Bold claim, I know, but hear me out. Markets (defined here as companies that people can invest in) have existed for several hundred years. The Dutch East India Company was the first company to ever be listed on an official stock exchange back in the 17th century. If you allow your mind to drift back to middle school history class, perhaps you can recall a few formative world events occurring between then and now, some good, some bad, some apocalyptically terrible. Here are a few: American Revolution, French Revolution, American Civil War, invention of the telephone, WWI, Great Depression, WW2, Cold War, etc. World power shifted between nations, wars ended countries and began new ones, and the only thing more predictable than another war was another famine (interestingly, there was a permanent global food shortage from the dawn of time until WW2). However, one thing you may not have heard in your middle school history class is that through all of the raging of nations, markets continued to provide a return, decade after decade. Market data, as primitive as it may have been in the 17th and 18th centuries confirms what we’ve seen from more comprehensive data in the 20th century, that markets consistently offer a significant return over time from company dividends (which were more popular back in previous centuries) and from company growth. As we well know, the market doesn’t go up every day or every year, we see the hills as well as the valleys, but history has demonstrated without exception that down markets are temporary and market growth is inevitable. It’s easy to fall prey to the idea that this time really is different, and it’s true that there are different things happening today than there were in the 1700s, but a prediction that the market won’t perform in the future is a bet against history.
What is it about the market that ‘works’? I mean, how do companies keep creating and innovating so consistently over time? How is it that you can invest money in your 20s and receive six times your investment when you retire in your 60s? How is it that people create value?
I’ll submit that the consistency and value of the market (of companies) and of people is directly tied to failure. You see, progress is made through trial and error. If there were no mistakes there would be nothing to learn from. The simple fact that companies and products sometimes fail is what drives innovation forward. It’s why entrepreneurs, regardless of their level of intelligence, are able to create immense value, they’re iterating on failure after failure. It’s why free markets have prevailed for centuries, failure is built into the mechanism. It’s why, on a personal level, the way that failure occurs to you will play an oversized role in your personal success. Winston Churchill famously said, “Success is the ability to go from one failure to another with no loss of enthusiasm.” But it’s even better than that, failures are the milestones on the way to success, they’re what makes success possible. So next time you fail, don’t dress it up, don’t make up reasons or excuses, squeeze every bit of valuable information you can out of it. It may have actually been a huge success.
As a concept, socialism is appealing. It’s idyllic, it seems to diminish unfairness, promote the less-fortunate, favor equality, all good things. So what’s the problem?
The true problem with socialism is an economic one. It’s about simple math.
Socialism seeks to operate an economy, or society on the whole, by rules and regulations set by a small group of people in power.
Conservatives mainly criticize socialism as a system that misplaces incentives. While humans do operate by incentive, and socialism does skew incentives, this is not the most helpful critique. Socialistic regimes have imposed different forms of incentives throughout history, like fear of torture and death, to coerce their people into desired action.
There is also a basic problem with the idea that a few people should hold so much power over many. Regardless of the purity of a person, power generally corrupts. But, like the incentive criticism, this is not the most basic problem of socialism. The truth is, even under the most compassionate, just, caring leadership in the history of the world, socialism would still be doomed to fail.
The problem of socialism is, at its most basic, a problem of pricing. A truly free market is an incredibly efficient way to set prices and wages. Whenever there is too much of a good, demand (prices) goes down, and businesses and people react by creating less of that good. Whenever there is a shortage of a good, demand (prices) goes up, and businesses and people create more of that good. In a free market, this happens quickly, automatically, and constantly. Communication stems from millions of data points (decisions, knowledge, people) occurring every second of every day accurately determining what people want and delivering those goods.
When a government or ruling body steps in to set prices or fix wages (the standard operating procedure of socialism) instead of letting the market make a determination based on supply and demand, that body is bound to fail. Any group of people, regardless of their level of training, IQ, ambition, morality, etc. can never have a complete understanding of the millions of data points, decisions, and knowledge swirling within the market every second. A few people simply can’t know as much as the several billion people on earth collectively know.
Because of this, a set price or a fixed wage will necessarily result in waste (too much of a good) or lack (too little of a good). This state of mispricing, given enough time, will result in the collapse of society.
An example of wage-fixing can be seen in modern-day minimum wage policies. Minimum wage is an attempt to promote justice and protect the less fortunate from evil greedy companies; an understandable inclination, but unfortunately a worthless solution. In a free market, wages increase naturally (with bumps along the way) as demand for labor increases. In socialism, wage-fixing makes it difficult or impossible for some businesses to hire employees at a price they can afford, even if potential employees would be glad to work for such wages. At worst this creates an insane situation where businesses aren’t allowed to hire people who want to be hired, at best the market is inhibited and incentives are skewed (business may be more likely to hire contract employees or part-time employees to avoid additional costs required by regulation). A much more effective way to thwart greedy capitalists is to give the market space to create better jobs.
Socialism, as economic practice, will always necessarily fail. No group of people can ever possess the collective information of the entire market, and so they will never be able to accurately allocate resources and set prices.
We made it, another year is in the books and everyone has an opinion on where the market is going. My line of work involves me adamantly advising people not to try to predict markets, but even I have an opinion about what might happen in the future. Thankfully, there’s a difference between having an opinion and making a poor investing decision.
So where are we now? We’re coming off of a historically great period of market returns, especially in the category of U.S. large growth companies (the S&P 500, which happens to be the category we almost exclusively hear about in the news). Since U.S. large growth companies have faired well, so have investors, because the vast majority of investors have the majority of their investments in large U.S. growth companies. That’s great news right now. But it’s also a problem.
Large growth companies are historically one of the poorest performing asset categories in the free market. This holds in performance data going back one hundred years, but it also makes sense a priori. Large growth companies are inherently less risky than small and value companies, they stay in business longer, they seldom go bankrupt (it happens, just not as often), and their prices don’t fluctuate as significantly. Small companies are often younger, less established, and more susceptible to tough markets. Value companies are often distressed and sometimes never recover. These small and value companies default more often and their prices are more volatile, they’re riskier.
You’ve heard the principle, risk equals return. That applies here. It makes sense that as entire asset classes, small companies and value companies outperform large growth companies by a significant margin over time because their additional risk brings additional return. The fact that large growth companies have performed so well over these last ten years is great, but it also means that at some point we’ll see these returns balance out. Now, I would never pretend to know which asset classes will perform better or worse next year, that’s a fool’s errand which we refer to as ‘market timing.’ But I do know that most years will favor a diversified portfolio that leans toward small and value asset classes instead of a heavy weighting towards large growth companies. Next year the most likely circumstance is that you’ll be happy to have left your large growth company portfolio to get into a more diversified situation, which, incidentally, is true at the end of every year.
So the obvious question is how to diversify with a lean towards small and value companies. I’ve covered this before, but total market index funds won’t help you here, because of cap weighting total market funds are invested almost entirely in large growth companies. Index funds have become very popular over the last 20 years and, while they’re certainly an improvement over active funds, they’re inherently flawed. To get into an ideal portfolio takes an advisor committed to the academics of investing utilizing structured funds (a solution to the index fund problem).
Take the opportunity to review your portfolio as we head into the new year. The returns may look great, but that doesn’t mean you’re in a great portfolio.
So 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.