Why you will not beat the market but still can

A trusted VP that I worked with about 15 years ago told me that at some point he realized that “people don’t get rich from working, they get rich from investing”  This was somehow a revelation to me at the time.  Interestingly, about 10 years later the company that I was working for was being acquired at a certain share price.  However, the actual market trading price was much lower because the general public was not confident that the acquisition would go through.  I did not have any insider information per se but I was confident in the “expected value” based on the information available that the deal would close and so I ran all of my paychecks through our employee stock purchase plan rolling them through on a few month delayed arbitrage to protect my downside.  Don’t worry about the deets if this makes no sense to you, the point is that the deal closed and in one short period of time I made way more money from this investment move than the actual pay for the actual work that I was doing in that same time period.  That old VP was proven right in a super tangible way: at some point investing becomes more important than working.      

If you are a total newbie to investing, you have a lot of reading to do…or pretty much none after this post.  Let me explain why.

Easy Investing, Zero Work after this Post:

Every savvy investor knows that index funds beat the vast majority of actively managed investment accounts. Because index funds have more tax efficiency and lower expense ratios and because active investors are emotional and fallible, this tends to be true for the vast majority of financial advisors managing your funds. What is more, some of these assholes can act as your advisor where they have a fiduciary duty to do what is in your best interests but they may also be a broker who gets commissions or kickbacks from selling you those crappy penny stocks or annuities and they have no obligation to do what is in your best interests. It can be impossibly murky to tell when they are acting as your broker and when they are your fiduciary. In addition, advertised investing “systems”, day traders, market timers, and speculators generally lose money by the boatload.

All of this being said, the average return of the stock market over the past 90 years is around 7% per year (adjusted for inflation).  Hence, investing in stocks long term has made a great return over the last 90 years.  So if you want to be a simple and more carefree investor, many advise picking one or two low expense ratio highly diversified funds and putting your savings money there and then letting it sit for many years until you need it.  If the last 90 years hold, you would make around 7% per year on average.  Unless interest rates change dramatically from what they are today, this is a fine return compared to some of your alternatives.  But why do I keep bolding the word average?  Because the market can go up or down wildly like the 45% drop in 2008 / 2009.  If you want to get marginally more fancy, you can use “strategic asset allocation” and “modern portfolio theory” to reduce some of this volatility in your portfolio.  This means optimizing your risk vs. return and in practice often looks like having some % of your account in stocks and the other % in bonds.  Depending on who you talk to, this can look like stocks/bonds of 80/20 or 60/40.  That’s about it.

If you want to beat the market you have a lot of reading to do:

I already said that most professional money managers underperform a low expense ratio index fund.  If you think you are better than these pros, you need to read and study a lot.  You will also need to learn how to analyze the financials of a company = math.  Not only will this make you smarter but equally important it will give you enough humility to not lose your shorts. 

Individual Investors are at a Disadvantage

Investment firms like Blackrock have huge research teams of the brightest “quants” from MIT who are smarter than you and they have AI and super computers punching more data than everyone on earth could sort through to try to get a leg up on investing.  The big guys even have their own fiber optic lines to New York so that their trades execute a fraction of a second faster than competitors.  The point here is that almost always, everything is priced into the share price that you see and this share price is determined by the companies financials as well as the general collective sentiment of investors. 

The advice that the best investors may give today would change tomorrow or next week while this huge machine of the markets moves super fast.  This is why your most investment savvy friend probably doesn’t want to offer up advice to you that could change tomorrow and then you come back complaining a month later when you lose money. 

Why Market Inefficiency = Opportunity

Now that I have thoroughly beaten on you with some reality about investing, here is the upside: markets are not perfectly efficient.  If they were, everything would cost exactly what it was worth all the time.   But there are times where prices may not even reflect intrinsic value like crypto currency, every market crash of all time, or the tulip bulb mania of the early 1600s.  Markets are not efficient.  This is why even someone only marginally good at investing like myself was able to dump every penny that he could into the markets after the 2008 crash knowing that the long term fundamentals were a once in a lifetime opportunity. 

If markets were efficient, Warren Buffett would not have become the richest man in the world in 2008.  In fact he wouldn’t even exist as a storied investor.  I am not going to drool all over Buffett because its been done plenty but I will share 2 examples that are his:

“If a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his — and those prices varied widely over short periods of time depending on his mental state — how in the world could I be other than benefited.”  “If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.”

Now picture an all star baseball player up to bat.  If he gets a pitch in his sweet spot he may bat .400 but if the pitch is not in his sweet spot and he has 2 strikes on, maybe he swings and bats more like .230 on pitches like that.  Now picture you as an investor up to bat but you can take pitches all day and never strike out unless you swing and miss.  What would you do?  You would sit there and study and wait for days until the perfect meatball was thrown for you to blast out of the park.

Some real estate investors sit at that plate all day looking at house after house making low ball offers.  They have an advantage of knowing the market, knowing the value of the house, and waiting for someone who just needs to sell for whatever reason.  Eventually, someone says yes and they hit the pitch out of the park.  Two great friends of mine looked at businesses to buy for years taking pitches waiting for the meatball.  They got great at valuing businesses over time, they had fun, and they understood that while they want to buy, circumstance means that some people want to get out of business and the responsibility that it entails.  In these types of markets it is important to remember that every transaction has a buyer and a seller.  You don’t have to know everything about real estate, but everyone owns a home and has to buy and sell one at some point.  So if you know more than the average person and you take enough pitches, some market inefficiency meatballs are bound to come your way.    

My youngest son, will not play a competitive game unless he thinks he can win.  He likes to have an advantage.  That advantage in investing can be access to a market that others don’t have, information they don’t have, or analysis and insight that others don’t have.  I know many software developers that invested in google or Apple or xyz.com and got in early.  These people were close enough to the industry to know something that wasn’t in the financial statements.  What they saw was that this is game changing for peoples lives, has potential value that the average person hasn’t seen yet, and is early in it’s growth curve.  They had an analysis or insight advantage.  Venture capitalists talk to each other and have inside information.  There is a huge barrier to entry for others outside of the community to get in on the best deals, and these VCs are pros at deal structure dealing with amateur entrepreneurs who really need funding.  All of these things make Venture Capital almost unfairly advantaged toward the experienced and well connected VC investor.   

In a nutshell, this is how people beat the market.  They learn a bunch of stuff and then they sit around taking a lot of pitches all the while farming, meaning boring old investing conservatively very similar to the index fund investor that I described above.  They have a strategy based on their knowledge and it usually involves lots of diversification in a portfolio to protect themselves.  They don’t get emotional selling during crashes or buying when people drive prices irrationally high with their emotional moods.  They know why they bought and they have a plan and rationale in mind of when they will sell, only deviating if the supporting information for their plan changes.  And then every once in awhile, a meatball comes along where inefficiency in the market puts something out of whack with its fundamental value or an advantage presents itself.  These people are then knowledgeable and ready to act.  They don’t overplay these opportunities because even great pitches may still only bat at .400 and they have the humility of knowledge and experience.  With all of this in mind, being more on the active side in investing can be fun but takes loads of discipline, learning, and emotional control.  I have seen brilliant people make one costly mistake that destroyed a lifetime of gains and I have seen people that have done well investing but get lost in compulsive market watching and endless analysis that consumes their days when they could be enjoying their financial independence.  So the choice is yours whether to invest simply, or make investing hard but as that experienced VP told me “people don’t get rich from working, they get rich from investing.”

Want to read more about investing? Check out How To Invest and Get Wealthy.