Updated: Jun 15, 2020
It’s difficult to know what type of investing strategy you should adopt. Knowing a few simple facts about the stock market can help you develop a more rational investing strategy.
There are four truths that every investor needs to know about investing in stocks.
The stock market is (reasonably) efficient.
Picking individual stocks is a bad idea.
Market timing does not work.
Your instincts are probably wrong.
In this post, I’ll discuss how I make evidence-based decisions when developing an investment strategy.
We need more evidence-based discussions about investing
Investing is a topic that a lot of people have strong opinions and aren’t afraid to share them. Generally, it’s a good thing to have more discussion around personal finance. I usually encourage anyone to share their views and their experience with money. The more we talk about this subject, the better off we will be.
However, when it comes to investing, we need to be very careful with the discussions we have. A growing number of people are making investment decisions based on something they’ve read on the internet. This is a bit scary when you consider how many articles on investing are encouraging investment decisions not based on research and analysis but feelings.
That is why I have made a concerted effort to write more about important investment topics. I have aimed to keep my opinions to a minimum and make sure I cite credible research for every issue I discuss. I have no interest in giving “my take,” but instead writing a compelling narrative based on peer-reviewed research completed by people far smarter than I am.
With that in mind, here are four truths about investing you should consider.
1. The stock market is reasonably efficient
In his 2003 paper titled “The Efficient Market Hypothesis and Its Critics.” Burton Malkiel defined an efficient market as a market where “prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.”
Eugene Fama from the University of Chicago won a Nobel prize in economics for his research on the efficient market hypothesis. His most famous work was a paper published in The Journal of Finance in 1970 titled Efficient Capital Markets: A Review of Theory and Empirical Work.
The first important finding from Fama’s research is that the stock market is not “perfectly” efficient. Stock prices do not reflect 100% of information all of the time.
Through his research, Fama concluded that the stock market is “informally efficient.” To put that in relatable terms, Fama’s research finds that markets are reasonably efficient.
Whether stock prices reflect all known information has enormous implications for the rational way to invest.
If the stock market is reasonably efficient, there is no basis to believe in stock picking strategies that “beat the market” in the long run. This goes for individual stock pickers and professional investment fund managers on Wall Street.
The empirical evidence backs up the hypothesis of the informally efficient market hypotheses. Standards & Poor’s collects data on how actively managed funds perform against their benchmark index across the globe. Over the past five years, the majority of actively managed investment funds around the world underperformed their local stock market index.
81% of active fund managers in the U.S underperformed the S&P 500 index.
96% of active fund managers in Canada underperformed the TSX index.
78% of active fund managers in Europe underperformed the S&P Europe 350 index.
If the stock market is at least informally or reasonably efficient, the implications for investors is clear. The most rational approach for long-term investors is to invest in low-cost index funds, which take the passive approach of replicating the entire stock market.
2. Picking individual stocks is a bad idea
The subject where I get the most pushback from readers is when I review the historical facts that suggest picking individual stocks is a bad idea. As just discussed, if the stock market is at least reasonably efficient, we have no reason to believe that investors can consistently beat the market.
This is where one of the worst human biases comes into play; overconfidence. The general response I get when I write about this topic is that while it’s “hard” to beat the market, many people believe if they “work harder than the average investor,” they can outperform the market.
There is not a shred of evidence to support the idea that you can beat the market if you simply work hard enough.
In his 2018 paper titled “Do Stocks Outperform Treasury Bills?” Hendrik Bessembinder of Arizona State University provided some jaw-dropping historical facts about picking individual stocks.
60% of all stocks that he studied had a lifetime return less than a 30-day U.S Treasury Bill (T-Bills).
That means that you would have had better returns if you had invested in T-Bills (which are risk-free) than if you had invested in the majority of U.S stocks since 1926.
4% of U.S stocks accounted for 100% of the gains in the U.S stock market since 1926.
Bessembinder concluded that “The results help to explain why poorly-diversified active strategies most often underperform market averages.”
Picking stocks is time-consuming, risky, and costly. As a rational investor, it is something I actively avoid.
3. Market timing doesn’t work
On paper, market timing sounds fantastic. I pull my money out of the market before the crash and then invest at the bottom.
The problem is that successful market timing requires you to know two things.
Exactly when to pull your money out of the market.
Exactly when to put your money back into the market.
When an investor pulls their money out of the market, they run the risk of missing out on gains if the stock market surges upwards.
The case against market timing is simple. You have no clue when the market is going to crash. We obsess over the “paper losses” when the market tanks. But those who engage in market timing seem to neglect the very real, and much more likely risk of missing out on the markets hottest months while their money sits in cash.
Merril Lynch researched this very subject. They examined the return on a $1,000 investment in the S&P 500 from 1989–2018 under three scenarios.
Scenario 1: The investor implements a buy and holds strategy.
Scenario 2: The investor pulls their money out of the market and misses the ten best performing months.
Scenario 3: The investor pulls their money out of the market and misses the 20 best performing months.
The results demonstrate the risk of market timing.
Buy and hold investors ended with $17,306, a 1,631% return on investment.
Investors who missed the ten best performing months ended with $6,959, a 596% return on investment.
Investors who missed the 20 best performing months ended with $3,328, a 233 % return on investment.
It should be noted that this timeframe includes the “mini” market crash in 1989, a severe market crash after the dot-com bubble in the early 2000s, and the worst financial crash since the great depression in 2008–2009. Even with those market downturns, the long term buy and hold index investor comes out on top.
4. Your instincts are probably wrong
If you’ve been paying attention to the first three points in this article, it should be pretty apparent that when it comes to investing, your instincts are probably wrong.
The human brain suffers from several biases that make us naturally bad investors.
Overconfidence. An investor who suffers from overconfidence is likely to concede that “most people” can’t beat the market. At the same time, they believe they have some magic formula, method, or intuition that will make them the exception to the rule.
Loss aversion. The human brain experiences much more intense negative feelings from losing than positive emotions from winning. This causes people to freak out when the market crashes and sell at the bottom. This panic decision turns “paper losses” into “real losses.”
Confirmation bias. We tend to seek out information that supports what we already believe. The person who thinks that Bitcoin is the future is more likely to read “pro-Bitcoin” blogs that only present one side of the story and reaffirm what they believe to be true; Bitcoin is incredible. This leads to investors to make uninformed investment decisions that can cost them big time.
I could go on, but I think you get the point. Humans are not the rational actors we would like to believe we are.
What all this means for investors
If we accept that;
The stock market is at least reasonably efficient.
We are unlikely to outperform the market by picking individual stocks.
Trying to time the market is too difficult to pull off.
Our instincts about what is happening in the stock market are usually wrong or at least missing the bigger picture.
How should these truths impact our investment strategy? Each investor will need to do their research and make a decision for themselves. Here’s how I look at this information to inform my investing strategy.
The evidence suggests that it’s highly unlikely I can beat the stock market by picking stocks, so I never pick individual stocks.
The data clearly shows that most active fund managers can’t beat the market either, so I invest in low-cost index funds. These funds mirror the stock market, so if the market goes up 10%, I would expect a 10% return minus the minuscule investment fees and any tracking error.
Since timing, the market does not work, and my instincts about what I think is about to happen in the stock market are unreliable. I make investment decisions independent of what is happening in the news.
Put simply, I look at the evidence and conclude that the rational way to invest in the stock market is to take a buy and hold approach using low-cost index funds.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions