Why it’s hard to invest sensibly

By Felix Salmon
December 28, 2011

It’s that time of year when resolutions get made, and people have a bit of free time on their hands, and so thoughts turn to financial planning. This is a good thing. Top priority should always be liability management: make sure you’re not paying more interest than you need to, especially since interest rates are so low right now. If you’re carrying a substantial balance on your credit cards which isn’t likely to be paid off any time soon, look hard for some kind of loan which can pay that balance off.

Once you’re done with your liabilities, move on to your cashflows: put together a budget, set up automatic transfers into savings, that sort of thing.

Finally, and least importantly, there’s assets: where you should you invest your savings? This is the bit which people actually like doing — or certain people, anyway, including a quite enormous proportion of the readers of finance blogs and financial journalism.

The syllogism goes something like this: if you’re investing savings, that makes you an investor. If you’re an investor, then you should know what you’re doing. So go out there, get informed, make good decisions, and watch your net worth soar as you make your money work for you. Companies like thestreet.com and the Motley Fool make millions of dollars by selling information and investment advice to such people; Barron’s has been doing it for more than 90 years.

But you shouldn’t buy what they’re selling, even when it’s free. Trying to respond to global events so as to maximize your returns and minimize your risk is a great idea, in theory. But for individual investors — for you — it doesn’t work. Inevitably, there will be comments on this post from people saying that it does work, for them: that they’re successful individual investors. Those commenters might or might not be telling the whole truth. But even if they are, you’re not going to be able to replicate their success.

Henry Blodget has a fantastic post explaining why this is a game you simply should not get involved in.

If you’re an individual with some money to invest, the first thing you need to know if you want to invest intelligently is that you shouldn’t play the Losers’ Game, following global economics and markets and investment advice and trying to make smart decisions along the way.

If you play that investment game, you’re almost certain to lose.

If you want to invest intelligently, the first thing you should do is ignore 99.9% of what you hear in the financial media.

Because, if your goal is to invest intelligently, what you hear in the financial media is mostly distracting noise that will trick you into making expensive mistakes.

Go read the whole thing, it’s very good. And then, just for giggles, read some of the financial media. How would you “play Europe”, for instance, if you read the WSJ’s “Ahead of the Market” column?

Mr. Masterson worries that Europe could fall into recession and that China could suffer a sharp slowdown. “If that scenario plays out and we get a global slowing, then the U.S. will slow as well,” he says. “We’re all connected, and the strength in the U.S. markets now will be perceived with the benefit of a hindsight as being somewhat optimistic.”

On the other hand, some investors argue that European and Asian stocks could rebound dramatically next year, leaving the U.S. behind, if the sense of crisis fades. That could unwind the safe-haven flows into the U.S. this year.

The fact is that you can’t get “ahead of the market”: the market will always be ahead of you. You really only have one possible advantage over the market as a whole: if you’re investing over a very long time horizon — 20 years or more, say — then you can ride out volatility and take advantage of illiquidity premiums. But both of those things are easier said than done, especially for people who follow the news. And illiquidity premiums are hard to find for small investors: investable products like stocks and mutual funds tend to be run by companies which are constantly marking to — and trying to anticipate — market reactions.

But here’s the thing: simply following Blodget’s good advice — buy a handful of index funds, and rebalance automatically when the allocations get out of whack — is much harder than it should be. It’s hard enough that a company called Betterment feels comfortable charging a fee of 0.9% of all your assets, every year, just for doing it for you. The fee continues to rise as your asset base rises, but starts falling as a percentage once it goes over $25,000: if you have a nest egg of, say, $200,000, then Betterment will charge you $1,250 a year to put it in index funds: that’s 0.625%, over and above all of the fees on the index funds it’s investing in. To give an idea of what that means, $200,000 compounded at 7% over 20 years will become $770,000. The same amount compounded at 7.625% over 20 years will become $870,000. That’s a difference of $100,000.

For people who try to save a certain amount of money every paycheck, rebalancing should be done dynamically — you just buy whatever you need to buy to keep your asset allocation stable, and you never sell anything. But no one wants to do that kind of math manually every paycheck. One thing you can do is simply put all of your money into a single balanced index fund, like a target-date fund; that solves a lot of problems while adding a chunk of idiosyncratic fund risk. But in general the world of financial services is designed to extract as much money from you as possible, by offering as many unnecessary products and bits of advice as it can. Which is why following Blodget’s advice is much easier said than done.

Update: As various commenters and Timothy Lee have noted, there is at least one easy way to get a low-cost, diversified, set-it-and-forget-it portfolio: buy a Vanguard target-date fund and just keep adding money to it regularly over time. This is very good advice.


