I lurk in a lot of online groups related to the Financial Independence (FI) movement. Although many members in that movement advocate investing in low-fee index funds and letting time do the work for reaching FI, I see constant discussion about picking individual stocks.
Is it wrong to pick stocks? Absolutely not. I oppose anyone who tries to dogmatically force a specific path to FI down someone else’s throat. That said, I think there are a lot of strong arguments to be made in favor of the low-fee index fund, fire-and-forget strategy. Let’s look at some of this.
Can the Pros Beat the Market?
My main reason for suggesting that we avoid picking stocks is that the vast majority of the pros fail to beat the performance of individual index funds.
You’re skeptical? I believe it…I was too at first.
I first read this assertion in JL Collins’ fantastic book, The Simple Path to Wealth. (Amazon affiliate link.) You don’t have to buy the book to read his assertion though. He’s published the same content for free in Part III of his excellent Stock Series. He asserts that 80% of actively managed investment funds fail to beat the market average. Over the past few years, the disparity has gotten even worse.
Perhaps the most notable recent illustration of this fundamental comes from this headline: How Warren Buffet Won His $1 Million Bet. Mr. Buffett is one of the wealthiest people alive, and perhaps the greatest investor of our time. Even with all of his knowledge, he recommends that the average investor just by low fee index funds and let them sit. When he dies, his instructions for taking care of his family are that 90% of his wealth to be placed into index funds.
We got this recent headline because Mr. Buffett made a bet many years ago. He’d put $1M into index funds, and the other party would put $1M into any combination of actively managed funds. The winner would be the person with a higher account balance at the end of a decade, and would get both pots of money. Mr. Buffett, frequently called The Oracle of Omaha due to his stock-picking prowess won the bet by investing in low fee index funds.
The point you should take from this article is not that Warren Buffett is smart or that we won a $1M bet. The point is that the article about his bet goes on to mention that 93% of actively managed investment funds fail to beat the market. That number skyrockets to 98% for government bond funds! Why in the world would you invest in something that has a 93-98% chance of failing to beat the market when you could just invest in the market itself by purchasing shares of a fund like VTSAX, VTI, FSKAX, etc.?
Having just used The Oracle himself to make my point, I’ll say that there are some valid caveats here. We’ll get into some others, but first we need to look at fees.
Even a somewhat passively-managed index fund like VTSAX needs to pay human beings to manage it. VTSAX is a “total stock market” index fund. The over-simplified idea is that every time Vanguard gets some money, they use it to by shares of stock. Specifically, they buy one share of stock from each company on the market. Once they have one share of each, they go back through the rotation and buy another share of each. This continues for as long as people give them money. It’s a pretty simple process, but it still requires some human action to complete.
Thankfully, the process is simple enough that Vanguard can do this cheaply. Vanguard charges most investors an impressively small 0.04% fee for their services. (This is also referred to as the fund’s “expense ratio.”) This means that for every $100 you invest, Vanguard takes four pennies. That’s downright reasonable for a fund that’s rewarded me with a 35% Return on Investment (ROI) over the past year, and returned 7.92% since inception!
Let’s compare this to actively managed funds where you pay a financial advisor a fee to pick stocks for you. The idea is that he or she sits around all day studying stocks and businesses and can choose winners while leaving out losers. I’ll be upfront and say that there are plenty of people who do this some of the time. Warren Buffet is the leading example, but there are plenty of others. However, most of them fail to consistently out-perform the market. As we’ve noted, the number of failures has risen to 93%.
Part of the reason that these individuals give you lower returns that the market is that they charge you much higher fees. While you can find a variety of fee structures at different investing firms, you’re likely to pay a minimum of 1% Assets Under Management (AUM.) This means that for every $100 you invest with this actively managed fun, they take $1.
