There’s nothing like getting a hot stock tip from some talking head on TV.
“Tesla’s got nowhere to go but down”
If you see it in the news, it’s gotta be reliable, right?
So, you follow their advice and dump your Tesla shares.
Unfortunately, you waited too long to act. By the time you placed your sale, the price had already plummeted.
But hey, a small loss beats a complete loss, right?
A week later, Elon Musk announces a quantum leap in their battery technology, and the Tesla stock soars.
Time to buy again, right?
Of course, by the time you open your app to place the order, the stock is already at all-time highs.
But that sense of FOMO is overwhelming, and your favorite stock-picking blogger said, “you don’t want to miss this rocket ship”. So even though the price is now absurdly high, you take the plunge and buy back in.
Ok, let’s stop there. What’s wrong with this picture?
A lot. And it’s not just that you sold low and bought high.
Today, we’re going to talk about one the of the biggest mistakes individual investors make in the stock market and how we can fix the situation.
If you’ve invested any of your net worth into single stocks, or you plan to, I’m going to show you why you might want to rethink your strategy.
It’s Fun to Gamble
Okay, first of all, I get it.
Buying individual stocks is fun.
In fact, it’s as close as a lot of us can get to legal gambling. And if the profitability of Las Vegas is any indication, we humans love to gamble.
You see headlines about stocks jumping 200%, or 2000%, on blockbuster earnings or a mega acquisition.
That means if you buy $1000 of stock in the right company, a 2000% increase could turn that into $20,000 bucks.
That sure beats groveling to your boss for a bigger bonus.
And woof, do you have a good feeling about that stock. In fact, you just heard from your friend that the company is about to have a technological breakthrough.
Better get in now before everyone else does, right? Don’t want to be late to the game.
The problem is, as an individual investor, we’re ALWAYS late to the game.
By the time you heard about the company’s good news from your friend, any professional investor monitoring that company will have already acted.
In fact, those professionals acted long before your friend even knew about the good news. They acted within milliseconds of the press release, which was picked up by their AI supercomputers scanning millions of headlines per second.
So, unless you have millions of dollars to deploy on high-frequency trading equipment and sophisticated machine learning algorithms, you’re going to be at a huge disadvantage.
Now maybe your friend actually works in a management role at the company, and the tip she shared with you isn’t yet public. Okay, fine. In that case, you would beat out the professional investors. But you might also go to jail, because trading on private, privileged information could be considered insider trading.
So either way, you lose.
But your troubles don’t stop there.
Even the Professionals Suck at This
Even the professionals, with their super computers, algorithms, and bleeding-edge mental models, still lose money.
In fact, according to Washington DC think tank American Enterprise Institute, less than 5% of professional money managers outperform the stock market.
Just think about that for a second.
Within the elite pool of people who are fully trained and fully equipped to make smart stock picking decisions, which comprises some of the smartest people in the world, over 95% of those people would be better off simply picking stocks at random.
So what makes stock picking so darn hard?
In a nutshell, life.
Consider projections of your own future. You know more about yourself than anyone else on the planet. You have the most privileged information possible, and you know it instantly, before anyone else.
Yet despite that comprehensive information, can you say with complete certainty where you’ll be professionally a year from now? How about two years from now? How about five?
Will you be promoted? Will you switch jobs? Will there be a war, recession, or pandemic that forces your employer to shut down, causing you to be fired?
The answer is that none of us really have any clue.
So if you can’t say with confidence what the future holds for you personally, even though you know your own situation intimately, how can you possibly claim to know what’ll happen to a company that you’ve only read about in the news?
You can scan all the 10-Q’s and investor memos you want, but you can’t predict a scandal with the company’s senior management, or the sudden rise of a competitor that puts the company out of business, or the discovery of a new technology that renders the technology obsolete.
The bottom line is that we live in a highly unpredictable world. And the more globalized our world is, the more interconnected geopolitics and transnational supply chains become, the more variables emerge that make our predictions even less accurate.
Even the most powerful supercomputers in the world can’t come close to predicting what will happen the next day, much less what will happen a year from now, or five.
The 5% of stock pickers who do outperform the market, are either really lucky, or have a uniquely powerful intuition about highly specific business dynamics that enable them to SOMETIMES make really good bets.
But they are still making bets. And eventually they lose. They just try to keep their loses smaller than their gains.
And let’s not forget that they have billions of dollars of capital to make mistakes with. For every investment decision they make, they can hedge against being wrong with a contraindicating investment. So if one goes down, the other goes up. That’s where “hedge funds” get their name from.
As individual investors, we don’t have that kind of capital. And we don’t have patient investors who’ll give us money to cover our losses.
If we bet the farm on a company that goes bankrupt, we go bankrupt too.
Now if at this point buying stocks is starting to sound insanely stressful and reckless, good. I’ve done my job.
But don’t despair. There is a better way.
