Nobody Can Beat the Market

Any investor who has been around a while has heard that they can’t beat the market.  After hearing it so many times, you start to believe it.  Pretty soon, you want to move all of your money into an index fund.  Then you light your torch and grab your pitchfork ready to storm the gates of whoever tried to sell you an actively managed mutual fund with a high expense ratio.  And if anybody still believed they could beat the market, they could be shown research that shows that the majority of actively managed funds fail to beat the market.  But is it that simple?

Before we look at this problem we need to agree on some definitions.  When people say you can’t “beat the market” they are usually referring to the S&P 500 index.  And even then, it usually comes with some conditions:

1.)  You can’t beat the S&P after costs.
2.)  You can’t beat the S&P consistently over many years.
3.)  You can’t beat the S&P without taking on additional risk.

It sounds like we’re defeated already.  With all of this stacked against us, how can we possibly beat the S&P?  Before we give up, we need to look at exactly what the S&P is.  It’s simply an index comprised of the stocks of 500 large, well known companies.  But wait, there’s thousands of stocks in the world - how do we choose these 500?  Answer:  They are chosen by Standard and Poor’s, which is a research company.

Aha!  So the S&P 500 is chosen by people!  Once you realize that, you can turn the phrase “you can’t beat the market” into “you can’t beat the people picking the stocks in the S&P 500″.  And that truly doesn’t make sense.  It implies that the people working at Standard and Poor’s are the best stock pickers in the world and they always have been and always will be.  We know that can’t be right.

So then what do fund managers do wrong?  The reason they don’t beat the S&P 500 is because they don’t play by the S&P’s rules.  You don’t outrun a horse with a bicycle - you outrun it with a better horse.  This boils down to:

1.)  They have too much turnover.
2.)  They have either too many or not enough stocks.

For example, look at the Fidelity Large Cap Value Fund (FSLVX).  It tries to beat the S&P 500 but it doesn’t play by the same rules.  This fund holds 105 stocks instead of 500.  Turnover is 243%.  And it doesn’t beat the S&P 500.  If you told Standard and Poor’s to make a fund that plays by those metrics, I’ll bet they couldn’t do much better.

But we don’t have to look to mutual funds if we want to beat the S&P 500.  Other indices do the job just fine.  Over the last 30 years the NASDAQ has beaten the S&P 500.  And over the course of its life, the Wilshire 5000 has a slight gain on the S&P.  Other indices have failed.  The Dow Jones (which is only 30 stocks) has racked up about 50 years of losing to the S&P.

So, as I see it, it’s not that the market can’t be beaten.  It’s that everybody is trying the wrong way.

Own Things That Produce Cash Flow or Appreciate in Value

Once you’ve learned to spend less than you earn (or earn more than you spend) you should start to see money piling up in your bank account.  But this isn’t the end - that money is sitting there doing nothing!  Your money is like a little army of dollars and you are the general.  It’s up to you to deploy it properly, so that it starts earning more wealth for you.  Lazy money that relaxes in a checking account earning 0.0001% interest doesn’t build wealth.  You need to use it to own things that make money.

The debate over what money producing things to own is vast and never ending.  Some people love the stock market, some hate it.  Some love owning real estate, others would never touch it.  In my opinion, there isn’t one asset to own that’s better than the rest.  The only thing I know for sure is that you need to own something.

That ”something” doesn’t even need to be tangible.  Owning skills or knowledge is a great way to make money.  Another way to do it is to own things that produce no cash but are likely to appreciate in value.  This means that owning gold, a stamp collection, or antiques are all viable ways to get wealthy.

Once you own things that produce money you can take advantage of compounding.  Compounding is where you take the money produced by an asset and use it to buy more of that asset.  It seems like a simple idea, but it’s really a game changer when it comes to building wealth.  It changes the math behind making money from something linear (such as I’m saving $500/month) to something exponential (I’m saving $500 this month, $600 next month, $700 next month, etc.)

Exponential math is what causes flu pandemics.  It’s what causes viral videos on YouTube.  It’s what is taught in elementary school math class as A Penny a Day Doubled.  And it’s what can make great wealth.

