Efficient

There are only two ways to invest (part 3)

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carolina-pimenta-J8oncaYH6ag-unsplashSo there are two basic strategies to invest, and your first decision as an investor is to decide which road to take. In part 2 we talked about the active option, in part 3 we’ll cover the alternative option: passive investing.

Whereas active investing feels right, passive investing is a little counter-intuitive. You actually don’t have to do anything to be a successful passive investor. You should probably have an understanding of how the market works and have a conviction about why you’re investing the way you are, but as far as activity goes you’re taking it real easy.

One of my favorite analogies for passive investing is salmon fishing. Salmon fishing is not sport fishing, it’s almost like harvesting, like work. The importance is not in casting and reeling (a staple of sport fishing), the importance is in how well you’re set up. You need to have varying types of bait at varying depth of water, you might try variations in boat speed, variations in direction, variations in water depth, etc. The important thing is to be equipped to catch a fish at any moment by diversifying your offering as much as possible. Once you’re all rigged up, you sit back and let the market do its work.

The basic question here is about whether or not you’re confident in the fact that the market is efficient. If you believe the market is efficient (which data supports) any attempt to outperform the market by actively picking stocks or timing the market is vain. Instead of spending time on all different types of analysis and market trends, the focus can be on how to design the most efficient portfolio possible, how to diversify in the best possible way. Instead of trying to bet and predict the market, you simply need to own the market as efficiently as possible. It’s an entirely different game.

Passive investing is a wonderful thing, it reduces a great deal of stress. A poor year of returns is simply a result of the market, it’s not the result of some poor guesses by you or anyone else. A recession is no longer terrifying because you’re well-diversified and you understand that the market always bounces back, that the average market downturn lasts less than a year. Your retirement is no longer a question of ‘if,’ but of ‘when.’ A passive investor is free from analyzing endless piles of company data, the uneasiness about the market sectors they’re invested in. Passive investors don’t have to worry about how the riots in Hong Kong, or Bolivia, or Lebanon, or Iraq will affect their portfolio. It’s an entirely different way of being.

So the first decision you’ve got to make as an investor is whether you’ll be active or passive. That’s certainly not the last question you’ll have to answer, but it’s a very important one and one that set the direction of your investing journey and your financial future.

There are only two ways to invest (part 2)

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carolina-pimenta-J8oncaYH6ag-unsplashSo we’ve identified the two basic ways you can invest. That’s great, but how do you know which one to choose? Let’s talk about the active option.

Active investing feels right. We’re active people after all. We shop around for deals, we love sales and Facebook Marketplace. We check weather forecasts on the regular, we set future plans on our calendars. We do research before we buy things (some of us perhaps to a fault), we read reviews, we ask our friends. All of these things are active. So then active investing just seems like the normal way to do things, look for underpriced companies, do some stock research, make a prediction about the future, nothing too out of the ordinary, right?

There’s just one small problem, investing isn’t like normal life. We’ve got really smart people positing that the stock market is efficient, which means there aren’t actually and sales or deals on underpriced companies. Sure, stock prices will generally move upwards, but not because a company is underpriced. New news and information comes into the market and affects stock prices, new things happen that we can’t know for sure beforehand are going to happen. Research into specific stocks is great, professionals are doing it all of the time, but no one person can possibly have a complete understanding of a company, let alone how unknown events in the future will affect the company. There’s just too much data to make picking stocks a long-term viable strategy. Predictions in the stock market are not like weather predictions, we don’t have a radar watching a storm-front move in. And if people believe there is a storm front coming, it’s already priced into the stock prices because again, the market is efficient.

It’s really tough to be a good active investor. Even professionals fail to outperform the market at an extraordinary rate (over the last 15 years, 92% of active funds trading in the S&P 500 have underperformed the S&P 500), and even those who seem to be good at it tend not to repeat their performance. So maybe you’ve guessed by now, I don’t advocate active investing. If you really believe that the market is not efficient and that you or someone you know has a special ability to buy and sell the right stocks at the right time then active investing is the way to test your belief. Unfortunately, the odds are not in your favor.

In part 3, we’ll talk about the alternative option.

There are only two ways to invest (part 1)

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If you’ve faced an investing decision at any point in your history you know it can be daunting. Maybe you’ve reviewed your 401k options within the plan at your work, how in the world should you decide which funds to use? Maybe you’re feeling the pressure to start saving for your future, how do you decide who would manage your hard-earned savings well? Conduct any amount of research and instead of settling anything you’ll find innumerable different philosophies and strategies and a lot of recommendations to ‘invest in what you believe in.’ Well, I’m going to try to help you understand the first decision you have to make.