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Felix, what makes investing in index funds difficult is the employer 401(k) system, which gives most people awful fund choices and, even if they have a good 401(k), segregates the money unnecessarily from their other retirement savings.

If all your retirement savings is in, say, a single IRA at Vanguard, investing in index funds is trivial: you can buy a balanced or lifecycle fund, pay less than 0.2% in total expenses, and be absurdly diversified. If you’re half of a married couple with two lousy 401(k)s, a couple of Roth IRAs, and so on, soon you’re either building a spreadsheet or paying an advisor 1% to build one for you.

No company can rebalance automatically across all of your various accounts, because you don’t get to choose your 401(k) provider. So your beef is with the 401(k) system.

Posted by mamster | Report as abusive

I’ll bite on Felix’ teaser…

There are two big reasons why individuals tend to underperform the market.

(1) The financial system taxes their transactions. Mutual funds run fees between 0.15% and 1.5% annually. Brokerage fees can easily add up to more than $1k/year. Capital gains taxes eat into income in taxable accounts. If the real returns on a balanced portfolio approximate 2% per year, then management and transaction fees of 1% kill half your real gain. Hard to get ahead that way!

(2) Individuals tend to lose faith in their investments at the worst possible time. It is a proven fact that most people buy when sentiment is running high (and prices are high) and sell when sentiment is in the toilet (and prices are low). Even if you “beat the market” by 5% per year, if you cashed out in the first quarter of 2009, your overall returns were horrible.

Of course, the second factor is far more significant than the first in individual underperformance. Moreover, those who take a more active interest in their investments are MORE likely to cash out at the worst possible time.

Unfortunately, index funds only address the first piece of this equation. Felix has a better chance of finding the data than I do, but equity index funds almost certainly participated in the net outflow of cash from equity mutual funds between October 2008 and June 2009.

So my take is very different from his. Rules for SUCCESSFUL individual investing.

(1) Don’t attempt to beat the market. That will just drive you crazy. Besides, you aren’t any smarter than the millions of other people trying to beat the market. Any (sensible) strategy will beat the market during some periods and trail during other periods. Craft your investment strategy to meet your personal goals and to fit your personal risk tolerance. Don’t worry about what everybody else is trying to do.

(2) Read the financial commentary, but ignore 99% of what you read. It is only relevant to you if the rationale fits your personal investment strategy. If there is no rationale given, or if the rationale is poorly explained, or if the rationale is based on a different investment strategy, then ignore it. (Easiest to do if you don’t pay for advice. Cheaper that way as well.)

(3) Don’t try to guess the market direction. Know what you are willing to pay for any stock or bond that you might own. If the market assigns a higher price than you are willing to pay, then sit back and wait for the mood to change. If the market assigns a lower valuation, then you’ve found your bargain. Be happy and buy more.

In conclusion, I think Felix may be on to something when he talks about liquidity. As best I can tell, the market collapse in 2008/2009 was driven by deleveraging from investment desks. They didn’t particularly want to sell stocks, but they COULDN’T sell the (leveraged) MBS they were holding, and thus sold anything and everything else to raise cash. They faced a liquidity crunch. I didn’t, so I got a bargain.

Posted by TFF | Report as abusive

Well put, mamster.

Not to mention additional confusion created by having multiple savings goals (retirement, college fund, downpayment, emergency fund). Even simple investment isn’t all that simple.

Posted by TFF | Report as abusive

The “playing golf against Tiger Woods” analogy is only partly correct. Yes, the professionals have all the advantages in finding undervalued stocks. However, even professionals may speculate on stocks and create a bubble even if the stock is clearly overvalued.

In fact, few people have the patience or the money to go short on a stock and the short-sellers’ liquidity can be overwhelmed by those who have more to gain by speculating than buying on fundamentals.

For personal investors, I am NOT saying that they should go out and try to short overvalued stock. That would be absolutely disastrous. But I am saying that they shouldn’t blindly follow the advice to plow all their money into index funds. If the index is not throwing off as much money as bonds, then they should invest in bonds. Those who say equities always make more than bonds have too much faith in the Efficient Market Hypothesis, which does in fact create bubbles where regular investors can sense when the market is overvalued due to speculation and the shortage of short-sellers.

Posted by mwwaters | Report as abusive

LOL. :) Seems everybody agrees that market movements are about cash flows and/or liquidity. When cash moves into the market, prices rise. When cash moves out of the market, prices fall. Right?

So what dictates cash flows? The Efficient Market Hypothesis suggests that cash flows are always rational, calculated to perfectly balance risk and return. Yet most of the money (e.g. pensions) is driven by fixed allocation formulas that make NO explicit mention of risk or return. Much of the rest is driven by pro-cyclic sheep. And most of the hot money has moved into high-frequency trading, holding positions for seconds, minutes, or days.

