How Not to Beat the Market
It has always amazed me over the years whenever I see people managing their own stock portfolios, to see that the portfolio’s contents are merely a list of the currently most popular companies within the investment industry. Today, that list includes all the major tech companies - names like Nvidia, AMD, Apple, SpaceX, Microsoft, Tesla, etc. A few years ago everyone talked about Bitcoin, Gamestop, AMC, and Uber. During the dot-com bubble in the late 90s, everyone wanted Pets.com (went bust) and Webvan (went bust). In the late 60s and early 70s everyone wanted the Nifty Fifty companies, called “one-decision” stocks as you merely needed to make one decision - buy them - and then ride off happily into the fabulously wealthy sunset. Except - oops - they promptly fell 60-90% due to being ridiculously overpriced.
Think about this logically. Say you want to be a good investor. Say you want to do well. Say you want to earn good returns. Perhaps even better returns than the market overall given you’ve chosen to not simply own the market via an index fund. By choosing to buy individual stocks you’ve intentionally or unintentionally decided to try to beat the returns available to you for essentially no cost via a market-wide index fund. Because why earn 6% picking stocks yourself when you could expect ~10% on average over the long-term by just owning an index fund? So you want to beat the market. Does it make any sense at all to…….just buy the currently most popular companies? The ones that………..everyone else is buying? The ones that, due to their popularity, are selling at higher prices than most of the rest of the market? Does that seem to make sense?
One of my favorite analogies relates to basketball. Think of Michael Jordan or Lebron James or Steph Curry or Magic Johnson. Now say you want to be a great basketball player like them. If you study how they play, you see they all have different styles but the basics are the same - they shoot overhand with two hands, they take dunks or layups when available, when shooting their eyes are open and their bodies are facing the basket, etc. Now imagine that your uncle Larry says “yeah they don’t know anything." He says the key to basketball greatness is “shooting with your eyes closed, making one handed full court shots, shooting behind the back, or shooting while laying down on the court.” Which advice should you listen to?
In the investment world, we have that very phenomenon even though most people don’t realize it. We have the Michael Jordans of the investment world - people like Warren Buffett, Phil Carret, Ben Graham, John Templeton, Peter Lynch, Joel Greenblatt, John Neff, Walter Schloss, Shelby Davis, Prem Watsa, Tom Knapp, Charlie Munger, Bill Ruane, Lou Simpson, and Seth Klarman. If you study each one of these people (all of whom have outperformed the market for decades), you’re struck by something: though they’ve all had unique styles, they all had basically the same overarching principles. What are those principles?
Try to buy good businesses at good prices
Price matters - avoid fads
Deeply research a company and simply buy the ones you understand that are selling at a good price in relation to their future prospects
Eventually the success of a company/stock will tie back to its earnings, not its popularity
They all implemented these principles differently, but I guarantee you most or all would agree with those four bullet points. Those principles are the basketball equivalent of “shoot with your eyes open, face the basket, shoot with two hands, take layups or dunks if available.”
Instead most investors follow the uncle Larry approach:
Buy whatever they’re recommending on CNBC
Know nothing about your companies; just pray your stocks go up, baby!
Ignore market history and forget all the ways you previously lost money buying fads
Act like stocks aren’t real businesses - they’re just lottery tickets that are fun to play
Think the secret to wealth is buying overpriced IPOs or whatever industry is currently in vogue
Pay no attention to price or earnings. Never read financial statements
Never track your investment returns. Don’t evaluate your performance
With all that said, it’s not surprising that many personal investors fail to beat the market. They’re too excitable during bull markets and too disinterested during sideways or down markets. They frankly don’t take the game seriously enough. The stock market is a place of business where major corporations are offered up for sale. The true investor examines these companies, evaluates their financial position, contemplates and reflects upon its future, and only deploys capital when it makes business sense to do so. Most market participants merely want to play some shallow and unserious game. They want to gamble yet feel better about themselves versus going to the casino. So they “play the market” - a phrase I despise and one that hints at the unseriousness of many investors.
Yet even if confronted with this, most wouldn’t change. Money is a sensitive subject, and it elicits an ego in all of us. Perhaps more than most other areas of life, many individuals think they can handle their finances and investments without outside help. Whereas most people go to a mechanic for their car, a doctor for their foot, a lawyer for their legal questions - many people invest their life savings on their own even with no training, knowledge, or intellectual curiosity. Because we all are forced to use and spend money in our daily lives, we can confuse these basic transactions for financial fluency. We can think that because we know how to obtain a mortgage or buy a house, we must also be decent at buying the stocks mentioned on CNBC.
This problem is compounded by the fact that, as Howard Marks talks about, “bad ideas work all the time.” Tesla has easily been wildly overvalued for ~15 years; in so doing, it has taught people potentially wrong lessons that wouldn’t work on other investments. If you attempted to do your own brain surgery, you’d have a direct feedback loop as to your failure or success (failure = death). This isn’t how investing works. Bad ideas, ones poorly conceived or ones backed by deeply shallow reasoning, can and do still work. People can be right for the wrong reasons all the time. I know someone personally who put $100,000 into Nvidia and saw it climb to $1 million (10x!), even while having no idea the entire time what Nvidia actually did as a business, having never read their financial statements, having no experience or training as an investor, and having a lifetime track record of poor investment returns (though they’d never admit this). This is unquestionably luck, yet this person feels they’re a genius. You couldn’t actually convince this person that their gain was entirely a lucky gamble no different than a slot machine win. This phenomenon isn’t as prevalent in other industries. If you presented a terrible legal argument to a jury, you’d lose. If you incorrectly calculated certain aspects of a rocket launch, it would crash. If you tried to fly a 787 with no piloting experience, you would likely fail. Yet in the investing world where fads can persist and overpriced doesn’t mean “going down tomorrow” - bad lessons can be learned and egos can be unjustly padded.
The final point I’d make is that many investors don’t truly understand compound interest or exponential math. To many investors, if you told them their career returns from managing their own money had been 6% whereas they could’ve purchased an index fund of the market overall and made closer to 10% - they would recognize the fact that 10 is greater than 6 but wouldn’t understand that in the world of compound interest - that spread is huge. For context, consider $100,000 invested for 50 years at 10% or 6%, and say you added $10,000 a year along the way. After 50 years, the 10% scenario would have $23 million and the 6% would have just under $5 million. This small 4% difference in your compounding rate created an extra $18 million! If you earned 15% like Phil Carret did for 50 years, the end result would be $180 million. Though people would see that 15 is bigger than 6, they wouldn’t realize the end result would be $180 million to $5 million. The human mind thinks in a linear fashion and struggles thinking exponentially. So when people lag the market, they view it as not that big of a deal - when over time they’re very literally costing themselves hundreds of thousands and potentially millions. In the game of compound interest, even small improvements lead to huge outcomes.
So next time you think about buying the latest fad stock, remember the foolishness of uncle Larry, remember the principles of the greatest investors to ever do it, and remember that real wealth is built step by step over time using common sense principles.