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How to Lose

William Ehart

MY OLD INVESTING self was like the guy in the meme who twists around to ogle a woman in a red dress, while his girlfriend looks ready to break his neck.

Just as jumping from one relationship to another introduces new risks, the same holds true for jumping in and out of different investments. For me—and for most people, I’d wager—investing in individual stocks and narrowly focused funds involves a certain amount of trading, and we know such trading is an exercise in futility. Even the vast majority of professional fund managers can’t consistently beat the market averages. If your reaction to that is, “Yeah, but maybe I can, I’ve got a good handle on the way the world works,” you may need professional help with your portfolio.

Despite ample evidence that most investors trail the market averages, we all tend to “feel lucky,” like the ill-fated villain staring down Clint Eastwood in Dirty Harry. Why? A key reason: Stock market averages get a big boost each year from a minority of stocks that post big gains, and those huge winners make beating the market look easy. So how about buying those big winners? Unfortunately, yesterday’s winners aren’t necessarily tomorrow’s top dogs.

In fact, past performance has no predictive power. It may seem obvious today that we should have bought Facebook, Apple, Netflix, Microsoft, Amazon, Tesla and Google’s parent company Alphabet. But these “obvious” winners only seem that way in hindsight.

On top of our unjustified confidence in our own stock-picking abilities, we have a host of other behavioral faults, including impatience, a desire for quick gratification and the feeling that the grass is always greener somewhere else. Result? In our efforts to beat the market, we flit back and forth among different investments, as our latest stock picks lose their luster.

After taking fliers over the years on gold and energy funds, biotech and telecom stocks, and emerging markets specialty funds that focus on consumer companies, I’ve learned three key lessons:

  • I’m not lucky.
  • I can’t predict world events or the market’s reaction to them.
  • Undiversified investment bets give me a few ways to win big and a lot of ways to lose.

I came by these lessons the hard way. I would make a new investment and be excited, thinking I’d made a good bet. I’d anticipate my potential gains and the validation that I’d outsmarted the market. I would tell myself I understood the potential downside, but really, I was practically counting my winnings.

But the thrill would soon fade, along with my original investment rationale. Perhaps the idea had come from some legendary portfolio manager or from something I read. But when my new holdings struggled, I lacked a frame of reference by which to decide whether to sell or hold.

A star manager might have said a drug company’s clinical trials were going well or that certain companies were going to gain market share. But then these things didn’t happen, and the stocks underperformed. Was this bad news now fully priced in? It’s nobody’s job on Wall Street to answer that, least of all the managers who touted the investments in the first place, and they probably wouldn’t know anyway.

Another example: About six years ago, I read a series of articles that convinced me that the next big trend was emerging markets consumer spending growth. That prompted me to buy some high-cost niche exchange-traded funds. But the two funds I bought consistently underperformed. One has continued to do so since I sold, while the other folded last May. Again, no one can tell you when or if such performance will turn around. Wall Street gets paid to sell you high-expense funds and keep you in them. Those high fees pay for a lot of research, writing and marketing, which in turn filters its way into the financial press, which then encourages you to buy.

There are two sources of investment risk: systematic risk, which is the danger that the broad market will fall, and unsystematic risk, which is the danger that your particular investments will lag behind the market.

Investors in individual stocks and sector funds face both risks. By contrast, owners of broad stock market index funds face only systematic risk. Indexing lacks the allure of sexy strangers and the prospect of quick investment scores, but the strategy’s risks are also far lower.

Success in broad market-cap-weighted index funds hinges on fewer variables. You just need aggregate share prices—driven ultimately by corporate profit and dividend growth—to rise at well above the rate of inflation, as they have for more than a century in the global stock market, despite two world wars, hyperinflation, stagflation, market crashes, panics and depressions. In other words, with broad stock market index funds, you’re making just one bet—and it’s a pretty good one for globally diversified investors with long time horizons.

William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart and check out his earlier articles.

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Guest
Guest
8 months ago

The stock market is so much more efficient today that’s it’s becoming more and more difficult to uncover the bargains. My mix of passive and active funds has worked fine for me but my individual stock picking has been atrocious – and certainly not for lack of effort.
For a number of reasons, I’ll likely soon transition to a much more index based portfolio.

Thomas Taylor
Thomas Taylor
8 months ago

I’m always a little hesitant to chime in when it comes to individual stock portfolios as I know the general audience on this site emphasizes low-cost mutual and/or broad based index and EFT’s. I have individual stocks in part of my portfolio, but I’ve never considered myself a trader and I don’t try to time or beat the market. I buy and hold but not necessarily forever. If it continues to help me reach my goals, I’ll be patient until something changes. I have a few stocks that have not done well over the years, but I expect that from time to time. I sold 7 stocks in early 2019 and 6 of those were to reduce the holdings. The other one just had hurdles I didn’t think they would overcome and it’s still struggling today. I used the proceeds to buy some stocks I had been watching. I sat tight in 2020 until August when I sold 2 holdings. Both were bought in 2017 and one of them a little voice at the time told me it was a mistake. The other was a technology company in the travel industry and as the Covid situation has unfolded, I think it will take quite a long time to recover. Both were tiny positions and I moved on. The only way for me to have taken advantage of the market drop(s) in 2020 would have been to sell stocks, so I just increased my 401k contributions instead.

parkslope
parkslope
8 months ago
Reply to  Thomas Taylor

Have you compared the performance of your individual stock investments over the years versus the S&P?

greglee
greglee
8 months ago
Reply to  parkslope

I invest in active mutual stock funds. I just looked up the S&P annualized performance for 1990-2020. It’s 10.7%. My portfolio of active mutual funds (from TR Price) has returned 12.48% for 1992-now.

Thomas Taylor
Thomas Taylor
8 months ago
Reply to  parkslope

I probably have not done as good a job as I should keeping up with this, but over the past 4 years, I trailed the average by about 2 points in 2017, “beat” the average by about 8 points in 2018, trailed the average by about 1 point in 2019 and trailed the average by about 10 points in 2020.

greglee
greglee
7 months ago

“… unsystematic risk, which is the danger that your particular investments will lag behind the market”

This is mistaken in a minor but telling way. Risk generally refers to volatility, which includes the chance that you will beat the market. That happens, too, with active sector funds. For instance, I bought into an emerging markets stock fund 8/1/2018 which is now up 15.29% annualized.

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