compound until you need them (i.e. retire) and therefore can entirely avoid taxes at the federal level (or even the state level in certain states). So what exactly does that have to do with individual stocks vs index funds? Deciding the timing of selling your investments in accordance with your lifestyle and time horizon is MUCH easier when investing in the aggregate market than when speculating against a single stock and its underlying financials. It puts you in control without a single company having the power to force your hand when you’re not ready.
The tax benefits to true investors are a huge reason behind the growing wealth disparity we see in the US. This isn’t to argue for or against that effect, simply to acknowledge one of its root causes. As an example, if you have reached the point of retirement with a nest egg of $10 million (shoot for the stars, right?), a 7% return would generate $700k in growth for the year. If you’re working income is zero, there is minimal tax to pay on an this absurd amount of cash flow.
The IRS goes after income, not wealth.
We can lobby all we want for the rich to pay their fair share in taxes, but increasing the highest income tax bracket still keeps the wealthiest among us bulletproof. While this might be somewhat depressing to the other 99.9% of us, we can still stack our chips accordingly through the same long-term investing tactics to elevate our own lives. I’d rather deploy those tactics to invest in the entire market than to simply buy some Amazon stock.
The house always wins
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Individual stocks usually mean frequent trading. Frequent trading doesn’t make you rich — it makes your broker rich. Period.
Equity in the company writing your checks
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In many industries, particularly tech, a substantial piece of compensation may be in the form of equity. For a public company, this is likely restricted stock units (RSUs) vesting after the 1st year of employment and quarterly thereafter. The concept is sound, incentivizing a vested interest in the outlook of the company into an individual’s own reward system. It also benefits the company from an accounting standpoint.
While equity compensation is fundamentally a good idea, what employees often tend to do with this reward is misguided and unnecessarily risky. There’s often the thought that hanging on to the stock for a year or two, or even more, could have massive rewards. While that’s certainly possible, you can continue to benefit from any increased share price by selling all shares at each subsequent vesting period. Alternatively, if you hold the shares in hopes of appreciation only to see the value drop, it stings you on both your past vestings and your future vestings.
In addition to putting too many eggs in one basket, most tech stocks don’t issue dividends since their price relative to earnings is often extremely high, putting pressure to invest in growth rather than distribute profits to shareholders. Putting those dollars in dividend yielding index funds instead of waiting for your company’s stock to pop provides an additional advantage over time.
Another often overlooked risk of investing in your own company is bias. You may be aware of certain product releases or market expansions your company has planned, which may seem like “can’t miss” opportunities for future growth. Chances are the potential growth associated with those events are already baked into the current share price, especially for companies that have a lot of external hype surrounding them.
Investors aren’t just hoping for growth, they expect it, and the market prices that in more than a novice investor may realize.
The solution for the employee is to sell all (or most) vested shares and reinvest the proceeds into passive index funds tracking the performance of the entire market. If your company then skyrockets in value, don’t feel like you missed out — you captured a piece of that growth in your index fund anyway. If your company tanks, eventually it will make its way out of your index fund entirely.
Understanding the Buffett bet
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Warren Buffett publicly made a bet with a hedge fund manager that he could outperform the returns of a collection of hedge funds by simply investing in a passive index fund tracking the S&P 500 over a 10 year period. The bet ended at the end of 2017, and the results weren’t close — the index fund outperformed the hedge fund in compounded annual returns at 7.1% to 2.2%, respectively. Those of us who have been privy to index funds for a while perhaps were not surprised by this as there have been countless studies on the underperformance of actively managed funds. However, the exposure that this bet received around the investing community was huge and may have considerable influence.
If the greatest investor in the history of the world was endorsing (and proving) a strategy that anyone with a laptop and an Internet connection could deploy, this can have a seismic impact on 1) how the next generation of investors invest, 2) reducing the fear of getting started at an early age and taking full advantage of compound growth, and 3) improving the alarmingly low levels of financial literacy that keeps millions of people in self-imposed financial handcuffs for their entire lives.
How do we know the future of the markets will be as reliably positive as the past? We don’t. There are all kinds of doubts tied to international trade tariffs, volatile and divisive dynamics in Washington (even if you support the current administration you have to admit the uncertainty it creates is pretty unprecedented), and the fact that we are approaching an historically long bull market which many feel is a precursor to another crash. All these things can result in temporary decline, but the strategy that favors the long game will always win.
As a final word, a thought that resonated with me from Warren Buffett on market optimism in the face of chaos involves the impact of gender equality on investing. The markets did amazing things over a 50 year period with half its population on the sidelines. Buffett’s point of view is that with our sisters, daughters, mothers, aunts, and all of the other women in our lives now increasingly growing the global economy and having more influence in the markets, it will outweigh any geo-political risk that can erode its returns. The upside is uncapped and that’s as strong a buy as there is to ride the wave.
Originally published at chooseyourchaos.com on July 23, 2018.