Spend Less Than You Earn

Many personal finance writers like the mantra of “spend less than you earn”, but more than a few wish it could be reversed into “earn more than you spend”.  They argue that by adopting a scarcity mentality you will spend your energy being a baggie-washing frugalist and never truly achieve wealth.

I agree, to a point.  But before you can focus on earning more, you absolutely need to learn how to live on what you currently make.  Otherwise, even with a very high income, you will end up broke like MC Hammer.  Once you’re comfortable living within your means you can then switch the mantra around and focus on earning more.

Many people struggle with this step because it involves self-control and planning - two things at which human beings are notoriously bad.  But it doesn’t have to seem like a sacrifice.  Spending less than you earn is simply a matter of living one level below what you currently make.  If you’re a billionaire, live like a millionaire. If you’re a millionaire, live like a hundred-thousandaire.  If you make $50,000 a year, live like a college student.

Nor is spending less than you earn all about ascetic denial of the things you love.  When you have a budget or a plan you can still enjoy your favorite things.  If you are absolutely passionate about video games you can say to yourself  “I am going to spend 5% of my income on video games”.  In this way, you make room in your budget for what you love. As long as there is still an area in your budget for saving (for example, saving 10%) you can spend the 5% on video games with all the joy in the world.  And can congratulate yourself because you’ve taken a step to building wealth without giving up what you love.

1.) Spend less than you earn
2.) Own things that produce cash flow or appreciate in value

Granted, these two principles can be sliced, diced and expounded upon forever.  Also, the nature of how one carries out these principles is varied and certain methods gain or lose popularity and effectiveness over time.  When building wealth, it helps to think of the motto for Perl:  There’s more than one way to do it!

Principle #1 deals with either cutting costs or growing income.  Personal finance writers dicker back and forth about how best to do this.  Some focus on extreme frugality while others set their sights on growing your income by climbing the corporate ladder.  Some love the idea of budgets, some throw them in the trash.

Principle #2 deals with investing and how to deploy the money you’re generating from Principle #1.  Again, this is an area of hot debate with many different disciplines such as stocks, bonds, real estate, commodities or even things that have fallen out of fashion such as Dutch tulips.

Stay tuned for part 2 of this series, where I will go into detail about Principle #1 - Spending Less Than You Earn.

I found this incredibly amusing because most mutual funds are comprised (fully or partially) of stocks.  She went on to say how the stock market was too wild, it was full of fraud and that it was a sure way to lose your shirt.  Now I was struggling to hold back laughter, but I could be wrong.  Maybe she owned a corporate bond fund.  I asked her which mutual funds she owned and she stammered “umm, uh…whatever my financial guy bought for me”.

I find this deliciously ironic - a woman who was scared of stocks put her faith (and money) in a stranger, who ended up buying stocks for her.  The moral of the story?  Know what you’re buying when you invest.

When I was a kid I wanted to be various things when I grew up:  astronaut, mailman, dinosaur rancher, President of the USA.  My friends typically had the same ambitions and our parents usually responded by telling us that we could be anything if we just set our minds to it.  However, somewhere along the way we all encountered some snarky pessimist who shot our dreams down by telling us “Hey stupid kid, you’ll never be president!  There’s millions of people who want that job!”.  Poof!  Our dreams are popped.  Is this really what we should be telling our kids?

It’s true though - the chances of you becoming president are one in a billion.  The chances of you becoming an astronaut don’t look good either.  In fact, the majority of kids’ fantasy careers can’t be attained.  But rather than bitterly shooting down our dreams or slathering us with unfounded optimism, perhaps adults should take the middle road.  Encourage a child in pursuing their fantasy field, rather than a particular dream job.

After all, with a little hard work the chances of you attaining some kind of political position are decent, even if you’re the mayor of a small town.  And if that fails, working for the government in some capacity is a very realistic goal.  And although your child may never set foot on the moon, the chances of getting a job involving flight, astronomy, NASA or satellites is fairly good if they’re wililng to work at it.  You may never become a famous rock star, but that doesn’t mean you can’t learn to sing, play guitar and perform in a local band.  Do you get the picture?

So next time you’re tempted to shoot down somebody’s dreams, think twice.  We may end up with more dinosaur ranchers that way.

