There are only two ways to invest (part 2)

 

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.

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.

5 ways your investing app is ruining your retirement

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In the last five years, we’ve seen the explosion of alternative investment avenues, especially through apps. While technological advances (computers, algorithms, the internet, you get it) certainly make investing a better and easier experience than it’s ever been, they’ve also promoted some troubling trends in popular consumer investing apps.

Here are a few ways your investing app is ruining your retirement:

  1. Investing apps are built for active trading which loses money compared to the market. In order for investing apps to be interesting, they promote active trading. No one wants or needs an app to help them buy and hold and never make trades. Unfortunately, active trading is a recipe for disaster. Even professionals lose to the market when they actively trade stocks, not because of any inherent flaws in themselves, but because it’s literally impossible to consistently beat the market.
  2. No great offerings. Because they’re designed to encourage active investing, investing apps don’t offer many great investing options. Even if you could ignore all the crap, the best funds aren’t in there. Sure, you can find some cheap ETF and index funds, which aren’t the worst options in the world, but they’re definitely not the best. And investing apps know you might try them out, but ultimately you’re going to be moving money around.
  3. Your earliest years are the most important years and you’re wasting them. Investing apps appeal unilaterally to younger people. The great thing about investing when you’re young is that money invested early will compound far more significantly over time than money invested later. Unfortunately, many young people fall prey to these investment apps which do the opposite of maximizing investment dollars.
  4. Mis-education, worthless news. In order to make active investing seem legitimate, investing apps often share news and information regarding the market. Unfortunately, the news is not helpful for investing. Instead of learning about how the market works and how to prudently invest money over time, these excerpts simply validate terrible investing strategies.
  5. Encourage bad behavior. This is the biggest problem. Instead of educating investors, investing apps take advantage of them. Active investing feels right, it seems legitimate, and investing apps only encourage that feeling. Unfortunately, the feelings of investors have no correlation with successful investing, if anything they’re negatively correlated.

So dump the investment app. Learn about important investing concepts like Efficient Market Hypothesis, Modern Portfolio Theory, the Three-Factor Model. Get a good advisor who will get you into the best funds and help you remain disciplined through scary markets. Take your purpose seriously, it’s probably something worth more than speculating and gambling with your investments.

Is a recession coming?

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Last week Wednesday (the 14th) was a bad day, at least it was a bad day for the markets. I actually had a pretty nice day, maybe you did too. The market took a hit though, the DOW was down 800 points (about 3%), its worst day of this year, and other indexes didn’t fare much better. The chatter is heating up, the next recession is on the horizon! But is it?
Well, the Wall Street Journal certainly seems to think so. In an article title Stocks losses deepen as a key recession warning surfaces published last week, the WSJ espouses the fearful sentiment pervading the industry last week. A few quotes:

Whether the events presage an economic calamity or just an alarming spasm are unclear. But unlike during the Great Recession, global leaders are not working in unison to confront mounting problems and arrest the slowdown. Instead, they are increasingly at one another’s throats.

This sounds especially bad. At least in 2008 people were trying to fix the problem!

“The stars are aligned across the curve that the economy is headed for a big fall,” said Chris Rupkey, chief financial economist at MUFG Union Bank. “The yield curves are all crying timber that a recession is almost a reality, and investors are tripping over themselves to get out of the way.”

Yikes, sounds like someone is about to get trampled.

The U.S. economy has shown signs of weakening in recent months, but high levels of consumer spending in the United States have helped enormously. Still, the escalating trade war between Trump and Chinese leaders has stopped many businesses from investing. And there are signs that the large tariffs he has placed on many Chinese imports is costing U.S. businesses and consumers billions of dollars.

If this isn’t a rollercoaster of emotion I don’t what is. Signs of weakening? Oh no! High levels of consumer spending? Okay, so not too bad. Tariffs are costing U.S. business and consumer billions? Run from the market!

I kid, but this is actually serious stuff. The WSJ is only one among many news outlets forecasting the next crash. The problem is, no one knows when the next crash will be, regardless of ‘key recession warning’ claims, because the market moves on new news and information, things that no one knows. Unless of course, you know the future.

Just today, exactly one week later, we’ve got a new narrative in the news: Stocks are on a comeback. Dow rises 250 points. The rollercoaster is exhausting.

Instead of tuning into the cycle, remember that great returns don’t come from any ability to time the next crashThe market recesses sometimes, and it could be contracting now, or next year, or in five years. We don’t know when, we just know that’s how the market works. The disciplined investor who has a plan for whenever the next crash comes and a coach to get them through it will always win.

The prediction problem

Investing is hard. If you’ve visited this blog in the past you’ve probably noticed a lean against active types of investing (buying and selling stocks all the time). Trying to predict the market, pick winning and losing stocks, find the best times to be in or out of different market sectors is really hard. Actually, the data suggests that it’s impossible, or at least no one has ever consistently been able to do it (Efficient Market Hypothesis). So prudent investing doesn’t leave space for active investing, the two don’t mesh. For many people, that’s not a satisfactory conclusion. We like to think we actually can pick winners, maybe not every time, but at least most of the times. We like to think we actually can see trends and understand market movements. We like to think we can make predictions. Well, call me a downer, but those instincts aren’t very helpful.
I’ve been reading through Factfulness: Ten Reasons We’re Wrong About the World – and Why Things Are Better Than You Think by Hans Rosling, a scintillating read. Rosling makes the helpful point that predictions about anything are never certain (he even specifically references the market), and advises readers to be especially wary of future predictions that don’t acknowledge that fact. So here’s my question: why is the future so tough to predict? Here’s my stab at it, with some helpful input from Rosling: the future tough to predict is because the world is far more complicated than we like to think. Rosling notes that the complexity of the systems involved make accurate future predictions essentially impossible. It’s impossible to predict the market because there are billions of factors to consider, all moving and changing every second. Even if we were able to consider each of the billions of factors, we would still have trouble guessing which direction they’ll each move because none of us knows the future. It just doesn’t make a ton of sense to actively trade stocks based on our limited understanding of market factors, not even for professionals. But there’s still happy news here. Even though we don’t know how the market will move today or next year, we do know that the long term general stint of the market is up. So we can actually stop worrying about predictions and news and market trends, those things ought to be the least of our concern, all we have to do is own the whole market as efficiently as we can and stay on for the ride. Owning the market efficiently is a separate discussion, that’s something professionals can actually help with, but the first step is to admit the prediction problem.