Marvin writes in:
I don’t understand why ‘beating the stock market’ is such a big deal. In theory, couldn’t you just buy a stock at random and have a 50% chance of ‘beating the market’? Because it will either do better than the overall market or do worse.
Marvin is correct to a small extent. If you truly don’t care about risk, you can give yourself a decent percentage chance of “beating the market” in a stock investment.
First of all, let’s talk about what he means by “beating the market.” That phrase simply means that you’re investing in something that has a better return than investing broadly in the stock market through, say, an index fund. I often use the Vanguard Total Stock Market Index as my estimation of what the “market” is, so, in my eyes, “beating the market” means getting a better return most of the time than the Vanguard Total Stock Market Index.
Marvin’s Plan Is Like Gambling
There are some big drawbacks to Marvin’s plan of simply buying a stock at random and beating the market half of the time.
First, it doesn’t include the investment fees, such as the brokerage cost of buying and selling that individual stock. Let’s say you’re paying a typical brokerage fee of $10 per transaction. You have $5,000 to invest. Just to “buy” the stock you’re thinking about buying, you’re going to burn $10 of that money, getting only $4,990 in value of the stock you purchased. Then, when you “sell” the stock, you’re going to pay another $10 out of your return. The stock you buy will have to “beat the market” by at least a little bit for you to have a return that matches the market. Obviously, this becomes less and less of a factor the more you invest in a single stock, but that brings us to the second point.
Second, there’s enormous risk involved here. Let’s say that 2% of stocks match the market so well that the fees above take that investment from “beating the market” to “not beating the market.” That would mean that if you buy into a stock at random, 52% of the time you’ll fail to beat the market. That’s a key thing to note. More than half of the time, you would do better by simply putting that money into the Vanguard Total Stock Market Index. There’s a significant percentage of the time that you actually lose money on the single stock investment – a higher percentage than investing in that index.
Now, of course, there is a 48% (or so) chance that you’ll make more money with this stock, but the reality is that this is akin to gambling. You might buy into what seems to be a red-hot stock, only to find that the company is about to announce a huge quarterly loss.
The problem is that unless you’re an insider, you often have little idea about the financial state of the company represented by the stock you’re buying. It might have a long history of stability or a reputation as a “hot pick,” but the reality is that past performance is never an indication of future returns.
In other words, you can beat the market occasionally if you largely treat it as a roulette wheel at your local casino, but like that roulette wheel, the odds are slightly stacked against you and if you keep playing, you’re going to fail to beat the market over the long term unless you happen to hit your exact number and quit. The transaction fees, if nothing else, are going to get you.
The third problem is taxes. This isn’t a major problem if you’re doing this in a retirement account that has natural tax advantages, but you’re doing yourself a real disservice if you’re using retirement funds with such risky investment choices. If you invest like this in a normal taxable account, you’re going to have to pay taxes on your gains and losses, and if you trade very often, most of those gains are going to be short-term gains, which are taxed at a higher rate. Compare that to just buying an index fund, which means you’re just going to sit on that investment until you need it and then pay the lower long-term capital gains tax on that.
The fourth problem? Psychology. We are hard-wired as people to respond instinctively to price jumps. On paper, buying low and selling high makes sense, but to our primal instincts, we want to sell to avoid a falling price because it feels like a big risk to keep holding it, and we often want to buy the hot, rising stock because it feels like a big opportunity.
Add up all of these factors and it begins to look a lot like gambling.
What Good Is Research, Then?
If investing in individual stocks is akin to gambling, what is the value of researching individual stocks? Shouldn’t the purpose of such study be to help you improve your odds of selecting good stocks to invest in?
Obviously, improving returns is the purpose of doing research and examining the data on individual companies and stocks. However, there are several problems with this approach.
First, past performance is never indicative of future returns. Simply looking at the price history of a stock is just as likely to give you the wrong indication as to the future of the individual stock price as the right indication. The stock prices of individual companies peak and valley all the time. If you’re going to do research, you need to dig deeper than the stock price and learn about the company.
