Although I’ve admitted to disliking the stock market, there are those rare days when everything goes right and I just love it. Those days are when your shorts go down in an up market, when your longs go up in a down market, your longs go up more during an up market, and your shorts go down more in a sell-off.
Plenty of people proudly proclaim their investment prowess now that the stock markets are back. You’ve got recent college grads who can’t even get an interview at a investment house recommending stock ideas on Motley Fool and Seeking Alpha as freelance writers. Are they confusing journalism with investing?
You’ve got grocery store clerks highlighting their latest stock ideas to customers during check out. Why work at Safeway for $9.25 an hour when you could make more trading stocks full-time?
You’ve got folks who put all their net worth in the stock market and think they’re brilliant because they’ve never seen a bear market having only started four years ago. The best attitude is when asked what if the markets go down? They say they’ll just buy more, as if they have infinite capital and courage.
Even people like me are writing more on the topic of investing while working on a new investment forum. Bubbly bubble perhaps? Probably. At least we’ll focus on short ideas as much as long ideas. A large reason why I’m writing this post is to remind myself not to be delusional in my investing abilities.
It’s very rare to meet someone who has admitted to losing money in the stock market. Perhaps it’s natural to talk about our winners and keep our losers hidden. If you’ve never met anybody who has lost money in the stock market, well let me be your first. I lost about $30,000 in a company called Gastar Exploration (GST) in a span of six months when I kept doubling down thinking gas prices would rebound. Now that was an expensive lesson in commodities trading!
What I do wonder now is whether people are once again being led to slaughter by becoming overconfident in the stock markets. If you start extrapolating 15% a year returns in your portfolio due to the past four years, many of your other assumptions change e.g. age of retirement, rate of savings, spending decisions, and so forth. You might think, “Why work hard and save as much if my investments are going to make me so much money? My $100,000 investment portfolio will turn into $1 million in 10 years!” I recommend everyone run scenario analysis on their portfolios. Be conservative in your assumptions please.
Are people confusing investing with simply the process of saving? When you are mindlessly buying a index fund, mutual fund, or a set list of dividend stocks on a list with every paycheck are you really an investor, especially if you consistently underperform? Let’s discuss.
THE DEFINITION OF ALPHA
Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.
In other words, if a capital asset pricing model analysis estimates that a portfolio should earn 20% based on the risk of the portfolio but the portfolio actually earns 30%, the portfolio’s alpha would be 10%. A 1000 basis point outperformance kicks ass, and if you were an active fund manager you would likely receive a substantial year end bonus. The issue is that you must combine outperformance (alpha) with managing a large sum of money to get paid. Otherwise, who cares. It’s the same with individual investors. If you’re up 40% on a $25,000 portfolio, $10,000 isn’t going to make a difference in your life at all.
If you buy a S&P 500 index fund, your alpha is 0%. Theoretically, your alpha is negative by the cost of owning the fund. Isn’t it interesting to think that with all the praise over index fund investing, you are automatically underperforming your respective index? Think about that for a minute. Trillions of dollars are chasing guaranteed underperformance! At least by investing in an actively managed mutual fund you have a chance of outperformance.
Looking at it from the fund administrator’s perspective, a company like Vanguard doesn’t need to pay a team of portfolio managers and analysts millions of dollars to invest because all Vanguard is doing is rebalancing the portfolio whenever there is an inflow or outflow of funds and a change of names in various indices like the S&P 500, which doesn’t happen too often. They are administrators, which should eventually be replaced with machines.
There’s also a very interesting dichotomy in the money management industry. Hedge fund managers will look down on active mutual fund managers for being “index huggers.” Index huggers are money managers who basically buy all the stocks in their benchmark and only overweight a few names so as not to underperform too bad in case their calls go wrong. They have no guts in other words. Meanwhile, active mutual fund managers look down on index managers given they don’t have to use their brains.