How much money is truly available to move in a contrarian fashion for holding periods measured in months or years? The evidence of the last decade suggests, “Not nearly enough to prevent bubbles.”

Posted by TFF | Report as abusive

Investors following Blodget’s advice, which I believe most 401k investors have been doing a long time now via index funds, got hammered along with everyone else over the last 10 -20 years. The US 401K system has basically become a bet on the direction of the stock market, which is nuts given its inherently speculative nature. Even allegedly conservative life-cycle funds have people in their late 50s with a 75% equity allocation. The fact is, there is no path to a safe retirement now except to live frugally, save as much as you can, and try to protect yourself against the government destroying what you save by means of inflation/financial repression. But you won’t find information on how to do that unless you disregard Blodget’s advice and start paying very close attention to what’s going on in the world.

Posted by maynardGkeynes | Report as abusive

While it does seem difficult to conclude that one should ignore 99% of investment advice, the implementation of this strategy isn’t so hard (in an IRA, anyway). Buy a Vanguard Target Retirement fund for 19 basis points and call it a day. Felix’s point about idiosyncratic risk isn’t really an issue. See bogleheads.org for simple investing advice.

Posted by thatch22 | Report as abusive

“Buy a Vanguard Target Retirement fund for 19 basis points and call it a day.”

Not a bad approach, perhaps, but how many people lack the discipline to stick with this even when the market (and their Target Retirement Fund) is down 40%?

Truly, that is the crux of the issue. There are MANY potentially successful investment strategies, but reacting emotionally to a market drop will torpedo any and all of them.

Posted by TFF | Report as abusive

The best investment, of course, is higher taxes to build a more robust nation capable of providing you with higher social security benefits and more goods and services. Unfortunately, the private sector is in the way, and there are some people who make good money suppressing growth and trying to make sure you retire poor.

You always hear the retirement planners saying that you can expect a 6% return from stocks, but a minute or two on a mutual fund finder shows only one or two funds ever do that well, let alone the 20 or 30 years you have left to save for retirement. Even if you quit your job, bought the fanciest trading software and expensive informational services, you’d do no better than the best mutual fund. In other words, the whole idea of financializing retirement is just a con.

Posted by spiffy76 | Report as abusive

mwwaters is correct; I laughed when I read Felix’s calculation assuming that the stock market could be “compounded at 7% over 20 years”; which stock market is that Felix? The one that prevailed just after WWIII? The returns you can get, as a practical matter, highly depend on your timing.

See the story by Cordell Eddings posted at bloomberg.com on Oct 31, 2011 entitled “Say What? In 30-Year Race, Bonds Beat Stocks.” Summary: Long-term government bonds have gained 11.5 percent a year on average over the past three decades (a period containing Felix’s twenty-year investment horizon), beating the 10.8 percent increase in the S&P 500 index.

Posted by Strych09 | Report as abusive

“Those who say equities always make more than bonds have too much faith in the Efficient Market Hypothesis”
Wouldn’t that actually be incompatible with the EMH? If the claim you reject is true, bonds are systematically overpriced and equities are underpriced.

Posted by TGGP | Report as abusive

Strych09, the way I read that is that stocks are likely to dramatically outperform long-term government bonds over the NEXT three decades. Or you could just look at current bond yields to figure that out.

These things really aren’t random…

Posted by TFF | Report as abusive

Oh, TFF I agree with you that it’s not purely random. Looking back on it again, I poorly worded my previous comment.

I was just mentioning that fact because, as mwwaters wrote, stocks don’t always outperform bonds, and so you can’t just assume that they will as most books for non-financial professionals about retirement plan asset allocation do.

Posted by Strych09 | Report as abusive

One thing that is often dressed up as good advice is the question of saving costs. The difference between an expensive and a cheap provider is far less than the difference between a good performer and a bad performer – and bad performers tend to be consistent.

Savers these days seem however to be on a different wagon train. Investors got burned in stock markets with the Dot Com boom so switched to Housing. When housing bombed they switched to debt repayment – and they’re still paying down debt pretty fast, which is why the economy is having problems growing. At some point governments will reinstate the tax benefit of holding debt, and consumers will open their bank books again.

Posted by FifthDecade | Report as abusive

interesting comments….

I’ve got a friend who manages billions in private equity, and she laughs and laughs at all the people who think they can outsmart the stock market but only make commissions for bankers and brokers….

