The Truth About Investing
Regardless of your investing style, there are certain truths about investing and finance that are crucial to learn sooner rather than later. Some of these truths are perhaps best learned through experience and won’t really ring true until you start to see them come up in your own life, but many are undeniable with or without first-hand experience.
The interesting thing about money and investing is, though it may seem like a hard science from the outside, it’s much more of a soft skill. You can try to read all the books on economics out there and even be a Ph.D. economist, but that doesn’t make you good with money and it definitely doesn’t make you a market guru.
Doing well with money has little to do with how smart you are and a lot to do with how you behave. Countless very intelligent people are terrible investors and plenty of seemingly average people outperform Wall Street’s top firms every year. Such a confusing disconnect would only be possible if being good with money and investing well were more behavioral than scientific.
In the face of this realization, it follows that we should concern ourselves with the traits and characteristics of good money managing more than any information about markets or companies we might come across. Trying to follow and trade off market news will likely harm your performance, but consistently saving, indexing, and compounding are all but guaranteed to yield you positive results. With that in mind, the habits you form around money will be more conducive to your success than any detailed investment strategy.
Yet despite the saving and indexing approach offering such a clear path to long-term success, it’s important to remember how that plan is implemented should cater to each individual. Nobody’s goals with money should be based on someone else’s, even if that someone is widely successful. We are all different people with different objectives and, therefore, must carve our own paths to discover what works best for us. Understanding the advantage of indices, the magic of compounding, and the importance of savings are a few ways to yield greater success, but you still have to fill in all the gaps, which is much more challenging. Nobody can tell you how much to invest, when to invest, when to sell your investments, or how much to save, but you can still come to the conclusion that all roads lead to indices, saving money, and preparing for the future as best as you can.
As I dive into these insights, understand the aim is to underscore the need for an individual approach to investing while simultaneously advocating for the same approach for most investors. Financial decisions are both unique and personal, but the basic framework for how most people should invest or save for the future remains the same: embrace your uniqueness by tailoring your financial plan to your experiences, but have that plan revolve around indexing, compounding, and saving.
DIFFERENT PEOPLE, DIFFERENT GOALS
Before I get into indexing, compounding, and saving, let me explain why this idea of different people and different goals is so important, and how it plays into investing.
Though investors and money managers often suggest they know the best way to invest your money, people have very different goals that demand very different approaches, so there is no one size fits all. Any investor can find a strategy that works for them if they have the time and discipline, but that doesn’t make it the right strategy for anyone else.
Everyone’s personal experiences with money from when they were a child all the way to present day contribute to their whole conception of how money works and what constitutes an appropriate way to spend it. Their life experiences shape their psychology around money and how to manage it far more than any school, book, or secondhand experience.
The unabashed frugality of your parents might have driven you to enjoy your money in adulthood by spending it just as fast as you earn it. On the other hand, perhaps a fluke car accident when you were 19 forced a near ruinous bill on you, which drove you to always have a rainy day fund. There are endless reasons people can view money the way they do and there’s nothing inherently wrong with any of them. The point is we all have unique experiences and preferences that make a universal approach to handling money or investments impractical.
Some people are too risk averse to touch the markets and others can’t look away when they’re active. With such a wide spectrum of personalities, it should be no surprise that every investment should be made with each individual’s personal goals in mind. Those goals will usually include completely different risk tolerances, time horizons, motivations, and worldviews that make copying anyone else’s approach entirely unrealistic.
When investors have different experiences, goals, and time horizons leading them in life, there is no cookie-cutter approach. All the human emotions, narratives, and personal preferences feeding into an investment style are relevant because you have to be comfortable with whatever plan you end up committing to. What’s right or valuable to you does not mean it’s right or valuable to someone else, so you have to think long and hard about what your actual goals are, and what plan will work best to achieve those goals without sacrificing too many of your other objectives and desires in life.
WHY YOU CAN’T FOLLOW THE CROWD
It’s easy to succumb to the temptations of listening to others and their investment advice, especially if you aren’t particularly knowledgeable about the space, but it’s a recipe for disaster.
