Lately, quite a few people have been mentioning to me that they’ve purchased individual stocks sometime during the past couple of months on the back-end of the fastest plunge into a bear market in US history. I think a lot of people used the famous Warren Buffet quote of “be fearful when others are greedy and be greedy when others are fearful” as an excuse to justify this. However, I’m not sure that they’ve heard the stories of evidence-based investing yet.
Who Are You Listening To?
It’s pretty easy to be drawn into a well-produced YouTube or TikTok video from someone showing you how well they’ve done trading stocks. It’s important to remember that they don’t have to (and probably aren’t going to) show you when they’ve lost. Most of these people probably don’t have a background in finance and have never been exposed to the data regarding investing in the stock market.
They may be showing you all of the winners, but are they showing you their losers as well? Are they showing you what’s actually happened in real time or are they showing you what could have/would have happened? Even worse – are they doctoring their performance? It would be hard to tell.
I think that it’s fine to set aside a small piece of your investments to play with individual stocks, if that’s what you want to do. However, I also think that you need to make sure that your financial picture can afford it. Most people have never been formally educated in financial markets or security analysis. Don’t assume that you’re going to get rich off of trading stocks and that you’re going to be able to retire next year.
The evidence suggests that the opposite is likely to happen.
What Does The Evidence Say?
Dimensional Fund Advisors (DFA) is an investment firm that was founded (and is still advised by) the leading academics in finance. The company does not offer investments directly to individual investors like most mutual fund companies do (such as Vanguard and Blackrock). The funds can only be accessed through financial professionals or certain retirement plans. Not allowing individual investors to invest directly is something that DFA has been very intentional about given the emotions that individual investors often act upon and actions that they take.
DFA provides slide decks of evidence and information about investing in financial markets that are free to use for financial advisors who use their funds. There’s a lot of gold shared in them and I want to share some of that here for anyone who thinks that they want to trade stocks with anything more than some play money.
Here are some points for you to consider if you’re someone who has been led to believe that trading individual stocks is going to make you rich. All information is from DFA’s presentation titled Pursuing a Better Investment Experience.
The market processes billions of dollars of trades every day.
Each of the people and institutions behind each trade thinks that they have some sort of knowledge that someone else doesn’t. There’s someone on the other side of every trade that you place.
If you sell a security because you don’t think it will perform well, there’s someone on the other side buying it from you for a different reason. If you buy a security because you think it’s the next big winner, there’s someone on the other side selling it to you because they don’t want it anymore.
From 2000-2019, “only 22% of US equity and 10% of fixed income funds survived and outperformed their benchmarks”.
These are people and institutions with much better education, access to much better research, and more sophisticated models than me. If they can’t outperform their benchmarks, then what makes me think that I can? The deck is stacked against them and it’s certainly no better for me.
“Most funds in the top quartile of previous five-year returns did not maintain a top‐quartile ranking in the following five years.”
A lot of people select stocks based on past performance, but that isn’t necessarily the right thing to do. Just because an investment has performed well in the past doesn’t mean that it will continue to do so. In fact, the evidence suggests that it probably won’t.
Missing only a few days if strong returns can drastically impact overall performance.
Missing the 1 best day in the market between 1990-2018 reduced the performance of the S&P 500 index by 0.42% annualized. Missing the 5 best days reduced that performance by 1.54% annualized.
How are you supposed to know when the 5 best days in the market will be? Take this year for example. It’s crazy to see how quickly the US stock markets dropped earlier this year and how quickly they recovered.
As of the 6/8/20 close one week ago, the S&P 500 was actually slightly positive on the year – the Dow was down around 3%. The S&P was down over 30% YTD on March 23. Since then it’s up over 36% from that low.
So many people sold out, took the losses, and missed out on the gains. A lot of those same people are now scared to get back in because they think the market is too high. On March 24th, the day after the market low, the market gained over 6%. On March 26th, it gained nearly 7%. By April 6th it had given up some of those gains, but it gained nearly 7.6% on the day.
How many of those people who sold out near the bottom do you think were back in it for those huge up days?
Here’s a graphical representation of what annual returns look like from year-to-year.
As you can see, it’s hard to predict which segment of the market will outperform in a given year. How are you supposed to know which asset class to go big on this year? How are you supposed to know which stock is going to be hot? This is why diversification is your friend.
Market news and financial commentary aren’t there to help you.
Keep in mind the main purpose of these sources – to keep your attention and sell ads. Market news and commentary often pushes people to make emotional decisions rather than those based on logic or previously thought out rules, especially when those people are invested in individual stocks and see the talking heads mention them on TV.
Investing is a long-term game. Most people should not look at daily market values, especially in their retirement accounts. It causes more anxiety than it’s worth and can lead to making rash decisions that can hurt in the long run. A long-term perspective is key.
Protect Your Assets AND Have Fun
Who knows what will happen going forward? The market could crash again tomorrow or it could continue going up as it recently has been. What I do know is that someone who tells you that they know what’s going to happen is lying. If it’s hard to know what’s going to happen to the overall market, then it’s even harder to know what’s going to happen with individual stocks. Any piece of information, whether positive or negative, could radically change the projection of that stock.
The majority of the money that you’re investing for retirement should be invested in an evidence-based portfolio with a long-term view. I think it’s okay to have a small portion of your portfolio (<5%) set aside as play money where you can experiment with individual stocks if you’d like, but I wouldn’t do this with money that I’m depending on.
If you want to set aside some fun money to trade individual stocks with, then you need to accept the fact that you could lose all of this and your financial plan should be able to absorb the impact of not having this money available. If it can’t, then you should reconsider.
Be smart with your money. Protect what you need for retirement. Have fun with your play money if that’s what you want to do. Don’t be surprised if you take a big hit.