The first decision is actually pretty simple, there are only two options because there are only two ways to invest. You can invest your money actively or passively.

  1. Active means that either you yourself or someone you delegate to selects stocks and investments they believe will do well. At work in active investing is a fundamental belief that the market is not all that efficient and smart people can achieve better returns by only investing in the ‘right’ things.
  2. Passive investing means that you don’t try to choose the ‘right’ companies or even market sectors. Instead, you own the whole market and hold it passively. At work in passive investing is a belief that the market is mostly efficient, and probably better at setting prices based on supply and demand than you are.

You certainly aren’t done making investment decisions when you’ve answered this question, but it’s the first thing you need to interact with. So when you start evaluating, start with this question, will you be an active or passive investor?

We’ll dig into these options in part 2.

What does ‘efficient market’ mean?

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‘Efficient market’ is one of the most important terms to understand when it comes to investing. It’s important because what you think about the efficiency of the market will dictate how you practically invest your money, which will shape your retirement and legacy.
So first, what does it mean? If the market is efficient it means that stock prices react to news and information really fast. For instance, news breaks that a company has committed fraud, and the stock price of that company falls immediately. It also extends to any small bit of news or public sentiment regarding the market or specific companies. Market prices are always moving based on new information and perceptions, and they move almost immediately upon receiving that new information. Those are signs of an efficient market. The speed at which information travels today has only made the market more efficient.
So why does that matter? Well, if the market really is super efficient, it means that picking stocks is futile. Think about it, if the market prices react and update immediately upon receiving new information, the only thing you can do to beat the market is to guess right. Unfortunately market guesses are less like investing and more like gambling. So if the market is efficient, the entire way you’ve previously thought about investing is not only impractical, it’s basically a roll of the dice. Instead of trying to beat the market, an efficient market would suggest you own the whole thing as efficiently as you can. You would diversify and hold stocks instead of research and pick stocks.
There is another important thing to recognize about investing in relation to the efficient market: people do beat the market sometimes, they sometimes pick the right stocks and get better returns than the market as a whole. It’s not often, somewhere around 90% of stock pickers underperform the market every year, but that leaves around 10% who seem to be doing something right. That 10% either figured something out, found some inefficiency in the market, or they got lucky. The thing is, it doesn’t really matter if they’re smart or lucky, and there’s not really any way to empirically test it anyways. Because the market is efficient, if a smart person does find an inefficiency it will close up before long, and if a lucky person gets lucky, they’ll also get unlucky at some point. Either way, by the time you’ve heard about their success, it’s too late. People who have beat the market in the past are much more likely to underperform the market in the future than to beat it again. In fact, they’re more likely to underperform even their contemporaries in the future. Any way you cut it, in an efficient market it simply doesn’t make sense to try to find or profit from market inefficiencies, regardless of whether or not they really exist, or to what extent.
So if the market is efficient, to whatever degree you agree, don’t try to beat it. Instead, own the efficient market as efficiently as possible.

Financial Advisors aren’t evil (mostly)​

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I met a stranger this morning (the beauty of Facebook marketplace). He had looked me up in advance, not to be creepy (he assured me), just to make sure he wasn’t meeting a crazy person. He saw that I’m a financial advisor and wondered if I had ever met his financial advisor, whom he trusts very much. In fact, he trusts his financial advisor so much he recently handed over full discretion, meaning the advisor no longer needs his permission to make trades and move money. It was becoming cumbersome to give the okay every time the advisor wanted to make a trade. I informed him that I had not met his financial advisor, and he assured me that his advisor is a great guy.
Here’s the thing, I’m sure he is a great guy, I’m sure his intentions are (mostly) pure. Many financial advisors are really great, and they really care. But that little discretionary bit he shared with me is alarming. When it becomes cumbersome to approve every trade your advisor wants to make, that’s a problem. According to the data, financial advisors who actively trade routinely underperform the market, even advisors who are really great guys. Don’t work with an advisor only because he or she is a great person. Find an advisor who is a great person, but who also understands how the market works, how to most efficiently capture returns, how to avoid stock picking and market time and trying to beat the market, and most importantly, how to coach you. Your future depends on more than the integrity of your advisor. He may not be evil, but he may also be submarining your retirement.