Not only do most people underperform when they handle their own investments, but they have their own personal reasons for buying those investments that you are usually blind to. You never know what assumptions or personal experiences are contributing to their bias, but you do know they have different life experiences and different financial goals that will lead them toward different conclusions. So whether it’s your next-door neighbor or someone on CNBC, don’t let their life experiences and the investments that follow from them influence your financial decisions.
If you still aren’t sold on making decisions for yourself, understand that even facts and current events are processed in radically different ways by different people. Breaking news from yesterday, for example, might lead someone to sell, but that same news could lead another person to buy that very same day. Any investor can have a completely different take on what that news means based on their own personal beliefs or experiences. You never know what information people do or don’t have, but it’s safe to say most people would still act differently given all the same disparate string of facts, and that’s because we’re just not the same people.
Under these circumstances, would it make sense for one investor to let another investor’s bullish bias influence their own? Of course not, they’re both operating in two different worlds with two very different perspectives. If you don’t share the same experiences or financial goals, you probably aren’t going to be able to share the same beliefs about the market. Don’t expect to reach *your* goals with someone else’s plan. In fact, you might not even be able to reach your goals with your own plan, which brings us to our next point.
HUMILITY
Part of reaching one’s financial goals is being humble enough to know your best shot is usually not banking on your superior investing skills.
Whether we want to admit it or not, we don’t and can’t access every piece of the puzzle necessary to have a truly accurate understanding of the world or why things are happening in the market. We are all left with just a few pieces of the puzzle we happened to stumble across and attempt to connect the dots in whatever way suits our biases or makes the most sense given our very limited knowledge.
Yet, despite everyone having an incomplete view of the world, we still try to form a complete narrative to fill in all those missing pieces. A small handful might do this with relative success, but most will let their faulty assumptions translate into very poor investments.
If you expect to form a perfectly accurate worldview or assessment of market action with such a small fraction of data, you will very likely mislead yourself into thinking you can outperform a basic market index like the S&P 500. But, as a long history of statistics has shown us, that is not a gamble most people should be willing to take.
With the role personal experiences, differences, and humility play in finance hopefully now explained, let’s get back to those key elements every investor needs to consider orienting their plan around, starting with index funds.
INDEX FUNDS
Though everyone would like to be the next Warren Buffet or George Soros, these are one-in-a-million investors whose success will be near impossible to replicate. This is not a knock on anyone’s intelligence, discipline, or drive, it’s just the reality. Even if you were as informed and spent as much time learning and researching as any of the great investors, the odds are still heavily stacked against you. Over a twenty-year period, only 6% of professional investors have beat the S&P 500, so nobody should be ashamed to trust an index over themself.
Every year, multi-million dollar hedge funds with a fleet of analysts, the greatest technology, and all the right connections struggle to beat the benchmark indices. And that underperformance is certainly not for lack of trying, so it’s very telling just how difficult generating returns is.
This is not to say beating the benchmark is impossible as there are a significant number of funds and individuals who do just that, but there are also a significant number of people who play professional sports; a significant number of chess grandmasters; a significant number of ultramarathon runners. The point is that there are outliers in every field that can skew the public’s perception of what it really takes to succeed at that level.
As humans, we love to focus on the outliers because they are the most exciting, but the vast majority of people will not be professional athletes, chess grandmasters, ultramarathon runners, or elite investors. To join the elite class in any of these fields requires a level of discipline, time, and innate ability most people aren’t able or willing to provide.
I mention all this because investors have an obsession with managing their own investments in an attempt to beat the market, which is a challenge only a small handful of outliers will be able to accomplish. If you find joy in investing in individual companies, so be it, but if the goal is to grow your wealth, every investor should be much more receptive to the idea of putting all their money in an index fund. Not only does an index strategy take essentially no time or effort, but you’re guaranteed to beat over 80% of investors. If finance isn’t your career, it makes little sense to fight those odds, especially when most people whose career is in finance still fail to beat the benchmark.
The unlikely nature of beating the market may be a hard pill to swallow, but this gets back to the role of humility, which is a widely under-appreciated and even overlooked strength in investing. Knowing what you don’t know and being able to accept that an index strategy would be a more financially sound decision is as challenging as it is wise. Nobody wants to admit they probably won’t make the best investments or the chances of them underperforming a basic index are incredibly high, but they should make whatever decision earns them a better return, not the decision that strokes their ego.
