Thursday, January 25, 2007

why worrying about your stock portfolio is a waste of time

Nearly all the financial advice people receive these days is about investing in the Stock Market. I asked the question Should you invest in real estate or stocks? The key metric in my mind was risk.

I stated:


"One of the interesting things to consider when answering this question is what does the business world think about the risk of investing in real estate Vs the Stock Market? That answer is quite easy to answer. Just think about how much money a bank will loan you on a house Vs how much they will loan you to invest in a stock and the relative interest rate of each loan. From what I know, the maximum margin loan you can get on your brokerage account is 30%. On a piece of real property the amount is 80% or more in some cases. Interest rates on margin accounts are typically over 10% Vs less than 6.5% on real property. So the business community is telling us that stocks are an extremely risky investment while real estate is a very safe investment. "

JLP at AllFinancialMatters made a great table showing this risk based on the Callan Periodic Table of Index returns:








Now JLP, as a stock oriented financial person, analyzed the Callan Table looking for ways to beat the market or maximize his returns. But, from my perspective, as a statistician, I look at the table as proof that trying to get the best return from the market is purely random. And anyone that claims they can outperform the market is selling snake oil.

What JLP's table proves is that:

  1. Unless you have inside information, you are wasting lots of time and money buying advice and newsletters from someone to fool you into thinking that they can predict random events
  2. If you invest in the short term, you are entering a high risk gamble. You must stay in the market for long periods (20 years) to average the good returns you the market can provide.
  3. If index funds are this volatile, managed funds are worse, and individual stocks are insanely risky. Gambling on the next Microsoft may be exhilarating, but it is not a wise use of your investments.
  4. An S&P index is no doubt the safest of all and provides a very good return for your risk

Now, some people point to Warren Buffet as an example of how to beat the market. But a look at how he really made his money shows that his strategy was to buy whole companies and manage them well. He was not just gambling on a stock - he had control. When you and I invest we do not have control. So our risk is much greater and there is little we can do about it. That's why I suggest real estate (not REIT's which the financial planners will tell you to do) - control.

If you invest in the Stock Market (a good thing), even using index funds there is risk because you have not control. Understanding that risk and choosing to invest in an index fund is a pretty good long term investment. But putting part of your investment portfolio into into things where you have control is also extremely important in my opinion.

UPDATE: Here's an excellent analysis by MyPocketChange of the number of years needed to generate an average market investment. My estimate of about 20 years is statiscally pretty accurate. Here's Pocket changes quote:

My last comment… You’ll notice how the best returns are lessened as the investment period increased just like the worst returns improved. This truly shows the gambling nature of short term investing. The highs are high and the lows are low. And unless you can find a pattern to the 3rd plot above, you truly are rolling the dice. In the end, the average person will pick as many winners as losers, and he’ll end up getting the same total return as if he had simply invested for the long term, except one thing… transaction costs. Each time he buys or sells, returns are eaten up by fees. Sure, plenty of people will beat the long term return. But
they are lucky and even more are unlucky (due to transaction fees). My advice?Don’t gamble with your investment money. It’s worth too much. Invest long term, and invest with index funds (their low turnover makes them long term investmentsby definition). You’ll minimize your expenses and minimize your risk. It might not be glorious or exciting, but it gives us all the best shot.

4 comments:

Miller said...

The psychology factor is huge, and very underappreciated. Index funds have been described as "safe" and "boring" (which if they are so, it's merely so compared to managed funds and stocks -- but the risk is still VERY real). For me though (and I accept that this is just my opinion), the evidence is undeniable that statistically index funds are not only safer... but BETTER! Note, this is only a statistical (long term... "average", whatever you want to call it) result...

Paul said...

Statistics is something that most everyone hated in school, yet plays such an integral role in our daily lives and decisions. We make bad statistical decisions every time we buy a lottery ticket or panic over global warming.
From an investment standpoint, our failure to use statistics properly enriches all the financial advisers and makes us poorer

FIRE Finance said...

This is one of the finest posts at the carnival which has a lot of real life truths about investing. Thanks for the great job, we listed you as one of our favorites.

American Goy said...

Looks like we both saw the same thing..

http://americangoy.blogspot.com/2008/02/truth-about-mutual-funds-aka-i-am-idiot.html