One of the things that has always baffled me is that people are so easily willing to attack the intelligence of those who gamble and play the lottery, while nobody ever criticizes those who buy stocks. To me, buying stocks is the far less rational act.
Playing black jack is a poor investment. Black jack is a “solved” game, that is, we know the exact strategy to (which is very easy to learn – in fact, the nifty graphic below shows you how) to play the best possible game of black jack. Unfortunately, even when one employs “basic strategy” black jack, they still only have a 49.8% chance of winning each hand. This means that no matter what, every person who plays black jack will always lose in the long run. However, despite being a poor investment, black jack can be a great consumption purchase.
At $10 per hand and 60 hands per hour, a basic strategy black jack player will only be losing on average $3 per hour. With the excitement that black jack brings, social interaction and comps from the casino, $3 per hour is chump change for the level of entertainment you are getting. Similarly, buying a lottery ticket can be a great purchase for some people. While it will never be a great investment, for those who can suspend their disbelief and dream about their new life as a millionaire, the lottery is a great form of entertainment that many are happy to pay for.
Despite my justifications for gambling and lottery tickets (for the record, I don’t do either), I cannot understand why any of my friends buy stocks. Unlike gambling, buying stocks is not cheap entertainment, but similar to gambling, buying stocks is a very poor investment.
To understand why buying stocks is a poor investment, there are two things that one must know about; 1) the efficient market hypothesis and 2) index funds.
The efficient market hypothesis posits that the stock market is efficient and is therefore impossible to beat, as the market price for all stocks reflects all relevant information about the intrinsic value of a stock. While the EMH has some problems, it is mostly true and is sufficient for the purpose of this article. The concept behind this theory is that when one buys a stock, it will never be overvalued or undervalued, but will always be just right.
When a young investor starts seeing GoPros all over their Facebook feed, they naturally might be bullish on the future of the company and think that their stock is worth investing in. What this person is forgetting is that all of the professionals and algorithms on Wall Street (and everyone else who buys stocks) has access to this same information. In fact, the professionals almost always have access to far greater information and conduct far more sophisticated analysis on the price of the stock. These investors will continue to purchase or sell the stock until they think it is no longer profitable to do so, aka, when it is at its fair market value. If you buy a share of GoPro, you are essentially saying one of two things; that you know something that Wall Street doesn’t, or that your analysis of the stock price is more robust than that of professionals. So unless you have access to hidden information or have the ability to perform a more a more in-depth analysis of a stock, you should approach a stock from the presumption that it is fairly priced. From here, the growth or decline of any stock is random and not something that can be predicted. Add in all of the fees involved for every time you want to buy or sell a stock, it becomes clear why 99% of professionally managed funds have shown no ability to beat the market on a consistent basis. Over the past ten years, individual investors have had a 2.63% annual return on their investments, substantially lower than the 5.8%+ from an index fund.
The next thing that you need to know about are index funds. Index funds work by allowing you to invest into one fund that reflects all of the securities in the entire market. The value of this fund will mimic the growth and decline of the stock market as a whole. As the market as a whole will always increase over time, your investment will always increase.
One of the reasons why index funds are so attractive is because they fall under the category of “passive investing”. When you invest in an index fund, there is nothing more you need to do. No market watching, no trades, no nothing; just sit back and wait for your money to accrue. Because there are no trades involved, one of the most important benefits of this type of investing is the lack of fees. In comparison to buying stocks or an actively managed fund, an index fund will always have cheaper management fees, leaving more money for your investment.
This is why Warren Buffet told his family to put 90% of his estate into an index fund: “I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.” In 2008, Buffet made a bet with a New York money manager that an index fund would beat the manager’s choice of 5 hedge funds over the next ten years. 7 years after the bet, the index fund is up 63.5% while the hedge funds are only up 19.6%. If hedgefunds and major banks are losing to an index fund, then same is likely true of any stock you are thinking of buying.
I am not saying that you are guaranteed to lose money if you buy stocks, just that there are overwhelming odds of you receiving less money than if you invested in an index fund. While I can justify black jack and lottery tickets as cheap entertainment but a poor investment, stocks are far too costly to gamble in.
For any Canadian curious as to how they should be investing their money, please see this guide on Canadian Couch Potato.