It’s probably the most important question you can ask yourself when it comes to investing in stocks — can you beat the market? Unfortunately, the average investor won’t beat the market. Whether this means you should try or not is another topic entirely.
Investing is absolutely not one-size fits all. What you should invest in depends almost entirely on what your purpose for your portfolio is. Almost all pop-finance advice completely misses this fundamental concept.
Still, these are important concepts to understand and act upon, so I’ll go through some of the math, look at some long-term strategies, and then end with some conclusions most people should be willing to accept.
The Math: Almost Everyone Fails to Beat the Market Over Time.
John Bogle is one of the biggest names in investing, and he’s one of the famous guys behind Vanguard — a mutual fund company. He’s a huge fan of index funds — where you put money into the fund and the fund just tracks the overall stock market.
He wrote The Little Book of Common Sense Investing, in which he explains the following:
“Please think for a moment, about the relentless rules of humble arithmetic. These iron rules define the game. As investors, all of us as a group earn the stock market’s return. As a group — I hope you’re sitting down for this astonishing revelation — we are average. Each extra return that one of us earns means that another of our fellow investors a return shortfall of precisely the same dimension. Before the deduction of the costs of investing, beating the stock market is a zero-sum game.”
Burton G. Malkiel, author of A Random Walk Down Wall Street explains:
“Index funds have regularly produced rates of return exceeding those of active managers by close to 2 percentage points. Active management as a whole cannot achieve gross returns exceeding the market as a while and therefore they must, on average, under-perform the indexes by the amount of these expense and transaction costs disadvantages.”
Statistically speaking, individual investors under-perform the market as a whole. This is pretty much unavoidable. Almost everyone fails to beat the market. After taxes and fees, this statistic is even worse. Over time, randomness is less and less powerful, and it becomes more and more obvious that beating the market is extremely rare.
This is mathematically unavoidable. But math isn’t itself important. Statistics are meaningless unless we know what to do with those statistics — this is something most economists, financiers, investors and “experts” need to understand. So what’s the significance of these stats?
The Strategies: Beating the Market Over Time Isn’t Everything.
I’ve pointed this out to those who have subscribed to our newsletter before, and I’ll probably be pointing it out more in the future: I’m not just trying to beat the market. Beating the market would be nice, but it’s not my goal. That said, I have beaten the market by a remarkable amount since starting investing — but that’s just been a nice consequence of knowing how to invest strategically.
The market is volatile. I don’t like volatility. I’m trying to build an income portfolio that gives me a steady flow of cash for my living and other projects I might want. That’s very, very, very different from trying to amass as much of a portfolio “over time” as possible.
My main two goals are increasing my income and beating inflation. If inflation didn’t exist, my entire investing strategy would include much, much more cash. I know essentially everyone in the pop-finance world would reject that as a bad strategy, but it’s what I would do — a big portfolio isn’t my goal, funding my projects and life is. I’m goal oriented.
Here’s a list of some reasons why someone might not just put their money in an index fund:
- Extreme Volatility. Stock indexes are kind of crazy. They can gain or lose 40% in a year. It’s not that uncommon. Putting your money in stocks right now could take up to 20 years before they make money, after inflation. These kind of dry spells have occurred in the 20th century — even though it was an amazing century for stocks. That’s not comforting.
- Timing is Off. Just because index funds do well over time doesn’t mean it’s on a time-frame that’s useful. If stocks slowly lose a hunk of their value during the 25 years before you retire (and they’ve done this during the 20th century, after inflation) well, that’s just not helpful. You don’t want to wait your entire life to see returns only to find out that the market decided to destroy your earnings for a couple of decades before you retire.
- Income Investing. This is what I’m doing. I want my investments to provide me with cash-flow — not just in my 60s, but also in my 20s, 30s, 40s, and 50s. I want at least 40 more years of wear and tear on my portfolio. The long-term is important, but so is the relatively short term. Income investing is a relatively more secure way of making sure I get a nice portion of my returns in a liquid manner without having to try to time the market. It’s just more efficient and simpler.
There are plenty of other reasons as well, but these are three basic ones and should cover most people.
Note that my approach to income investing isn’t for everyone — it’s just my strategy. I have the ability to invest more per month than most, and should see substantial dividends faster than most — if you’re only able to invest a few thousand per year, then it might make more sense to focus almost exclusively on a long-term portfolio rather than a both-long-and-short term portfolio.
Your Strategy: How to Pick an Investment Strategy For Yourself.
This section is going to be short, because there’s no way I can explain what someone’s strategy should be. It depends on your goals and your age. If you’re 22, have marketable skills, and want to retire at 65, and don’t want to research stocks your entire life, then you should probably stick to index funds… and you’ll probably outperform most mutual fund managers by a small fortune by retirement.
But if you’d like to have a business of your own in 10 years, you might want to focus more on buying good, high-yield dividend stocks on dips. This little bit of extra cash flow could be a business saver at some point. It really just depends. It’s something you’ll have to pick for yourself.
As for myself, I’ll probably use index funds occasionally in the future. They often provide an easy way to get
Conclusions: Figuring Out If Index Funds Are for You.
I don’t currently own any index funds, and own a collection of stocks, one mutual fund, and lots of other assets. But I’m not against index funds. They can be extremely, extremely useful. For example, if you’re bullish on China for the next 40 years, putting you money in a Chinese index fund can be a fantastic investment. If you want to invest in coal, then a coal fund might be a great investment. It really depends.
In the end, like all questions of strategy, there is no one-size fits all investing strategy. It’s a question of which strategy makes the most sense according to your time-frame, goals, risk aversion level, and who-knows how many other variables. Either way, thinking through your strategy and sticking to it is vital to any level of predictable success.