This fallacy doesn’t just apply to romance.  People are always chickening out of things because of the fear that something won’t work.  They’re afraid to switch their college major or afraid to write a book or afraid to play sports because of the fear of doing something wrong.  What’s wrong is that people assume that if their date is bad, or if their new major is hard or if their book flops or if they miss a basket that all of their work was wasted.  This isn’t the truth.  If your date was bad you find another date next week.  If your book flops, re-write it or write another one.  The idea here is that failure isn’t permanent, it’s only one stop along a journey.  And that journey is going to have many successes and many failures too.

In fact, stories of failure are so common among people who eventually succeed that it really should be viewed as a prerequisite for success.  If you haven’t failed at something in the past, you’re probably doing something wrong.  I say “get out there and fail”!  If you don’t, you can’t ever reach the successes further down the path.

A great example is the history of American moon missions.  All we remember from popular culture is that President Kennedy announced in 1961 that we’d put a man on the moon and by 1969 we accomplished that.  What nobody remembers is that the first 15 American moon missions (starting with unmanned missions in 1958) were failures.  15 failed missions in a row would be enough to make most people give up, but we kept plugging away at it.  And these missions weren’t even glamorous - some just involved putting objects into orbit and a few involved deliberately crashing objects into the moon.  The Ranger 6 mission’s objective was to crash a spacecraft into the moon and snap a few pictures before it impacted and even that mission failed.  But these failures weren’t permanent - we kept working and we kept traveling down the path and it ended up with getting Americans on the moon in 1969 and bringing them back safely.

My co-worker may end up joining Match.com.  She may go on a lot of bad dates and a few good ones.  I don’t know what will happen to her if she joins, but I know what will happen if she doesn’t join - nothing at all.

I realize the Batman analogy is based upon a fantasy comic book world, but what if Tiger Woods or Warren Buffett had friends and family that tried to drag them down before they had achieved anything?  It’s hard to achieve something when your own side isn’t cheering for your success.  If you want to reach your goals - whether it is saving money, losing weight, getting a new job or learning a new skill you need to surround yourself with people who say “yes you can!” rather than “but what if this happens??”

The problem is that most people are weak and afraid.  Any time an unusual or bold idea crosses their paths, they run and hide rather than embrace it.  They have a huge fear response to risk taking and the unknown.  For example, if you told a friend you were trying to get a new job in the X industry, the fear response would sound like this:

“It’s hard to make it in the X industry.”
“Too many people are already in the X industry.”
“But you’ve never worked in the X industry before.”
“You need a degree in Y to get into the X industry.”

A friend with a positive respone would say things like this:

“Way to go!”
“I have a friend in the X industry - let me give you their number.”
“Let’s celebrate!”
“I always thought you’d be perfect for the X industry.”

Do you see the difference?  What kind of people are you surrounding yourself with?

1.)  Refusing to Buy Something

I know this sounds too simple, but refusing to buy something is the basis of saving money.  This applies mainly to things that you don’t need - fancy coffee, jewelry, designer clothes, etc.  Since a lot of people confuse wants with needs, I offer this simple test:  if you are thinking of buying something, just refuse it.  If you start to die, it’s a need.  If not, it’s a want.

2.)  Delaying Buying Something

There’s plenty of things that we can’t avoid buying:  food, water, toilet paper, etc.  But to save money, you can try to delay buying things that you need.  In the case of something like laundry detergent, this can be done buy cutting back on how much you use per load or choosing to wear an item of clothing another time before washing it.  There are plenty of frugality tips out there that offer detailed information on this, but it all boils down to saving money by delaying buys.

3.)  Replacing a Need With a Less Expensive Option

If you can’t delay buying a need, you can try to find the least expensive option or try to negotiate the cost of the need with whomever provides it.  For example, housing is a need but to save money you can negotiate the interest rate on your mortgage or the amount of rent you pay to a landlord.  This also covers using coupons at a store, or growing your own food.

4.)  Getting Somebody Else to Pay

I’m not talking about saving money by stiffing your friends on the restaurant bill.  There are a lot of times when you can take advantage of other people to avoid paying for something.  For example, if your employer offers tuition reimbursement you can use their money to save your own.  Or, if a friend owns a certain movie you can ask to borrow it instead of buying it yourself.