A dollar doesn’t seem too bad, until you compare it to the index fund’s expense ratio. That 1% AUM fee is 25 times more than VTSAX’s 0.04% expense ratio! When you compare these two options, the actively managed fund charges you 25 times as much money for a 7% chance of out-performing the alternative. You almost always lose that bet.
Sadly, this isn’t the worst type of actively managed fund either. There’s a company that I consider to be downright predatory, especially toward members of the US military, that charges exorbitant fees upfront to manage their investments.
Another very common fee structure for big hedge funds is “Two and Twenty.” This means 2% AUM (twice what you’ll be charged at many smaller firms) and 20% of your profits when you take money out. If those hedge funds consistently beat the market, it’d be one thing. However, knowing that 93% of these funds fail to perform as well as VTSAX, these fees are belong in Crazytown.
Frustratingly, it’s those fees themselves that account for much of the failure to beat the market average. A 1% AUM advisor has to beat the ROI from VSTAX by a full percent to justify their existence. By picking and choosing, they’re lucky to get above the average at all. But beating the market by a full percentage point (or more!) is even tougher.
The odds are never in your favor.
(If you want some entertaining television, Showtime has a fun series called Billions. It’s part high-stakes finance drama, part director getting to show off a lifestyle of mansions, fancy cars, and crazy hijinks, and part an illustration of what those hedge funds do with your “2 & 20.” If you think they’re giving you a great service and taking care of your best interests, consider the fact that Billions is based in part on decades of real-life examples.)
Hopefully I’ve convinced you that simple past performance show how professional investors are terrible at beating the market, and part of the fact is they charge you outrageous fees. I could leave things there, but it wouldn’t be fair of me. As it turns out, there are lots of individual investors who beat the market. Why? We have what one investor calls “unfair advantages.”
If you haven’t already, go listen to Episode 75 of the ChooseFI Podcast. The guest on this episode, Brian Feroldi, does a great job explaining a variety of factors that make things far more difficult for a big, actively-managed fund than the individual investor. Here are just a few:
- Overhead – Big investment firms need to have an office. They need to pay a staff. They need accountants, and payroll, and HR, and more. Of that 1% AUM fee (or worse) much of it is going toward these expenses. If you can choose stocks as well as the people at a big firm, you’ll have a large advantage because you won’t have the same overhead.
- Perspective – If you’re investing for yourself, you’re focused on long-term wealth building. Investment firms don’t have that luxury. Three letter agencies like the SEC and the IRS require them to report their performance to investors every quarter. The entire investing industry pays attention to these reports and rewards or punishes these firms based on their quarterly performance. Personally, I believe this is a terrible way to run any business or investment. I believe it’s causing long-term damage to our country and our world. If you want a good read on this subject, I highly recommend The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America. (This is another Amazon affiliate link.)
- Rational Self Interest (or Greed) – Like it or not, fund managers are in this business for themselves. Sure, they make money if you make money. However, they can also make a lot of money in ways that hurt you. One common practice is for these funds to do lots of buying and selling over time. Some charge you on a per-trade basis. Others charge you every time you make a profit (up to that 20% number.) This means it’s in their best interest to do as many trades as possible, as often as possible. That is rarely good for you.
I’ll leave it to Mr. Feroldi to give you more details here, but I agree with his assertion that the individual investor has a lot of advantages over most active fund managers. This means that you, as an individual reader, do have some hope of beating the market despite the fact that 93% of the pros can’t. But that’s not the end of the story either.
Before you take the points from that last section and run off to start picking stocks, let’s take a moment to consider the concept of expertise.
Is expertise valuable or important to you? Maybe it depends on the context, but overall I value expertise.
The COVID-19 pandemic has made this concept a hot topic. On one hand, you had doctors and scientists saying, “The best ways we know for you to protect yourself are…” (wear masks, stay at home, social distancing, etc.) On the other hand we had randos from politicians to Instagram influencers spouting all manner of nonsense. (One of my favorite examples of this jackassery was when a church not far from me started telling people that drinking bleach could cure the virus, and started selling it!)
