Are You a Gambler Or An Investor?

I was sitting next to Jim recently at a dinner party. Our conversation started around the usual topics. He works in biotechnology research and asked what I do for a living. I replied that I help my clients avail themselves of all that the capital markets, tax code, and estate rules offer in the pursuit of the life they want for themselves and their families. “You’re a financial advisor then!” “Sort of” I said. “I actually prefer the label wealth management advisor, because we address the full range of planning needs for our clients, rather than just focus on financial products.” “Got it” he said. I could see his mind turning.

He then launched into a story of how his father has bested the financial markets for years by making swashbuckling bets on stocks in his spare time. He appeared to really believe what he was telling me and seemed very proud of his father’s achievement. As he told me this story I started doing some mental math on what he was telling me. I estimated his father was claiming returns of more than double the S&P 500. Hmmn. If he was this good at investing in stocks he should be famous, or at least fabulously wealthy!

It turns out characters like Jim’s dad are not uncommon. Although Jim’s dad buys and sells stocks for fun, he’s much like Bob, who likes to bet on horse races. Or Grant, who gets to the dog track as often as he can. Usually each of them will be more than happy to regale their friends and family with fun stories of how they won money betting on one winner after another. What they fail to tell you—because it’s not nearly as much fun—is which bets they lost money on.

Unrealistic Expectations

Jim’s dad and others like him are harmless enough, provided of course that you don’t take seriously what they’re telling you. Treat the claims of success as a prop in the telling of a fun and exciting story, not fact. If you don’t, trouble awaits. You see, if you genuinely think he’s getting twice the return of the S&P 500, you’re bound to get unrealistic expectations for your investment portfolio. A perfectly acceptable diversified portfolio will look completely inadequate when compared to apparent heroics of Jim’s dad. That’s likely to drive you to start trading in and out of investments in the futile and never-ending search for investments to match his illusory returns. You might also be tempted to chase stock returns by concentrating your portfolio in areas of the market that have been performing particularly well recently, which of course sets your portfolio up to come crashing back to earth when trends reverse.

As someone who used to work on Wall Street for 15-plus years analyzing investments, I can tell you that very few people have beaten the market even for any significant length of time—let alone indefinitely. It’s just very, very, hard to do, despite what you hear in marketing pitches, financial media reports, or anecdotes at dinner parties.

Trying to be Warren Buffett?

Warren Buffett is widely believed to be one of the greatest investors of all time, with a long track record since the mid-1960s. His average annual returns for 1965-2017 have been double the S&P 500’s 9.9%–roughly what Jim’s dad claims—which over those 52 years have compounded to an amount that is 70 times that of the S&P 500, due to the power of long-term compounding. Anyone claiming to have Buffett-like stock picking abilities deserves a great deal of skepticism. Jim’s dad is about as likely to be comparable to Buffett’s stock picking track record as he is to Hank Aaron’s Major League Baseball career. Just, well… very, very unlikely.

Winners Take All

A recent academic study by Hendrik Bessembinder at Arizona State University shows just how hard it is to pick stocks and beat the index. In data going back to 1926 and covering all 25,782 stocks ever traded on the New York, American, and Nasdaq stock exchanges, Bessembinder found that just 4% of stocks beat one-month US Treasury bills. In other words, the remaining 96% of companies collectively only matched the gains in one-month Treasury bills—1.13% annually, on average.

How is this possible? Well, there have only been a fairly small number of companies, from the many thousands listed on US stock exchanges over the years, that have gone on to fabulous success and enormous wealth creation. ExxonMobil, Google, and Microsoft are examples. Only 42% of all the stocks were positive at all during this 90-year period, while most often stocks ended in total loss!

For Stocks, Choose Profitability, Smaller Size, Value

These statistics are downright scary. But I’ll wager that most buyers of individual stocks have no idea how long their odds are to just match the major equity market indexes, let alone beat them. For most investors it’s a massively losing proposition.

When you hear that stocks have historically returned some stated percentage each year, remember that that statistic represents an index, which is the average of many companies over many years. For example, the 9.9% that the S&P 500 returned annually during Buffett’s investing career since 1965, represents the outcomes of many thousands of stocks over 52 years.

You have two choices about how to try to capture that stock return in future years: try to pick the tiny group that will drive all the gains and expose yourself to the overwhelming likelihood that you’ll actually buy mostly duds, or simply invest in a diversified portfolio that targets three areas of long-term outperformance: profitability, smaller size, and value. I’ve presented on these three drivers of portfolio return in my ELEVATE Your Plan video. A diversified portfolio won’t get all your money into the winners, but it will at least invest some of your money in them.

Go ahead and enjoy all those tall tales of rock star stock returns from Jim’s dad and others like him. But when it comes to your money, diversify your investments across the world securities markets to capture available returns and avoid avoidable risk. Then dial up or down the Treasury bond component of your portfolio to modulate drawdown potential to levels you can stomach without bailing out during the next bear market. It’s possible you don’t have to take enormous risk to reach your retirement goals. A good fiduciary financial advisor can help you figure all this out and implement a sensible plan.