Everyone is obviously free to make their own investments and it’s always possible you are one of the select few who finds themself part of the elite investor camp, but there’s no need to expend all that extra effort or roll the dice if you aren’t aiming to make a career out of investing. You’ll likely rest easier at night when you aren’t worried about all your individual holdings and you’ll almost certainly be compensated more for doing it, so find joy in sticking to an index.
TAILS
Building off the previous points about indices, it might be helpful to dig deeper into why index funds are such an effective way to invest. The statistics around performance in the aggregate are very clear, but what’s contributing to those statistics being so heavily skewed to one side? With anything this complex, there are always multiple factors, but perhaps the most important reason indices provide better results is related to the role tails play in markets.
One particularly instructive fact about markets and business is that returns are predominately driven by the tails—the outlier companies and products achieving exceptional returns that more than compensate for all the failures and underperformance elsewhere.
For whatever reason, nature gravitates toward a power law where the top distribution (say the top 20%) is responsible for the vast majority (say 80%) of productivity, output, value, and everything else that keeps society and economies moving forward.
Despite billions of people on the planet, there are only a select few who had the means and the know-how to create the transformative technologies like electricity, the internet, or iPhones that all of us use and benefit from every day. If you were trying to find and bet on the individuals who would be responsible for those changes, it would be like picking a needle out of a haystack, but if you were simply betting on humanity as a whole to progress, you would win every time.
This analogy is equally applicable to picking a single company out of the entire market. You might get lucky or have such a talented eye that you find and buy the next Amazon before it gets big, but it would be much easier to just bet that there *will* be another Amazon. The thing about tails or tail companies like Amazon is they are so successful that they carry the rest of the market. There might be thousands of companies listed on stock exchanges, but only a small handful of them are responsible for the persistent long-term uptrend we’re so accustomed to seeing in the market.
Companies like Apple, Microsoft, Google, and Amazon are almost single-handedly responsible for the growth in the S&P in recent years, meaning it’s much harder to be a successful stock picker than people might think. If a small handful of companies are responsible for nearly all the returns, every other company is competing over a sliver of the overall profits and growth. Once you realize that, the challenge of becoming a successful stock picker becomes quite obvious.
There is often a misconception that the stock market goes up because every business is growing and earning more, but the truth is most companies fail. Even companies that eventually find themselves listed on public markets are not immune to failure. Whether public or private, most companies don’t last the test of time or generate substantial returns for investors for more than a few years, if at all. It’s the tails that move the needle and keep the needle moving over time.
Even if you were smart enough to invest in the few tails leading the market, there’s no telling how long their dominance will last. Only 0.5% of companies last 100 years, and even among those outliers, the leaders are eventually dethroned by a competitor: Sears before Amazon; Blockbuster before Netflix; IBM before Microsoft. So even a perfectly selected portfolio needs to constantly evolve to find the next set of outliers, which is orders of magnitude more difficult than identifying them just once.
Keeping the above in mind, there’s no need to take such an obvious gamble when an index fund will largely capture the gains of the ever-evolving list of tail companies. Being an outlier investor and successfully finding the outlier companies is simply not a realistic strategy—fun though it may be—so trusting the indices and the tails they naturally include is most people’s best bet at consistently growing their wealth over time.
COMPOUNDING
The next essential ingredient to a successful long-term investment strategy is compound interest.
Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” Some people argue whether or not Einstein actually said that, but the point is equally as profound regardless of who may or may not be credited with the claim.
Compound interest is easy to overlook in the early years of investing because it can seem borderline negligible, but it has a funny way of blowing our minds in the later years when the exponential growth really takes hold.
The reality of just how unintuitive exponential growth is can be easily summed up by an example Jeff Booth presents in his book “The Price of Tomorrow.” Most people are probably familiar with the strange but weird fact that you can’t fold a piece of paper more than eight times, but if you were somehow able to fold that piece of paper fifty times, it would stretch all the way from earth to the sun.
