Latest posts by Wanderer (see all)
- Investment Workshop 50: Goodbye TD Ameritrade, Hello Vanguard! - November 15, 2017
- The Three Paths to Financial Independence - November 13, 2017
- Investment Workshop 49: Expat Insurance - November 8, 2017
The Stock Market.
We hear about it nearly every day. The Dow dropped 110 points! The S&P 500 shot up 20 points! People seem to be getting rich off the stock market, but when I try to invest all that happens is my stock picks go into the crapper! How is that possible? What is going on?
Well, as someone who managed to retire in his 30’s because of the stock market, I have some insight into this. It’s actually quite simple, and it’s something you already suspected, which I’m about to blow the lid off.
You ready for this?
The Stock Market is rigged.
Sorry, let me qualify that.
In the short term, the Stock Market is rigged.
That is an important distinction, and I’ll get to why later, but first let me explain how most people deal with the stock market and why it doesn’t work.
Most people when they think about “stock picking” they are combing through a newspaper or their eTrade account and hunting for “winners.” And this process of hunting for winners typically involves reading CNN Money, picking up hot stock tips from your idiot co-worker, and outright guessing.
I myself gave this a shot back in the day, but with fake money in online stock picking contests. And out of 10 stocks, maybe one would shoot up but on average, my pretend “portfolio” would just keep grinding lower and lower.
Here’s why this doesn’t work.
Legendary investor Benjamin Graham described the stock market like so:
In the short run, the market is a voting machine, but in the long run, it is a weighing machine.
He said this because the market is basically millions of people pushing individual stock prices up and down with their buys and sells, like up-votes and down-votes in a Reddit thread. When investors believe a stock is actually worth more than its current listing price, they buy. When they believe it’s worth less, they sell. The idea is that this will eventually cause a stock’s price to settle to somewhere around it’s “real” value.
The problem is, it didn’t take long for Wall Street to realize that unsophisticated retail investors (i.e. us) are easily manipulated, and they soon figured out ways to exploit that. They’d find ways of getting access to news stories before they go public, or worse, completely fabricate stories themselves by leaking fake crap to the press, then get into positions that make them money as the retail investors (us) flood in, then use options or short selling to make money as the stock plummets when everyone discovers the stories were all hot air. They rig the market by manufacturing volatility, then profiting off that volatility.
I know this happens because I saw it first-hand.
Right around the time I left my job, my company was acquired by a major semiconductor giant. And in the months leading up to the buyout, rumours were flying around the press like crazy. Every day, a new piece on Motley Fool or Forbes would report some “inside source” claiming that talks had broken down, then resumed again, that our CEO was demanding some exorbitant amount, that their CEO was overhead saying he wanted to scuttle the deal.
And after the acquisition happened and the dust settled, we learned that all that drama was completely made up. Someone was leaking news to the press about all this boardroom cloak-and-dagger crap to make the stock price swing up and down. And it totally worked. Our stock price, who historically had just sat in one place for the last 5 years, was swinging up and down 10% per day by panicky traders who were trying to outguess each other. Whoever leaked that news made a killing, I’m sure.
So if the stock market is a minefield of danger, then how the Heck are we supposed to invest safely?
For me, success in investing only came when I realized one simple truth:
I don’t know how to beat the market
In fact, there’s plenty of evidence out there that almost NOBODY can beat the market. Not consistently, anyway. Oh sure, people can get lucky for a year or two, but the people who can do it consistently are so rare that they’re practically unicorns (I’m talking less than 1% of fund managers). So knowing that, it would be incredibly arrogant of me, an unsophisticated retail investor, to think that I was somehow one of those unicorns.
So knowing that I don’t know how to pick winning stocks, what do I do instead? Simple. I just buy ALL stocks.
Index Investing is the strategy of not even trying to beat the market, but to simply match market returns by buying the entire market. It’s a strategy that anyone can do, and is endorsed by none other than Warren Buffett himself, who famously advised his heirs to put his estate into index funds after he was gone.
Let’s break down why we should all follow Warren’s advice.
Reason #1: It Works
While some businesses rise and some businesses fall, all businesses in the country, as a whole, make money. If you look out your window, there are clearly more houses, more roads, more business and more buildings now than there were 25 years ago. That’s because while individual humans may get rich or go broke, humanity as a whole marches forward.
This, however, does NOT mean that if you just plunk money into the S & P 500 it will go straight up. As we’ve seen, the index does have negative years. However, when held over sufficiently long periods of time (i.e. 15 years or longer), it is impossible to lose money. In fact, the median annualized performance of the S & P 500 over 15 years is 12.2%! I’ll take that kind of performance any day.
Reason #2: It’s Simple
The finance world is rife with people selling complicated schemes, using options or collateralized debt or whatever in an effort to confuse you and rip you off. But making money in the stock market is not complicated. In fact, the more complicated the product, the more likely it’s terrible. But Index Investing is simply based on the fact that businesses make money as a whole, and will continue to make money as a whole. That’s a concept that an 8 year old can understand, and that’s why it works.
Reason #3: It’s Cheap
Active trading is expensive. Every transaction costs money, you have to pay the guy managing it, you have to pay for fancy ads, and office space. Besides, all that cocaine and hookers Wall Street goes through? That shit ain’t free.
Because there’s no fund manager who has to pick stocks behind the scenes, Index Funds and Index ETFs have ridiculously low fees. The average Management Expense Ratio, or MER, of an actively-traded equity mutual fund is north of 2%. An Index ETF that tracks the S & P 500? 0.1%
Reason #4: It’s Impossible To Go Bust
The number one fear of everyone that invests is losing all their money. And if you pick individual stocks, it is absolutely possible to lose your shirt if all your picks go bankrupt. However, because Index Investing buys the entire market, the only way for it go to zero is if ALL businesses cease to exist. And if that happens, the aliens have already invaded and blown us all to smithereens, so who cares what your portfolio looks like?
Reason #5: The Banks Don’t Want You To Do This
Which brings us to the final, and most convincing reason to use Index Investing.
Here’s an exercise: Walk into any bank, ask to speak to an Investment “Advisor” and tell them you want to put all your money in low-cost Index funds. Now watch with amusement as they try every salesman-y trick in the book to try to talk you out of it.
Why are they doing this? Because the banks don’t make any money from Index Funds. They can’t churn your accounts, they can’t lock your investment in for arbitrary amounts of time, they can’t even justify hiring an expensive money guy to run it! Instead, they want to put you into shitty actively managed mutual funds that charge over 2% for lagging the market, and then collect their fat commissions for doing a crappy job.
In fact, I’ve heard some Wall Street people grumble about “those damn Indexers.” Why? Because those analysts and traders spend all day trying to price and re-price individual stocks, which causes the index to rise and fall. And over time, if they do their job correctly, the index will rise because the index is getting re-priced to reflect the fact that businesses make money and are therefore worth more.
So from their perspective, they see Index Investors as stealing their hard work, benefiting from all the time and effort that goes into analyzing every company on the stock market, while not paying them a single cent.
So basically, every time you buy an Index Fund, you are stealing from Wall Street.
And if that’s not a good reason to invest using Index Funds, then I don’t know what is.
Read the next article in this series: How to Build a Portfolio