My last post touched briefly on the nature of regret in missing out (selling too soon, buying in too late). However, this is not a healthy mindset to have. As Marketwatch pointed out today, very few people have the intestinal fortitude to ride out the market’s gyrations and hold for the 10+ years needed for wealth to compound exponentially. How many of us would have sold out during one of the times when bitcoin or Netflix crashed >50%?
This Morningstar article serves as a reminder that we are our own worst enemies:
Well, it’s really about the target-date funds because they are sort of the confluence of good behavior. In other words, they are boring funds. You’ve got tremendous diversification. They don’t cause fear or greed. They are just boring. But then the other part of it is, in 401(k)s where you see nearly all the target-date money, people are investing every paycheck very steadily. So, they are also kind of shielded from the ups and downs of the market. So, if you go back to ’08, ’09, 2010, people just kept steadily investing, people generally did not panic in their 401(k)s, and so that meant you are really buying low and then staying with it to see those benefits. So, if you think about it, target-date is kind of the intersection of good funds and good investor behavior and it kind of suggests where we might want to go as an investing group as a whole because this is where things really work well.
The best returns actually came from disciplined boring investing. As Monevator likes to say, keep investing as boring as watching paint dry, so you won’t be tempted to buy and sell all the time. As another former mentor once told me, “Don’t just do something, stand there!” That is really the approach to take when investing.
If you’ve read my book on wealth, you know that I highly discourage trying to time the stock market or to cherrypick which stock to buy. In today’s stock market, we have another great example of why. The market overall has been wobbly, with a few stocks (Facebook, Google, Amazon) shooting into the stratosphere and the rest of the market essentially in recession-level pricing (especially the energy and industrial sectors). This is great if you have concentrated your wealth correctly in those few stocks that are doing well, but most people didn’t guess right and are instead dealing with huge portfolio losses.
Let’s illustrate this point with a simple example. Assume a stock market with four different stocks.
- A has dropped by 20% in the past year
- B has dropped by 25% in the past year
- C has gained by 150% in the past year
- D has dropped by 10% in the past year
Assuming that each stock is weighted equally in the market, this means that the entire stock market as a whole has increased by 23.75%, all on the back of stock C.
Now we have fifteen different people each with a different approach to the stock market, scattered on the spectrum between concentration and diversification. We also list their gains. For math/stats geeks, we are essentially enumerating all the possible combinations of choosing among four options.
- Person 1 concentrates all wealth in stock A (-20%)
- Person 2 concentrates all wealth in stock B (-25%)
- Person 3 concentrates all wealth in stock C (+150%)
- Person 4 concentrates all wealth in stock D (-10%)
- Person 5 buys two stocks (A and B) (-22.5%)
- Person 6 buys two stocks (A and C) (+65%)
- Person 7 buys two stocks (A and D) (-15%)
- Person 8 buys two stocks (B and C) (+62.5%)
- Person 9 buys two stocks (B and D) (-17.5%)
- Person 10 buys two stocks (C and D) (+70%)
- Person 11 buys three stocks (A, B, and C) (+35%)
- Person 12 buys three stocks (A, B, and D) (-18.33%)
- Person 13 buys three stocks (A, C, and D) (+40%)
- Person 14 buys three stocks (B, C, and D) (+38.34%)
- Person 15 is the closet indexer and buys all four stocks equally (+23.75%)
In short, the more stocks you buy, the closer you get to the index average and thus are more likely to get a positive return. The fewer stocks you buy, the greater the chances of scoring a home run hit, but with a greater chance of losing money as well. The effect is magnified even more when only 3/500 stocks in the S&P index are outperforming the index. This example illustrates the value of diversification. In a world where most of the gains come from a few stocks, and where most of the gains come on a few days, missing out on those days or those stocks can be catastrophic for the overall portfolio. This should serve as yet another point in why low-cost index funds, with their instant diversification, are the only correct way to invest in the market.