In the last two posts, I went over extensively into how investment income is taxed favorably over employment income and how you can benefit enormously by maximizing your tax-free swimming pool. However, as some of you might have already guessed, there are a lot of investing misconceptions. Naturally, you may ask:
- What do I invest in?
- How do I know if it is right? Should I rely on the professionals?
- Stocks are risky – what if I lose all my money?
- What if the stock market crashes and burns?
That is a lot of hot air. These concerns are understandable and to be fair, they do have merit. The investing misconceptions are driven in large part due to a huge number of mutual funds, hedge funds, professional money managers. Most of them are trying to sell their brand and promising above-market returns with their “unique, time-tested and superior” investment strategy, it is no question that the innocent bystander feels paralyzed. As if that is not enough, the media is filled with stories of major stock market crashes (the tech-wreck of 2000, the housing bust of 2008, the Greek sovereign debt crisis of 2011 and more recently the coronavirus crash of 2020) and the horrific losses that investors have had to face.
In this post and the next one, I am going to answer these questions by presenting two different points of view on the stock market.
The Stock Tip
For those of who are Seinfeld fans, you might remember an episode from its first season that shows, in a light-hearted and humorous way, what emotions people experience when they put their money in a stock.
In that episode, George buys a stock after he receives a “hot tip” from an insider. Not only that, he persuades Jerry to do so as well. Jerry is initially reluctant and does not want to take the risk. But, after some convincing from George that the tip is legit, Jerry does so. In the next few days, the stock price takes a tumble and Jerry starts becoming anxious. George tries to convince him to hang in but, in the end, it was too much for Jerry. He capitulates and sells at a loss. However, afterwards, the stock roars up and George makes a tidy profit. George wins, Jerry loses.
The best part comes right at the end of the episode where Jerry, George and Elaine are sitting in the coffee shop. George lets them know that he has another “hot tip” involving some robotic butcher. Interestingly, this time the reaction from Jerry is entirely different. There is no push-back. No resistance. He wants to know when he can “get in” on the action.
Fear And Greed
What I described above are two extreme emotional states that people often experience when it comes to investing. The first one is FEAR (you will lose your shirt in the market) and the other one is GREED (you can become an instant millionaire). These two emotional states drive most of the investing misconceptions. The wizards on Wall Street are well aware that people are susceptible to these two emotional states.
Over the years, Wall Street has perfected the art of capitalizing on these two emotional states by releasing a barrage of positive and negative misleading information, mixed in with a dose of truthful, visible and easily verifiable information that allows them to build credibility with the masses. In the age of smartphones and social media where almost everyone has instantaneous access to information, the effect of this misleading information is unfortunately more pronounced than ever before. This in turn creates irrational herd behavior and leads to fantastic profit-making opportunities for those with the deepest pockets. They are the ones who utilize the controversial practice of flash trading, where high speed computer technology is used to view market orders fractions of a second before it is available to other participants. However, for the average Joe, the scenario is not that pretty.
Fund Managers – Slick Marketing
Most ordinary people have a low chance of success of profiting by trading in the stock market. Lo and behold, the most common “solution” provided is professional fund managers. Surely, the swashbuckling champions of Wall Street, having their Ivy League degrees and managing billions of dollars of their clients’ money, are way more knowledgeable than you are. If anybody knows how to find the hidden gem, it MUST be them, right? Unfortunately, the fund manager industry only makes the investing misconceptions worse.
These stories captivate the financial media. The winning managers are elevated to celebrity status and lavishly praised for their superior fund performance. In fact, in recent years, this phenomenon has taken on a new turn. In 2013, two activist heavyweights, Carl Icahn and Bill Ackman, publicly brawled over their views on Herbalife and committed massive positions – one in favor and one against. Insults and accusations were hurled. The media pundits capitalized on the gory fight with entire talk shows devoted to “experts” debating on which heavyweight was right!
There is just one little problem, though. It isn’t true. These “fights” are staged and choreographed. It isn’t about who is right and who is wrong. Its about broadcasting the power and awe of these all-knowing fund managers and getting cheap publicity. The aim? Bring more individual investors into the fold. The financial media is more than happy to go along – the advertising revenues are too great! With a stream of new money rolling in, the professional managers can close the funds that under-perform and launch new ones. This, in turn, allows them to “selectively” display the few funds that temporarily out-perform the market. Combined with choosing a time frame that happens to work in their favor, the fund managers can proudly claim an all-star performance.
Fund Managers – The Stark Reality
In 2013, Vanguard released the results of an extensive study on the performance of 1540 actively managed equity mutual funds. This study was over a 15-year period from 1998 to 2012. The findings were released in its report “The bumpy road to outperformance”. The results were startling, to say the least.
Only 55% managed to survive through the full 15 years. At a first glance, you could look at that and say “Well, that isn’t so bad. More than half of them made it through.” However, once you looked at how many funds actually survived and outperformed their underlying benchmarks, the number stood at only 18%. Yes, that is right. A staggering 82% of the funds failed to achieve their stated objective!
If you think that is bad, hold on to your horses. There’s more. Vanguard went a step further and dissected the 18% of the winners to select which funds had less than three consecutive years of under-performance. The reason for selecting the criteria was based on the assumption that for many investors, three consecutive years of under-performance represents a break-point after which they will throw in the towel. This could be either because of a policy requirement or simply because they conclude that the fund manager is incompetent. The results were even more frightening. Only 6% of the funds managed to survive, outperform and had less than three consecutive years of under-performance!
Well Then, What’s Next?
Hopefully, the discussion above can address the investing misconceptions that forever seem to float around. Also, it is clear that trying to beat the market, either through picking individual winners or hiring professionals, is a fool’s errand. In your journey to financial independence, I discussed the importance of using your employment income to make the structural shift into investment income and allow it grow over time. But, according to what I just described, it is almost impossible to achieve that!
But not all is doom and gloom.
In the next post, I am going to present you a different point of view on investing and the stock market.
Yours truly,
Rizwan.