My wife is a dentist and sees similar ridiculousity. Science has exhaustively shown that fluoride treatments are both safe for human beings and necessary for healthy teeth. She gets patients all the time who have watched some random conspiracy theory video on YouTube asserting otherwise. She has patients who sit in her chair and refuse fluoride or other scientifically-proven treatments while complaining that their teeth are ugly and painful. She explains that they’re welcome to believe what they want to, but eventually their teeth will get so bad that they’ll need emergency treatment. One way or another, they end up paying a lot of money for their obstinance.
So, what about investing? Do you need to be an expert to make money?
Recent history has proven that no, you truly don’t. However, for every example of the random individual who’s made great returns on the market there’s an example of a naive investor who lost thousands or millions because they didn’t know what they were doing.
One of the things I love about JL Collins book, The Simple Path to Wealth, is the reason he wrote it. He happens to be a finance guy. He made his fortune playing the market and has retired comfortably. When his daughter got old enough to start investing he tried to broach the subject with her. Her response was something to the effect of:
“Dad, I’ve watched you do this for your entire life. You spend countless hours on it. I know you love it and that’s fine, but I don’t want to spend that much of my life thinking about all this. I have other things to do. I just want a simple way to invest my money that will give me a good chance of success without taking up all my time.”
And that is why he wrote about The Simple Path.
The big actively-managed investment funds cost a lot because they hire really smart, talented people to do what JL Collins used to do for a living…they sit around all day and study companies. They look at balance sheets and performance, they read news, they watch for new contracts and trends and deals. Frequently, they travel to those companies to look at the operations themselves and judge whether they think they’re done well or not. These funds have an incredible amount of data, knowledge, and insight about hundreds of companies.
Despite that incredible amount of living insight, 93% of them fail to pick winners while avoiding losers.
So, how does your level of expertise compare to this? How many hours per day do you spend researching companies? How closely do you follow every scrap of news about government regulations, mergers, partnerships, contracts, and other business deals?
If you’re in school, or you have a job, or a hobby, or you have a family (and I hope you have some combination of them all) I bet you don’t have as much time to devote to investing research as an analyst who earns a 6- or 7-figure salary to spend all day every day diving deep into research. If they do worse than average 93% of the time, how can you possibly hope to do better, even with your unfair advantages?
That last point is the main reason I put most of my investments into low fee index funds. Even if I thought I had the expertise to do professional-level analysis, I just don’t have the time. Frankly, I have better things to do with my life. I suspect you do as well.
I believe that the vast majority of us are better off living full, meaningful lives and leaving our investments on autopilot in low-fee index funds. I don’t think it’s worth the time and energy it would take to do the research necessary to beat the market. Your family, your friends, your hobbies, and yes even your job(s) deserve better.
Talking about jobs highlights another critical point. Can you make more money using your time in other ways?
Some jobs pay by the hour. If you make a high wage, I assert you can get a better ROI for your time by spending an extra hour at work as opposed to researching investments. As an airline pilot, this is almost certainly true.
If you aren’t a wage employee, do you get a performance bonus? I bet the commission from making an extra sale is better in many cases than spending an equivalent amount of time researching stocks.
Taking this further, have you considered a side-hustle? Sometimes these aren’t the most lucrative ventures as first, but I know of many side hustles that bring in a lot of money. I do some flight instructing that pays far better than I could possibly do picking stocks. I’ve heard of people who sell digital products on Etsy that make amazing money for very little effort.
As a fan of BiggerPockets, I strongly believe that investing in real estate is a great way to make money. I believe that a hardworking investor who sets up good systems and processes can vastly out-perform the stock market though real estate investing. If you’re out to make a lot of money, I assert that you’re far better off reading books, blog articles, and listening to podcast episodes on BiggerPockets (and then taking action!) than you are researching stock picks.
How I Pick Stocks
Having said all this, I’ll admit that I do some stock picking. Why? Because it’s fun.