Bet on Humanity
The solution is to stop betting on individual companies. In fact, don’t even bet on groups of companies, or industries, or commodities. Each of those, individually, is subject to the kinds of unpredictable risks we just discussed.
For example, if you bet on oil, you might be disappointed in a decade when renewable power becomes the dominant form of energy. If you bet on commercial real estate, you might be bummed when the workforce goes remote and brick-and-mortar shopfronts are replaced with digital ones.
When it comes to individual investing, my advice to you is to stop placing any bets all.
Except one. Bet on humanity.
Trust me, if humanity fails, personal finances will be the least of our concerns. And when humanity prevails, as it has done consistently throughout recorded history, you profit.
So how do you do this?
Thanks to a man named John Bogle, it couldn’t be easier.
Bogle pioneered the idea of something called an “index fund”. Index funds combine a “basket” of individual investments into one large “bundle” of investments. The more diverse this bundle is, the less individual risk it carries.
With index funds, instead of sweating about which company to bet on, you can invest in every high-performing company at once, in one single purchase.
No need to guess which industry is going to overtake the other. With index funds, you can invest in all of them in one go, weighted by their relative success.
And the best part is that the indexes are constantly rebalanced, so if one company or industry overtakes another, the index will reallocate accordingly, and you don’t have to lift a finger.
In other words, index funds have created an opportunity for us to bet on humanity as a whole.
If this fact isn’t blowing your mind right now, I need you to pause, rewind, and make sure you grasp the power of what we’re discussing here.
Now keep in mind that there are thousands of different index funds out there. Some are more specific, such as a fund that tracks precious metals or residential real-estate in the American Midwest. Others are much broader, such as a fund that tracks the Nasdaq or the SP 500.
How To Invest the Right Way
With all of the different index funds out there, how do we choose the right one?
Well, if our goal is to bet on humanity, we need to choose the broadest possible investment we can.
Fortunately, such index funds exist.
My personal favorite is Vanguard’s VTSAX.
This fund tracks the overall performance of the entire U.S. equity market, including small, mid, and large-cap growth and value stocks. And it has rock bottom fees, which you always need to pay attention to.
And for a variety of reasons, it also covers international and emerging market growth. And it even serves as an effective hedge against inflation.
In fact, I love this fund so much that it’s worth dedicating an entire separate discussion to.
But that doesn’t mean you have to go with VTSAX or any of Vanguard’s offerings. There are plenty of other broad-market index funds out there, offered by a wide variety of brokerages.
The point is that you want something that doesn’t expose you to isolated risks.
Sure, in a global recession, these funds go down along with everything else. But because they include the entire market, when the world recovers, these funds recover faster.
For some perspective, if you invested $100 in such a fund at the start of the last century, today, that investment would be worth over $7 million dollars. That’s a 7 million percent gain.
Sure, that’s over the course of 120 years, but even annualized, that’s still a highly respectable 9.73% gain per year.
Now, the catch with these funds is that once you put your money in, you need to leave it in there for a long time. That way, short-term market fluctuations don’t affect your returns.
This is very different than stock picking, where you’re buying and selling on a yearly, monthly, or even daily basis.
With broad index funds, you buy when you have the cash, and then let it sit for as long as possible. Just let it grow.
That’s easier said than done. It takes a lot of patience. But just remind yourself that every technological advancement, medical breakthrough, and human achievement, ultimately contributes to the growth of these funds.
In other words, as the world gets richer, you get richer. Not a bad deal, right?
And if you want more context on investing in index funds, fear not. We have a separate lesson that discusses how to invest in index funds the right way.
Now, as it happens, there are two companies that have done a fantastic job of combining several high quality, low-fee index funds, into one comprehensive package.
So if you’re looking for a super simple service that manages everything we just discussed in a few clicks of a button, I strongly recommend you check out Wealthfront and Betterment.
Both of these platforms make it super easy to set up an account and get started. They offer a fantastic blend of diversified, low-fee, market-tracking index funds. And they customize your allocation based on your age and financial priorities.
My favorite part is that you can set up a recurring investment that pulls from your bank account every time you get a paycheck, or when your balance exceeds a certain threshold.
In other words, they make betting on humanity as easy as it can possibly be. And they charge next to nothing to do it.
I’ve invested my own money with both Wealthfront and Betterment for years and can say they are equally excellent. You can’t go wrong with either. If you’re like me, go with both.
I’ve included links to both platforms here:
You and I both get a referral bonus when you sign up, which helps support what we do here at Stake Your Wealth.
So the next time someone gives you a hot stock tip, you can do the following:
- Thank them for their generous insights
- Let them know that stock picking is for suckers and that you’ll leave the reckless gambling to the professionals
- Explain to them the power of investing in human innovation
- Show them how an index fund allows them to do that
- And finally, congratulate them on joining the club of intelligent individual investors
Okay, that’s enough of me jabbering. Go out there and make a bet on humanity!