Second, doing the homework that can actually help, such as reading the company’s SEC filings and annual reports, takes a lot of time. The thing that really matters in terms of the stock price of a company is knowing what the company does, how it operates, how it’s currently doing, how trustworthy the upper management is, what the sector the company operates in looks like, and so on. A company that is strong in most or all of those areas is going to go up in value over time, and a company that is weak in most or all of those areas is going to go down in value over time.
However, finding all of that information, reading it, and analyzing it takes a lot of time. Let’s say you spend 20 hours a week doing homework into the companies you own and the companies you might invest in. That might allow you to beat the market by a percent or two with your stock investments, but to even make minimum wage on that time means that you’re going to have to invest a lot of money to turn that 1% to 2% additional gain into a real income for all of your time investment.
So, unless you have a very large amount of money to invest – seven figures or more – it’s likely that the time invested in studying stocks won’t pay for the time you invest.
Third, you’re going to be behind the curve in terms of information. This is the real reason that the deck is stacked in terms of individual investors. Not only are you not an “insider” with the company, you’re also not an institutional investor. In other words, when a company makes a decision or is preparing to release financial information about the company, there are a lot of investors that are going to know that information before you do.
Investment firms are going to be able to analyze public information far faster than you and sometimes have access to information before you do. That means that they’re going to be able to react – buying and selling stock – far before you’ll be able to do so.
In other words, if bad news comes out about a company, insiders and large-scale investors are going to be able to react long before you do, causing the stock price to drop rapidly before you ever even have the chance to sell. You can protect yourself to a certain extent by having a standing order to sell the stock if it hits a certain price, but that’s not a perfect guarantee, either.
Can Anyone Beat the Market?
There are many stories of legendary investors like Peter Lynch, who managed Fidelity’s Magellan mutual fund in the 1980s and “beat the market” year after year. Their stories manage to convince many individual investors that they can do it as well, even though it’s much more difficult than it seems.
First of all, most of the ‘legendary investors’ did it in a much different era than today. There was much less computer-based trading back then and far less sophisticated analytics. Many new innovations such as hedge funds and high-frequency trading didn’t exist back then, either.
Second, the investors that “beat the market” often did absurd amounts of homework. Peter Lynch worked absolutely absurd numbers of hours during the decade when he was excelling as an investor. Behind every success story is an incredible work ethic.
Third, you only hear about the exceptional ones who had a healthy dose of luck on their side. Even with all of the research and work, Lynch had some significant luck on his side. Many of the companies he invested in turned out to have made very good decisions and be run by honest people and not have many unfortunate incidents happen to them. There’s luck involved in investing and exceptional investors are often riding a wave of that luck, at least in part.
Finally, if such investors exist today, they’re gobbled up into hedge funds very quickly. They’re paid absurd amounts not to divulge their techniques. Hedge funds or other investment firms with huge bankrolls can beat the market using a number of techniques that are really only possible with a lot of money already in hand, something unavailable to most investors.
So, yes, the market can be beaten, but it requires a mix of luck, incredible work ethic, and a very big bankroll to make the odds worthwhile.
Your Best Bet as an Individual Part-Time Investor Without Tons of Money to Invest
If that describes you – and if you’re reading this site, it almost assuredly does – your best bet is to diversify your investments as much as possible and then invest with the lowest fees possible.
It’s easy to do that, of course – just buy into index funds directly through investment houses. I have most of our stock market investments directly in the Vanguard Total Stock Market Index, invested directly through Vanguard to minimize the fees. This requires very little homework once the investment is in place and it basically matches the market, minimizing your risk as much as possible while still being invested in stocks.
You can beat the market, but the tools you need to do it are largely out of the hands of the individual person who wants to dabble in the stock market. Unless you’re willing to essentially gamble, it’s not worth your time and effort, especially when it’s so simple to match the market.