Index Investing: Speculation

|| This article is Part One in a series on investing with index mutual funds. ||
||   I. SpeculationII. Index FundsIII. John BogleIV. Vanguard   ||
||  V. Moving to VanguardVI. Asset AllocationVII. Maintenance  ||

"The four most dangerous words in investing are: 'this time it's different.'"
—Sir John Templeton, legendary investor and philanthropist

The financial markets provide investors with the opportunity to grow their money by buying tiny pieces of company equity (the stock market) or corporate and government debt (the bond market).  As the economy grows and companies turn a profit, these investors are rewarded for their participation with debt payments (interest), payouts of corporate profits (dividends), and increases in the value of their investments (capital appreciation).

I've previously discussed the historical performance of the stock market.  The long-term, annualized, inflation-adjusted returns on the US stock market (as represented by the S&P 500) during periods from 1950 to the present have been on  the order of 5-7.5%.  Past performance doesn't guarantee future results, but these historical values provide a basis for calibrating our expectations.

These numbers are averages across nearly every company in the United States.  Shouldn't it be possible to buy only the better companies, and thereby attain a higher rate of return?

In a word?  No.

Attempts to beat the market by 'stock picking' and speculating on the future is always a bad bet.

The Market Already Thought Of That

Think about this logically: if there was a strategy that involved picking the 'better companies' that enabled higher returns, wouldn't everyone do it?  As investors piled onto these 'better companies', the stock price would rise, until... the higher stock price balanced out the corporate outperformance.  This is the essence of the Efficient-Market Hypothesis.  While the Efficient-Market Hypothesis is definitely an oversimplification, as human cognitive biases are clearly responsible for irrational market runs and bubbles, the weaker forms of this hypothesis do explain why it is impossible for you to quickly and simply select 'better companies' to improve your returns.

Information Explosion

There is one factor that can be used to pick securities and regularly beat the market: information disparity. If you know things about a company that other investors don't know, you may discover that the common assumptions underlying a company's stock price are flawed. When this information becomes more widely available to the investing public, the stock price will correct to account for this information and you will profit. Unfortunately for would-be speculators, insider trading laws have made the most obvious forms of information disparity illegal.

The legal way to build an information disparity is to do some serious homework. Fifty years ago, it's conceivable that it wasn't very hard to do enough research to gain an information advantage over competing investors. If you wanted information about products and industries, you had to rely on trade journals and whatever you could glean from your own commercial experience. If you wanted a company's annual financial reports, you had to make the trip to a library that carried them (and bring a lot of quarters for photocopies). There were no PDFs, no Google, no Wikipedia, and no ctrl-F. Nowadays, all of this and more is available freely and instantaneously on the Internet... where any interested investor can get it.

But What About Warren Buffett?

Warren Buffett is currently the second-richest man in America.  He has accomplished this by steering his company, Berkshire Hathaway, through nearly fifty years of average returns more than double those of the S&P 500.  He remains very active today, and wholly owns companies you may have heard of: GEICO, Dairy Queen, Fruit of the Loom, Heinz...

So why don't you just do what Buffett does?

The short answer: you can't.  He makes his money not just by buying some stocks and hoping they go up, but by buying out entire companies at great discounts and using his vast experience to improve how these companies are run.  You lack the capital and the years of training and the magical temperament that has enabled him to do this.  He is a single story that exists in a very specific context that is impossible to recreate.

The long answer: dozens of books have been written on this subject, so help yourself to the literature.

Buffet himself has warned others off of attempting to imitate his successes.  From his 1996 Berkshire Hathaway annual letter to investors:
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expense) delivered by the great majority of investment professionals. Seriously, costs matter.”
Index funds, he says?  We will get to those in the next article in this series.

But do remember: there is only one Warren Buffett, and you are not him.
(If you ARE Warren Buffett, leave me a comment and make my year)

Speculation Is A Zero-Sum Game

Short-term trading makes up the vast majority of the 'trading volume', the total amount of trading that goes on in the stock market in a given time period.  This means that most trades are speculators exchanging stocks with other speculators.  When one speculator profits at a rate above the market's average return, this is because another speculator is doing worse than the market average.  'Beating the market' is the definition of a zero-sum game.

Do you believe you have the skill to predict market movements more accurately than the brokers at Morgan Stanley, the professional institutional investors that manage the endowments of major foundations and universities, and the billionaire hedge fund managers?  They account for a majority of the trading volume, so that's who you're trading with.

Speculation Is Expensive

Portraying speculation as a zero-sum game ignores the fact that short-term trading is significantly more expensive than long-term buy-and-hold.  Each time you buy or sell stock of a company, there is a transaction cost for placing the trade.  The tax consequences of short-term trading are also negative: if you hold an asset for less than a year, you pay taxes on it at your marginal income tax rate; holding for more than a year, you pay only 15% (assuming you make less than $400,000 per year).

If you pay a professional advisor at Morgan Stanley to speculate for you, expect to pay an additional 1% annual fee on all of your assets under management.

While it's true that you can't afford not to invest, you also can't afford all of these fees.

Speculation Undercuts Diversification

Imagine that you have invested in only a single company.  If that company suffers major losses, you are at risk of losing your entire investment.  Of course, that single company could also do very well and make you a lot of money.

Imagine instead that you have now invested in five companies.  The rate of return provided by each company will average out.  There is now less of a probability that you will make lots of money very quickly, but your risk of major losses is also significantly reduced.  As you increase the number of companies that you hold, the dispersion of potential returns decreases, and the probability distribution of potential returns narrows:
When you engage in speculation, you must choose a subset of companies that you believe are going to beat the market average.  This necessitates narrowing your scope.  By doing this, you greatly improve the chances that you will lose big.

The Rise Of The Machines

As if the professionals on Wall Street weren't competition enough, the speculator must now deal with High-Frequency Traders.  But these aren't humans: they're supercomputers.

This new (<10 years) development deserves its own article, so I'll spare you the gritty details here.  In summary: legions of supercomputers are now watching the market prices, analyzing trading spreads, and even parsing and evaluating the news to make zillions of trades in the time it takes you to blink.  This is having some very interesting effects on the short-term markets, and has led to the creation of the 'flash crash'.  If you're interested, read up:

And The Winner Is: Random

Those investment professionals?  More often than not, they don't beat the market.

Research has even demonstrated that random investment strategies perform just as well or better than targeted rational strategies.

On the stock market, at least, unpredictability rules and you get what you don't pay for.

What's The Alternative?

If stock-picking isn't the answer, then what is?

Long-term, buy-and-hold investing in low-cost, passively-managed, broadly-diversified index mutual funds is your best bet.

Stay tuned for the second part in this series:  Index Mutual Funds.