Why do we invest? Most of us need to invest in order to fulfill our financial and retirement goals. By taking risks in capital markets, we expect a return on our investment that will at least outpace inflation, which determines how much the purchasing power of our wealth will erode over time. Although investing means taking risks, due to inflation, not investing means taking risks also.
Unfortunately, most investors still don’t know which actions can help their odds of investment success. There is just too much noise and nonsense out there intended to confuse, scare, and nudge us into making the wrong decisions.
For example, when you tune in to any financial news channel, you are persuaded with sensationalized market information. The flashing visuals about stock price movements, the conveyor belt of talking heads, and the broadcasts from the chaotic, noisy floors of the exchanges enforce viewers’ anxiety about being left out of the game. It seems that every day is full of opportunities for making profits and avoiding losses. Indeed, the financial news media wants you to think that you need their understanding. Otherwise, why would you watch? And the more confusing investing in the markets seems, the more you are willing to pay the experts for their advice.
Here’s something fundamental to keep in mind. Market-timing, stock-picking, and other conventional strategies that rely on forecasting to beat the markets are cost-generating gimmicks. If this sounds counterintuitive, it’s because you’ve been taught for so long that, to succeed, you need to outwit or outguess the markets. What if instead there are decades of data, peer-reviewed research, and real-world evidence that overwhelmingly declare forecasting to be extremely difficult? Well, that happens to exactly be the case, and it’s what academics and professionals have known for a very long time.
In 1933, Aldred Cowles III published in the journal Econometrica a paper entitled Can Stock Market Forecasters Forecast? He found that the financial institutions produced returns that were 1.20% worse a year than the DJIA; and the media forecasters trailed the index by a massive 4% a year. We can even go back further to 1900, when the French mathematician Louis Bachelier, in his PhD thesis The Theory of Speculation, demonstrated that security prices move in such a random fashion that “the mathematical expectation of a speculator is zero” (3).
John Bogle, founder of Vanguard, knew that fees chewed up returns and that most investment managers underperformed the market. In 1976, he introduced the first index fund, the Vanguard 500 Index Fund, which instead of trying to beat the market, simply matched the market (in this case, the S&P 500 index). It didn’t require much overhead, there was no active manager, and he kept the fees to a minimum, far lower than the rest of the industry. When he recently died on January 16, 2019, investors who stuck with his philosophy by investing in the first index fund have had a total return of 8559% (4). Warren Buffet once said, “If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle” (5). To this day, Vanguard’s low management fee index funds continue to be among the best options for all investors.
There happens to be a simple, yet powerful idea that helps explains why forecasting is difficult. An idea that should convince you to embrace the markets, rather than trying to beat or outwit them.
Think of the markets as an efficient information-processing machine. Millions of participants quickly and fully incorporate all news, information, and expectations into security prices. It doesn’t mean that prices are always right, it just means that prices are fair, the best estimate for what a security value should be at any one time. Millions of participants can better estimate the fair value of a security than can an individual.
This theory that asset prices fully reflect all available information is referred to as The Efficient Market Hypothesis. It was developed in the 60s by Eugene Fama, economist and Professor of Finance at the University of Chicago Booth School of Business. He won the Nobel Prize in 2013.
If markets are efficient, then the only way to predict what tomorrow will bring is to know tomorrow’s news. It’s the news that will drive securities prices tomorrow. Just like today’s news and information are driving security prices today. If news, by definition, is information not previously known, how do you predict it? Well, you need a crystal ball or some magical powers.
Brokers and advisors sometimes try to persuade you that their technical analysis is akin to having a crystal ball. Unfortunately, charts tell you nothing about the future. As a trader I was a technical analysis expert and had multiple screens devoted to more than 30 charts. Yet I was good at trading because I could swing trade around market volatility, not because I knew where the markets were headed. And, that happens to be the case for every successful trader that I’ve met. Of course, even the most mindless of technical analyses will work sometimes and maybe even for a short while due to sheer luck. For example, the most basic are moving averages and mean reversion, which also happen to be very popular with brokers/advisors. You might as well pick your next stock by throwing a dart at a board.
If not with technical analysis, then what about relying on fundamentals to make investment decisions? Because markets are so efficient, fundamentals are already priced in, and so are expectations about the fundamentals. Notice how quickly the markets react to the latest economic indicators as soon as they are released (like GDP, the unemployment figures, and the fed funds rate announcement). And, many times even a good result can lead to a break in the markets because the outcome wasn’t as good as what the market participants expected. Unfortunately, fundamentals turn out to be useless indicators for market predictions as well.
So, the next time that your advisor tries to impress you with a chart or a spiel about market conditions to explain the basis for their trading advice, ask them if they have a crystal ball. Without one, how do they know what tomorrow will bring? Tomorrow’s news and information is what will drive the markets tomorrow, not what happened today or yesterday. Without a crystal ball, your advisor is simply guessing in order to justify his/her fees and commissions while you take all of the risk.
And just keep this in mind as well. Professional traders hire the best programmers, use the latest in technology, develop powerful automated strategies, and compete in the milli- and microsecond high-frequency space. By some estimates, even >90% of these professional traders don’t make it. What makes you so sure that it is your broker/advisor who just so happens to have that special talent to not only outwit the professional traders in the short run, but also consistently beat the markets over longer time frames?
Well, what about paying a premium for access to supposed talent and better overall returns? The only thing that high fees guarantee is that more wealth will trickle up from your account to the pockets of your broker/advisor. Remember that no one has a crystal ball or magical powers. Don’t pay for gimmicks and proven myths. And research has actually shown that globally diversified portfolios of low management fee index funds have in the long run outperformed conventional, speculative strategies and the latest fads.
Be wary of commissions, sales loads, high expense ratios, unreasonable AUM fees, frequent trading or high portfolio turnover, account maintenance fees, operating expenses, 12B-1 fees, and other fees, some of which may even be hidden. Minimizing your costs should be one of your main goals. It’s one of the few things that you can control when you invest.
If the financial industry continues to be entrenched with high costs and speculation gimmicks, is there good news in any of this? Actually, there is awesome news for every investor, regardless of age, income, wealth, or investment experience!
All you have to do is shift your focus to the longer term (invest, rather than speculate), embrace the markets (let them work for you, rather then trying to beat or outwit them), and minimize costs (keep more of your returns). You’ll no longer have to be anxious or confused about the current financial headlines. You won’t need to stress about chasing performance. And, you’ll avoid paying a broker/advisor a premium for their supposed trading skill (since the overwhelming likelihood is that they don’t have any). The best part is that these actions help improve your odds of investment success.
First, start with an investment plan. At the very least, this plan should define your portfolio asset allocation. For example, if volatility makes you nervous, then you may be better off with more bonds than stocks. On the other hand, if you are relatively young and don’t pay attention to the market dips and swings, then consider tilting your portfolio to mostly stocks. Only if you are comfortable with your portfolio risk exposure will you likely to stay in your seat during market turmoil. The capital markets have rewarded disciplined, long term investors.
Second, diversify your portfolio. When you invest only in one stock, you are exposed to the uncompensated, unsystematic risk of that security. By investing in 100, 1000, or even 10,000 securities, you minimize the risks that have no expected returns. Diversification is the only free lunch when it comes to investing.
But diversifying only within your home market may not be enough–the US equity market rarely outperforms other developed markets. Instead, global diversification can broaden your investment opportunity set. By holding a globally diversified portfolio, you’ll be well positioned to seek returns wherever they occur.
Third, rely on index funds. Index funds not only help you diversify, but they also minimize costs. Some index funds even have expense ratios that are close to 0%.
Now, you may have heard that index funds are boring and average. Well, yes, investing with index funds is indeed boring. Fortunately for you, boring is very good, it’s what will help you succeed in the long run. You should actually look for boring when investing. If you want exciting, take your money to Vegas.
What about indexing being average? Well, there are still many myths about index investing that are meant to confuse you, because as more investors continue to flock toward index funds, the less profitable big brokerage firms and your broker/advisor will be. Long-term, disciplined investors who rely on low management fee index funds have done better than most of their peers and the professionals. It’s anything but average.
Finally, if you need an advisor (even if it is someone to simply help you determine your risk tolerance), seek out a reputable fee-only fiduciary. Fiduciary advisors must work only in your best interest. This is in stark contrast to the “suitability” standard by which most broker/advisors operate. “Suitability” is broad and open to interpretation. Good luck proving harm by a broker/advisor who sold you a financial product that s/he considered suitable for your goals. Unfortunately, the industry as a whole has been slow to move toward a fiduciary standard of care in which all licensed financial professionals legally must give advice that is in their clients’ best interest only.
And fee-only simply means that the advisor is not working on commissions. A fee-only fiduciary charges you for advice, not for selling financial products. They are only compensated by you, their clients, not by some third party, which means that they minimize conflicts of interest.
To help your odds of investment success in the long term, avoid fees and gimmicks that squander your returns. Embrace the markets, invest for the long-term using low management fee index funds, and ignore market headlines. You’ll be much more relaxed and rational about investing. Good luck.
Past performance data are always backward-looking and cannot predict nor guarantee future results. Diversification does not eliminate the risk of market loss. Like all securities, mutual fund investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost. A long-term investment approach cannot guarantee a profit. Investors should talk to their investment advisor prior to making any investment decision.