So you think you can beat the market? The chart below is a bit old but it makes the point I want to convey. Look at the average annualized return of the average investor on the far right. The average investor averaged a 2.1% return over the time period indicated. Just putting your money in a S&P index fund would have led to almost a 6% better return.
Average Investor Does Not Beat Index
When I first began “investing” I had similar poor returns. There were many years I lost money even though the overall market was up! I finally sat down and thought deeply about how I was going about investing.
I went through my old brokerage statements and analyzed why I had bought certain stocks. I looked at the stocks I bought and why I had sold them. In most cases I could not recall any rationale or reason why I had purchased many of these stocks.
Investing or Gambling?
In many cases I had not even held the shares of certain company shares for six months and holdings for others was even less. I than realized that I was not investing I was gambling (some people call it trading).
Everybody knows that most gamblers in the end lose money. The only reason I had made any money at all was because I had just gotten lucky. I would have been better off just dollar cost averaging into a low cost passive S&P fund index fund.
One reason people like to gamble in casinos is because it is exciting. It is a scientific fact that when gambling you get dopamine releases into the pleasure centers of your brain. These releases of dopamine make you feel good and relieve anxiety, at least until you are driving home from the casino with no money.
Gambling Is Fun, Investing Not So Much
This Scientific American article talks about the similarities between gambling compulsions and drug addiction. I think that for many so called small investors this is why they like to dabble in the market.
For the average person who is not committed to undertaking the craft of investing, and it is a craft, than dollar cost averaging into a low cost index fund is your best bet. However, lots of people simply will not do it. The reason is that they like to gamble and like the action in the market. Dollar cost averaging into an index fund is boring and there is no dopamine release.
There are people out there, I was one of them, that like the action of finding a hot new biotech company that is proclaiming the next cure for cancer or Alzheimer’s disease and then being able to dump a few grand into the stock.
Follow The Herd
We base the decision to buy the hot biotech stock on something we heard on CNBC or something we read on a stock message board only to find that the stock drops 50% or more over the next several months. To compound the mistake we just let the loss fossilize in our brokerage account hoping the stock price comes back to where we bought it so we can get out even. Did you ever notice that for the most part the price never comes back?
Do you think that successful world class investors like Warren Buffett operate this way? In case you are confused they do not operate this way.
For most people investing in the stock market should be done over long periods of time via passive investing and dollar cost averaging into index funds with low operating expenses i.e. Vanguard Funds. Following that principle allows the power of compounding to work over a long period of time. It will not be exciting but it will make you money.
Investing Successfully Is Hard
Investing successfully is not easy. Many people are very good doctors, lawyers, carpenters, chefs or whatever their current trade happens to be. That means they sometimes think that they can be good at other things that are outside their sphere of expertise. In some cases this is true. With respect to investing it is mostly not true.
If you must get your gambling craving in the stock market than my advice would be to segregate 90% of your money into long term low cost index funds. That way you can take advantage of dollar cost averaging and compounding and build a nice nest egg over time. Take 10% of your money and open a separate brokerage account for your individual stock purchases so you can fulfill your desire to gamble (trade) in the market.
If you are insistent on investing in the stock market yourself and think you can beat the market than here is some more bad news. Most people simply do not have the time to hone their skills to a sufficient degree in order to be successful in the market.
Successful Investors Are Rare
You are competing with people that, in many cases, have billions of dollars under management. These people have the ability to hire the best and brightest accountants, computer scientists, analysts, lawyers and any other professionals they need to find an edge in the market. They spend millions per year in research and all day everyday thinking about and analyzing the market.
How many of you reading this article know how to read a company balance sheet? What is a 10-K and where do you find it? What is ROE, ROI, price to book, P/E, EV, debt to equity, and I could go on. If you cannot identify what these are or what they mean how can you properly analyze the prospects of a business to understand if the stock is a good investment or not. Are you just trusting your gut? Did Jim Cramer just say buy, buy, buy and so you did?
You think that after working forty hours a week at your job, spending time with your family, doing household chores, and having some time to yourself you will somehow have enough time to find an edge over these professional investors? I am sorry to inform you that it will more than likely not happen.
The third reason that most people are not successful investors is because they do not have the psychological makeup to be successful in the markets. There are many studies that show that average investors are notorious for buying at the tops of markets and selling at the lows. If you are doing this than you will not be successful.
Groupthink Holds You Back
The reason why people do this is easily explained due to psychology. We are hard wired in our chimpanzee brains to be group thinkers. This was a necessary trait when we were hunter gatherers ten thousand years ago trying to take down a woolly mammoth or seeking protection from saber tooth tigers.
The group provided security and sustenance. Individuals and lone wolfs simply would not survive. However, what was true then is not applicable to being successful in the markets today.
People buy at the tops of markets because the media is saying how great the economy is and how earnings for companies are at record highs. It is unicorns and rainbows as far as the eye can see. Because they really do not know what they are doing they seek affirmation from their peers, the media, family, and friends.
They go to Thanksgiving dinner and their goofy brother in law is bragging about that hot cyber security stock he owns that went up 300%. The group mindset fear of missing out (FOMO) is setting in and begins to justify buying stocks when they are fully valued or worse overvalued.
Groupthink and the validation of the group allows people to delude themselves into buying overvalued markets. And hey I am smarter than that dopey brother in law of mine so if he can make money in stocks I know I can. Let me pull out my phone and buy some stock.
Unrealistic Expectations
One mindset issue that holds people back from being successful investors is not setting realistic expectations on returns. I answer questions on investing on Quara. I get so many questions asking things like, “How can I turn $10,000 into $1,000,000 in a year?” or “Give me a stock that will go up 100% in a year”. Now I understand that people that do not know anything about investing ask these type of questions. However, the get rich mindset guarantees that the person asking these questions is going to be disappointed in the results they get when investing.
This incorrect thinking about investing will lead to the person taking outsized risks that ensure that they will eventually suffer huge losses. This will then sour the person on investing and deprive the person of a huge opportunity if only they had approached things in rational and well thought out manner.
How Top Investors Beat The Market
Many successful investors follow the maxim that the return they expect to achieve in an investment is primarily based on the price they pay for a stock. This is the contrarian mindset that I follow and it is the main reason why I have been successful in the markets.
However it is difficult to be a contrarian and buy at the lows. Back in 2008 during the Great Financial Crisis when the news media was saying the economy was collapsing, people were losing their homes and jobs, and the market was down huge were you buying stocks? Of course not, but Warren Buffet was buying. The S&P bottomed at 666 and nine years later it is trading at close to 2600.
Average Investor Now Playing His Part Again At The Top
The market has went from extremely undervalued to extreme overvalue. In fact the market has only been this overvalued two time before 1929 and 2000. These two times were right before the great stock market crash that preceded the Great Depression and the Tech bubble. Of course guess what the average investor is doing, they are pouring into the stock market at a time of historic overvaluation.
I am not saying that the market cannot get more overvalued. I actually believe that it will get even more overvalued and that it will suck in every last dumb dollar from individual investors. What I can predict with certainty is that at these levels of overvaluation history strongly suggests that most individual investors will not achieve returns that they think they will over the next five to ten years.
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