If you’re just starting to invest for retirement, you may be making a big mistake without even realizing it.
For decades, the industry drumbeat has been that stock investing is extremely challenging for individuals. These days, those on Wall Street picking stocks for funds have PHDs, or MBAs, on top of Chartered Financial Analyst (CFA) designations. Mathematicians, otherwise destined for NASA, have been lured away to build trading algorithms which crunch millions of data points per hour.
Since stock picking is mostly a zero-sum game (if I win, you have to lose), how can individual stock pickers fight these giants?
Jack Bogle agrees. Citing numerous studies, his best selling book “The Little Book of Common Sense Investing” shows how poorly individual investors fair at selecting individual stocks for their own retirement portfolio. (Hint: It ain’t good.) Faced with these stats, he argues that small investors should just buy American index funds.
Index funds are pools of money managed by a money manager who has the sole aim of mirroring the content and return of some market index, such as the Dow Jones Industrial Average or S&P 500. By buying index funds, Bogle claims, investors can claim their full share of profit and growth achieved by American business.
But, Bogle ignores the fact that you can’t abdicate your responsibility for picking investments. Even if you stick with American index funds, you still have to decide which index fund to buy. Fidelity, one of America’s largest brokerages, had 104 index funds to choose from in 2018. This is only one financial institution and your decision becomes far more complex as you begin to look at offerings from other institutions. Arbitrarily selecting from one institution’s index funds may lead to subpar results.
The same goes for sticking to America. While the US has the largest financial markets in the world, other modern first world countries, such as the UK, Belgium, or the Netherlands, have stock markets that predate those in the US. Rule of law and small investor protection in countries such as Canada, Australia, the UK, and Japan are at least as good as in the US. This makes the decision harder, but it’s not the biggest challenge new investors face.
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By far, the most serious concern is valuation. You can’t simply “put your money in an index” and expect to do well long term. A lot of your success comes down to valuation. Pay too high of a price for an investment and you’ll likely lose money long term. By contrast, you earn your best returns when you pick up an asset (eg. an index fund, a stock, a bond, a car, or a house) for a cheap price. Valuation is a major factor in success or failure of your retirement.
So where are American markets right now, today, in February 2018?
They’re very expensive. In fact, the American markets are about as expensive as they have ever been in American history. The only dates that compare are in 1929, just before the Great Depression, and the late 1990s Dotcom Bubble. That does not mean that markets will necessarily crash (nobody can accurately predict short term market movements) but it does strongly suggest that you will not fare well as an investor if you blindly put your money into an index fund.
Other first world countries are much cheaper, so index funds covering those markets are probably better buys, but you’re still faced with having to become an expert global index fund picker. And, while Bogle would disagree (he does run an index fund company, after all), there are much better ways to save for retirement.
One way is to effectively create your own index fund by buying a diversified basket of deep value stocks that are cheap on some fundamental basis. Remember the industry drumbeat mentioned above? Well, it’s mostly marketing. Small investors CAN earn great returns picking individual stocks, and even beat Wall Street professionals. I’ve taken this route and have done very well.
I don’t have investing super powers, but I have adopted two vital techniques for success: adopting a solid deep value strategy and investing in tiny companies. Some investment strategies have records of large outperformance that span decades and have been used successfully in practice by people such as Warren Buffett. Leveraging these strategies, as Ben Graham recommended simply means buying a diversified basket of stocks that display a handful of basic criteria. It doesn’t make sense to focus on anything else.
But I also refuse to compete against professional money managers. Luckily, they’re restricted to larger firms, companies with market capitalizations roughly over $500 million, because they’re trying to manage tens of billions of dollars and can usually only buy less than 5% of a company’s outstanding shares. If they trespass over this line, they start pushing the stock price up, or they get a stern warning from regulators. As a consequence, investors like me completely sidestep competing against the pros.
Saving for your retirement is serious business, so it pays to really think about what you should do to make wise choices. Blanket statements such as “buy index funds” or “most small investors underperform” are not helpful. You owe it to yourself to look deeper.
Author Bio: Evan Bleker is a private investor who spends a lot of his time helping small investors through his two sites: Net Net Hunter and The Broken Leg. He’s been investing since 2001 but started to consistently beat the market in 2010 when he stumbled on to Graham’s net nets and deep value investing.