I’m never going to stop trying to outperform the markets with a portion of my equity holdings. The problem is that in order to generate alpha, I’ve got to stay on top of my portfolio like a hawk because of both endogenous and exogenous variables. Sometimes the effort will result in a positive 7% alpha in the month of May due to Chinese internet stocks. Other times I’ll work harder and generate negative alpha. Whatever the outcome, I plan to keep trying. I recognize that most active fund managers underperform their benchmarks hence why I only dedicate a minority of my equity to active investing.
SAVE, ALLOCATE, HOLD = INVESTING?
If you religiously set aside 20% of your paycheck into a low cost index every year for the next 40 years of work (holy crap that sounds long), you’ll likely do very well if history is any guide. However, everything is relative when it comes to finance. If everyone else who earns the same as you sets aside 20% of their paycheck in the same index fund, you are running in place. If everyone else who earns the same as you sets aside 30% of their paycheck in an actively managed fund that outperforms your index fund by just 1% over 40 years, now you are really falling behind!
Anybody can save money and automatically contribute to a fund that is run by someone else. Can anybody analyze a cash flow statement, forecast operating margins, build a dividend discount model, and put their own money to work in a hopefully risk tolerant way? Probably, but it requires education and effort.
One of the great jobs in finance is managing a Fund of Funds. You essentially raise capital to invest in various funds who you think will generate alpha. Your job is to research historical performance, stability of the fund management team, and analyze the portfolio manager’s investment acumen through interviews and presentations. A Fund of Funds manager should have his or her own investment insights by which to compare notes when choosing new funds. But other than that, is the Fund of Funds manager really an investor? Hard to say. I would argue that a Fund of Funds manager is an investor in people, not stocks.
SAVINGS IS A GOOD WORD BUT DON’T CONFUSE ITS MEANING
Before you can invest, you must save. We’ve gone through various savings strategies and savings benchmarks in the past. We’ve also discussed how one can find higher paying jobs in order to boost the absolute amount of their savings. Saving is the easy part. Any knucklehead can save. What to do with your savings to improve its money strength is truly the hard, but fun part of personal finance.
The reason why investing is hard is because investing is a zero sum game. You can and will lose money in investing, no matter how much you think people only make money in the stock market. With savings, you either save more money, save the same amount of money, or save nothing. You don’t start impaling your net worth by not saving. (See Proper Asset Allocation Of Stocks And Bonds By Age)
Sites that focus on minimalism and frugality are very popular because the topics are easy to understand and implement. However, it’s clearly much better to make more money than cut costs to improve one’s net worth and lifestyle because there is only so much in costs you can cut. I say pursue a good amount of frugality in your life as a comfortable base case scenario and then go for glory.
The wealthy own most of the assets in the world which is why most people don’t feel the same amount of satisfaction in a bull market. It’s up to you to find your own outperformance. Let’s not confuse investing with the basics of saving. Perhaps the definition of “real investor” can simply be answered with a question: Would you trust the person to invest your retirement savings? I hope this post gives you something to think about now that everybody is a money making machine.
RECOMMENDATIONS TO BUILD WEALTH
Free Wealth Management Tool: Sign up with Personal Capital to track the performance of your investment portfolios. They’ve got a fantastic Investment section that measures your risk and let’s you calculate various return and contribution scenarios. Furthermore, they’ve got a fantastic 401(k) Fee Analyzer tool which spits out how much in fees you might have no idea you are paying. After finding out I was paying $1,700 a year I switched out of a Fidelity Growth Fund and into a similar fund from Vanguard that costs $1,200 less. Fees eat away at alpha and takes years off your retirement goal targets if left unchecked!
Mobilize Your Idle Cash Earning Nothing: Wealthfront is an excellent algorithmic advisory choice for those who want the lowest fees and can’t be bothered with actively managing their money themselves once they’ve gone through the discovery process. In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being invested in the market. Wealthfront charges $0 in fees for the first $10,000 and only 0.25% for any money over $10,000. Their minimum is only $500 to get started. Invest your idle money cheaply, instead of letting it lose purchasing power due to inflation.
About the Author: Sam began investing his own money ever since he opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $150,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2016 and beyond.