One’s early percentage gains in the market—much like the early folds of a piece of paper—will appear so small that it seems impossible for it to eventually stretch to something so unimaginably large, but that’s the power of exponential growth. The beginning stages of compounding go largely unnoticed, but the last few shake our whole understanding of math.
A single-digit gain on your portfolio each year might sound laughable until you consider its real implications. Say you have $1,000 earning 7% interest. After the first year, that $1,000 will turn into a whopping $1,070, but, in the following year, that 7% interest will be earned on the cumulative value of your portfolio. So after year two, $1,070 will become $1,144.90, an increase of $74.90 instead of just $70 the first year. I know that doesn’t sound like much, but just hold on. After five years, you would have $1,402.55; after ten years, you would nearly double your money with $1,967.15; and after thirty years, you would nearly octuple your original investment of $1,000 with $7,612.26.
Now imagine if you started with $10,000. The value of your portfolio after thirty years would be $76,122.55. And keep in mind this is with just a 7% return over the years, which is generally lower than the average return of a major index. Even the smallest degree of compounding can lead to tremendous gains because the secret isn’t in the return, it’s in capturing exponential growth.
Another example of the importance of compound interest is Warren Buffet. Many consider Buffet to be one of the best investors to ever do it, but 90% of his wealth came after he was sixty-five years old, and 99% came after he turned fifty. The reason for this is Buffett understood compounding and was smart enough to stick to it through all those years. His gains in his early years may not have been astronomical, but he was always compounding his growth. Eventually, a 10% return on his portfolio would pay out more than most of his previous years combined.
Patience is key when it comes to investing. If you aren’t a day trader or professional investor, your focus should always be on compounding. Everything else is likely just a distraction and steering you away from the magic that is exponential growth.
SAVINGS
The last crucial element to a thriving financial plan is your savings rate.
When it comes to investing, the focus is usually on one’s investments, but the truth is, what you pick, assuming it doesn’t all go to zero, matters far less than how much you save and add to your investments every year.
Nobody can control or perfectly predict what the markets will do, but everyone can control how much they save. A simple but consistent savings strategy is often the difference between achieving and not achieving one’s financial goals.
Why put your entire financial future in the hands of the markets when you can easily supplement the growth of your portfolio with a small portion of your paycheck every month? Not only do you benefit from having the tens of thousands of dollars those savings ultimately add up to be, but you can have that money slowly compound with the rest of your investments to drastically expedite the growth of your wealth.
Investing isn’t just about market returns, it’s about wealth generation and preparation for the future. Viewing the market as the sole provider of your wealth generation is leaving out a key driver of financial freedom and long-term portfolio growth: a consistent savings rate.
If your goal is financial freedom in retirement or financial freedom at any stage in life, savings are going to play a critical role. Even if you believe you will reach your finical goals without adding to some sort of savings, the growth potential of savings compounding at even a few percent every year can lead you to far exceed your finical goals and possibly motivate you to retire much earlier.
To truly succeed in investing, you must study the endgame before anything else. If you don’t have a good idea of where you want to go, you won’t know how to get there and you probably won’t see the need to save in the first place. Even if you don’t have any definitive plans for the future, you’ll never regret having a hefty savings to fall back on.
Don’t leave your future solely to markets—take control of your wealth and find a savings rate that works for you because any amount you decide to save, even if it seems like pebbles in the grand scheme of things, will eventually add up to the whole mountain.
CONCLUSION
As mentioned in the beginning, the goal of this article is to highlight the many facts about the world and markets that lead us to make poor financial decisions. First, our differences not only require we create and stick to a financial plan that works best for us, but it demands we avoid following anyone else’s plan because they naturally have completely different goals and experiences influencing their decisions.
The second major point of this article is that none of our differences change the fact that index funds outperform the vast majority of investors, compound interest is every long-term investor’s key to success, and consistent savings can contribute more to our financial success than any investment. Once you recognize these truths about investing, the line between your financial goals and reality starts to fade.
The last thing I’ll leave you with is a simple but profound insight about markets: People can afford not to be the greatest investor in the world, but they can rarely afford to be a bad one.