A low-cost index fund is the most sensible equity investment for the great majority of investors. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals. –WARREN BUFFETT, LEGENDARY INVESTOR
BLUF: For the best gains, follow the market (with index funds) vs. trying to beat the market. No one can time the market, and 88% of active fund managers fail to beat the market average. Instead, consistently invest in index funds early and often for the best gains.
We learn a lot of lessons throughout our lives that serve us well in most situations. However, much of this wisdom simply does not work when investing. If you try to use the same mindset that you use in the rest of your life when investing, you will lose money. Instead, you must push against some of your most ingrained tendencies to avoid major mistakes.
In the “The Bogleheads’ Guide to Investing,” the authors cover several ways that investing is very different from life. One way that resonated with me was that, in life, it is always best to not settle for average, and to always strive to be the best. However, this can be a losing strategy in investing, especially when you try to beat the market.
For most of us, trying to beat the market (especially over the long term) is a recipe for disaster. This is because:
- No one can time the market (especially long term)
- Past performance hold no bearing on future performance
- Investments with higher returns usually have much higher risks.
No One Can Predict the Market!
Despite thousands of articles that promise to show “five hot stocks to beat the market,” these sites do not have the clairvoyance needed to predict the future. No one does. Though their technical analysis seems compelling, they are just listing stocks that performed well in the past. However, just because a stock did well last month it doesn’t mean it will do well next month.
In Dr. Burton Malkiel’s foundational book, “A Random Walk Down Wall Street,” he outlines his well-researched theory that the performance of the stock market is a “random walk”. In short, each day’s performance of the stock market is random, and not at all determined by the past. This is because the infinite number of things that can affect stock prices cannot be predicted. A company’s CEO could be fired tomorrow, or they could be bought by a larger company, etc. Without being able to tell the future, you cannot predict the future price of any stock.
Furthermore, over 88% of all actively managed funds failed to beat the market over the last 15 years. These are funds led by financial professionals, and still they were unable to outperform a simple passive investment strategy. Most individual investors tend to fare even worse, especially when they follow investing advice that comes from the “five hot stock” articles in their news feed vs. an analysis of the financial assets and revenue of a company.
Invest in Low-Cost Index Funds Instead
Instead of trying to beat the market, you can follow the market by investing in no-load, low-cost total market index funds. These funds buy a balanced amount of the whole stock market, allowing you to earn the returns enjoyed by the whole market. Historically, this has stood at ~7% per year over the long term. A 7% compounding return roughly doubles your money every decade. Better yet, these index funds are diversified, protecting them from taking the same kinds of massive losses possible from buying single stocks.
“I think a lot of people are trying to get clever and time the market. The reality is, it’s time in the market, not timing the market.” Bank of America Vice Chairman, Keith Banks
With this in mind, it is most important to invest early. Time in the market is more important than timing the market. If you have a long time before you are retiring, you should be investing early and often. If you haven’t already, start by investing automatically every month. If you are still in the military, make sure you are investing part of your paycheck into TSP every month (follow the instructions in Step 3 in this post) and/or into a Roth IRA. If you are using a Roth IRA, buy no-load, low-cost index funds.
The trick is to continue to buy and hold index funds every month… even if the market is down. When the market is down, stocks go on sale. When the market is up, your investments grow in value. Either way, you have to dedicate yourself to saving and investing in your future wealth. If you build a solid investment plan and then stick to it, you are preparing to win over the long term.
Value Investing:
Note: Ok, so there are some investors who have beaten the market average over the long term (like Warren Buffett) through value investing. Value investing involves buying companies’ stock whose price is much lower than it should be based on their revenue and assets, and then buying and holding them over the long term. However, this takes serious research and a little luck, and is a riskier plan than passive investing (as you are buying individual stocks that could possibly lose their entire value).
Value investors – like everyone else – cannot time the market. However, they give themselves a “buffer” to make it easier to gain a profit (i.e. by buying stocks priced at half of what they should be based on revenue/assets).
If you are interested in learning value investing, I’d recommend reading the following books:
- “Invested,” by Danielle Towns (a lightweight book for beginners to learn value investing)
- “The Intelligent Investor,” by Ben Graham (the basis of value investing, by Warren Buffett’s mentor)
- Anything written or said by Warren Buffet or his investing partner, Charlie Munger
For now, I have decided that I do not want to spend my time reading the financial reports of companies, so I do not currently practice value investing. However, for those who carefully research and buy stocks with high upside, there is opportunity to build wealth.