There’s something thrilling about the fact that my investment in Virgin Galactic (NYSE:SPCE) is still up 257.12% today even though the rest of the market is way down. Unfortunately, that great pick is being dragged down by my shares in LYFT that have done nothing but sink since I bought them. Because…
…93% of the pros do worse than the market average. I lack their expertise and my picks stand a decent chance of being even worse than theirs, despite my unfair advantages.
And yet, I have shares of few companies that I think will go up over time. Instead of wasting all my time and energy on picking stocks, and risking all of my family’s savings on my inexpert abilities, I’ve chosen to give myself a sandbox to play in. I have a section of my Roth 401K set aside for stock picking. I allow myself to buy and sell whatever I want in there, knowing that I could potentially lose it all.
To mitigate that risk, I only gave myself a small portion of our overall savings to play with. I recommend the average investor like me allows a maximum of 5-10% of your total nest egg for stock picking. This way, if you make a dumb choice and lost it all, the loss isn’t catastrophic. If you pick a home run, it’ll be a nice boost overall.
I’ve found that this little sandbox satisfies my (probably irrational) desire to pick stocks and see if I can outsmart all the big hedge funds and the market at large. Overall, I’m doing about as well as my holdings in FXAIX, plus or minus a few percentage points on any given day.
I’m doing all this trading at Fidelity where they no longer charge a fee for individual trades. I’m doing it specifically in my Roth 401K so that any profits I make don’t increase my tax burden. If your company doesn’t offer a Roth 401K, you could do the same thing with a Roth IRA account.
Do You Have Unique Expertise?
A few moments ago, I blithely assumed that none of us has enough expertise to out-perform a pro at a big investment firm, but I don’t think that’s universally true.
I think most of us probably have quite a bit of expertise in our chosen profession. I’m a pilot, and specifically an airline pilot. I guarantee that I have some very unique insight into my particular company that no bean-counting analyst could ever obtain. I believe that between my network of airline pilot buddies and my first-hand understanding of our industry, I can make some pretty good calls about other companies in our industry too.
Want an example? When two 737 MAXes crashed, killing hundreds of passengers, Southwest Airlines stock tanked. I don’t work for Southwest, but I think they’re a great company and I understand how and why they’re profitable. (I still think my company is better.) I bought some Southwest stock believing that Boeing would get the MAX back into the air (they have) and that Southwest would go back to being the profitable powerhouse it always has been. (That hasn’t happened yet, but when it does, I expect a pretty decent ROI for that little corner of my little sandbox.)
I’m also a tech guy. I have a degree in Computer Engineering and I’ve made real money selling apps on Google and Apple app stores. I’ve been known to buy shares in a few select tech-related companies based on my knowledge. Again, that’s only a small part of what amounts to 5-10% of my overall nest egg. Am I likely to get rich off those picks? No. However, picking those stocks scratches an itch, and keeps me from making bad decisions with the rest of my money. In the meantime, most of my money is making my rich by sitting quietly in low fee index funds.
If you’re going to pick stocks, limit it to a small part of your portfolio. Invest where you’re strong – where your education and experience give you unique insight. Take advantage of your unfair advantages, and try to invest in places where making a profit from short-term trades won’t cause you tax issues.
However, I recommend you spend the overwhelming majority of your time on something other than researching and picking stocks. At worst, work more at your primary job or scale your side-hustle. Better yet, spend more time doing things that you love – things that bring lasting happiness into your life. Spend time with your friends and family.
I promise that on your death bed you will not say, “I wish I’d bought more shares of TSLA at $240!” Personally, I’d rather be able to look back with contentment and pride knowing that I had love and been loved by people that matter…and that I’d spent my life enjoying time with those people.
Put most of your money into low fee index funds and forget about it until you need it. The Shockingly Simple Math says that this strategy will help you reach FI. Let that be enough and spend the rest of your time and energy on things that really matter.