The Secret to Investing
Well, we now know that our money is constantly losing 3% to inflation. So we need a vehicle to combat that 3% and drive us forward to freedom. That vehicle is called investing.
We’re going to begin at the basics. Then we’ll talk about a place where you don’t need a large lump sum of money to start. All you need is a solid savings ratio and a fun-ass life.
A stock is a small portion of a company that you own. Yes, you own it! You can attend shareholder meetings and vote on company decisions. And you have a right to any of the future earnings of the company, called a dividend or return.
Stocks rise and fall because there are millions of people buying and selling them everyday. These people are glued to the news day and night, munching nervously away at their finger nails while they watch their one company type stocks.
When Obama’s State of the Union reflects on past growth and projects further economic growth they scream, “Buy, buy, buy!” (Stocks go up.) And when they read on Yahoo! News that Canada is opening its oil shale for sale, which will drive the price of oil down because of the greater supply of the good, they scream, “Sell, sell, sell!” (Stocks go down.) These investors are called active managers. Here we’re going to call these people Chicken Little investors.
Chicken Littles are glued to the news in dire hopes of doing one thing: Having their stocks beat the market. They hope their stock picks will produce a greater relative return than the stock market during the same period of time.
You do not want to be a Chicken Little investor. For one, setting your life up to react to the highs and lows of the market is an absolutely ridiculous way to live. And two, WAY more often than not, Chicken Littles do worse than the people who are just chilling and doing something fun like cycling before work, lounging with friends after work or hiking on weekends. These type of investors are called passive managers. Here we’ll just call them Fun-Hogs.
Fun-Hogs use their savings ratio each month to purchase stocks called index funds. Then they spend their days outside surfing, hiking, or climbing -- not worrying about the financial news. Index funds hold a portion of every stock in the market in the same proportion that each stock exists relative to the total market.
For example, if Apple represents 3% of all the stocks in the S&P 500 (this is the market, or the index that trades the largest 500 public companies), then the index fund that relates to the entire S&P 500 will have 3% of Apple.
If Apple lowers to represent 1% of all the stocks in the S&P 500, then the index fund will adjust (without you doing anything!) to make sure your holdings of that index fund have 1% of Apple.
Fun-Hogs purchase the exact representation of the market. In a sense they are simply purchasing the market.
Now, for the Chicken Littles to beat the market, they have to have a stock portfolio that differs from the representation of the market. Once they pick their stocks the Chicken Littles’ game is to buy or sell when they perceive a stock is mis-priced. And because these perceptions change frequently, they trade (buy or sell) stocks often. That’s why Chicken Littles are called “active managers” in the world outside of this blog.
With an understanding of how a Fun-Hog and a Chicken Little invest, it’s time for a story.
Imagine you are a condor soaring through the sky looking down at earth. There’s a group of Fun-Hogs and Chicken Littles. They are earth’s only investors. The group you’re watching starts and ends investing in the S&P 500 at exactly the same time.
At the end of the time period you can see that the S&P 500 has a return of 7%.
You look over to the Fun-Hogs and you see that every single Fun-Hog has made a dividend of 7%. “Of course!” You say. “The Fun-Hogs made precisely the same return as the S&P 500 because they own the entire S&P 500.”
You turn to look at the Chicken Littles. You see that some of the Chicken Little’s made more that the S&P 500’s 7% and some made less. But then you see that the average return of all the Chicken Littles is the same as the S&P 500’s 7%. “Hmph?” You say. “How could that be?”
Looking back at the Chicken Littles you see that the Chicken Littles are the only investors in the S&P 500. “Ah, ha!” You say. “The sum of the Chicken Littles return is the same as the S&P 500’s return because the return of the S&P 500 is all of the Chicken Littles’ returns.” (Fun-Hogs are part of the S&P 500 too, but the Fun-Hogs' returns would keep the average at 7% so let's omit them to keep it simple.)
You think for a moment longer. Then upon revelation you say, “Ahh, and therefore the average of all Chicken Little return is the same return of the S&P 500. Hence 7%.” The Chicken Littles in mass are the S&P 500!
So looking back at earth you see that 100% of the Fun-Hogs have the same return as the entire S&P 500. And some Chicken Littles have a higher return and some have a lower return, but the average of all the Chicken Littles’ returns is the exact same return as the S&P 500.
Then FLASH! A bright light beams through the sky. And once it clears everything looks a bit different. You squint your eyes to look at what has happened. And you see that both the Fun-Hogs and the Chicken Littles have lost a bit of money. “Oh!” You say. “That was from the fees for initiating the trades of the stocks."
You look over at the Fun-Hogs and see that the fee is low -- nearly all are .03% or less. “Hmph.” You say, “Low-fees seem like a trend for these Fun-Hogs.”
Then you look back over at the Chicken Littles. There you see trading fees for 1%, 2% and even more! “Why are the Chicken Littles paying more on their fees?” You scrunch your brow and ponder.
You look at the perimeter of the Chicken Littles and you see a group of stock analysts, brokers, trade specialists, etc. counting money. “Ah, ha!” You say again. “Chicken Little fees are higher because they must pay the ‘market-makers’ for more trading and more research.”
And now you look back at both groups side by side -- the point of true returns (returns minus fees). You see that the total return of all the Chicken Littles is lower than the total return of the Fun-Hogs.
"Holy smokes!" You say aloud. “If the Chicken Little’s total return is lower, then the average return of all the Chicken Littles must be lower than the Fun-Hogs dividend too because of the difference in fees! And that's true for any market over any time period.”
But looking back at the Chicken Littles you can still see that a few have outperformed the S&P 500, and hence outperformed the Fun-Hogs. You do that weird squinty thing again to figure out how many. You see that only:
7% of Chicken Littles outperformed all the Fun-Hogs on bonds
23% of Chicken Littles outperformed all the Fun-Hogs relative to the S&P 500
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William F. Sharpe, "The Arithmetic of Active Management," The Financial Analysts Journal, Vol. 47, No.1, pages 7-9
The Elements of Investing by Burton Malkiel and Charles D. Ellis p. 35, p. 43
How to Make Money in the Stock Market, Mr. Money Mustache