She smirks when she hears the term ‘stock market analyst’ .. … she says almost all bankers and brokers should simply be called “salespeople”

Posted by vca | Report as abusive

Wow, the fees from Betterment seem insane. Sometimes it is hard to invest with a “simple” mutual fund allocation due to multiple IRAs, various savings accounts, etc. I use a low cost DFA mutual fund advisor to stay balanced with my preferred bond/stock allocation, never trying to time the market. I pay less than $500/year/million for this and get great monthly reports, personal consultations when needed, and no selling or churning. I use strictly passive asset class investing, using primarily DFA funds. Google “DFA Advisors” for the general idea, there are several; I use Cardiff Park Advisors and like them.

Posted by ftc2112 | Report as abusive

It’s not impossible for individual investors to beat the market, but it’s not easy either.

To start with, you’ve got to have discipline and patience. Then you’ve got to be intelligent enough to make sense of what is going on in the world and how it affects your investments. And lastly you’ve got to have the time and be willing to put in the effort to research and monitor your investments diligently.

The problem lies in the fact that most individual investors only posses few, if any, of these traits, which makes it almost impossible for them to beat the markets.

Posted by mfw13 | Report as abusive

@Strych09 – But that article also highlights the fact that this is an unusual state

“Stocks had risen more than bonds over every 30-year period from 1861, according to Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School in Philadelphia, until the period ending in Sept 30.”

Which is exactly the point that TFF and other make above – if you invest in treasuries now, based on the current once-per-century results, chances are your will sell stocks in a trough to buy bonds that their peak – selling low and buying high, which is the mistake many casual investors make.

@maynard G Keynes – if you are concerned about inflation and want to preserve the value of your savings above all else, there are always TIPS.

Posted by Ragweed | Report as abusive

My only concern about index investments is that it builds up a lot of correlation risk, which Felix raised with a post about ETFs a few weeks ago. If a large enough percentage of the investment population is invested in an identical strategy such as SP500 index funds, then a broad change in risk tolerance can cause a large mass of investors to move together. The value of diversification is lost if investors are too highly correlated.

Posted by Ragweed | Report as abusive

The idea that the professionals on Wall Street have the advantages is absurd. Professional are playing with one arm tied behind their back. First, they are evaluated on a quarterly or at most annual basis. 20% drawdown and they’re fired. But if you can’t tolerate a 20% drawdown now and then, you can’t take on much risk. Someone investing 100% in the stock market (which is wise, if you won’t be touching the money for 40+ years) should expect occasional 50% drawdowns. So the professionals are forced to sell at the first sign of a possible drawdown, which is the worst type of market-timing. Second, professionals can’t just hole up in treasuries for a few years when the stock market is expensive. No one will pay professional management fees for that. Nor can professionals leave the financial markets entirely for rental real-estate, like individuals. There have been many times when real-estate was a bargain compared to stocks and bonds. Right now, if you are living in Sacramento or one of the cities hit hardest by the bubble, you’d be much better off buying single-family houses to rent than buying stocks or bonds. No, you won’t make quick profits. But you should be able to get 8%/year returns after inflation AND these returns are partially tax-advantaged, which is much better than what you will get from stocks and bonds at today’s prices.

The only thing individuals have to fear is other individuals. In particular, individuals like Warren Buffett. People who don’t blink at the possibility of a 50% drawdown in market values, because they buy with plans to hold forever and so they don’t care about market values, just long-term earnings. But there simply aren’t that many smart-money individuals like Buffett. Most rich people don’t want to watch the market like a hawk for opportunities to buy low and sell high. Which leaves the field wide open for individuals who are willing to watch the market constantly to take Wall Street to the cleaners. They just need to maintain a long-term perspective. Over a twenty year period, there will be times when the market is cheap. That is when you buy. And there will be times when it is expensive. That is when you sell, if you want to sell (holding forever is also acceptable).

Posted by revelo | Report as abusive

You broke my heart Felix. As one of your most loyal readers I’ve read at least a thousand of your posts. Many hundreds of those are fantastic enough that you should put them into a book. A few have missed the mark. And this one is the worst you’ve ever written!

TFF and others have offered more eloquent rebuttals than I could. Individual investors have every reason to belive they can acheive good investment results over the longterm.

Fear not though Mr. Salmon you remain my favorate finanical news source by far! Best wishes for the new year!

Posted by y2kurtus | Report as abusive

There’s a saying among poker players (well, I read it in a book on poker)–if you look around the room, and you don’t know who the mark is, it’s you. I believe that this how one should approach the market, and the players in the market. Of course don’t listen to advice from web sites and tv shows–their job is to sell advertising, not to make you rich. Fund managers are in business to generate fees for themselves. If they incidentally make money for you, well, that’s your luck, but don’t bet on it. I’ve kept my money as far away from the stock market as possible since the late 1990s. It was clear that the market was unmoored from reality, and I’ve never seen any reason to believe that it’s gotten any better in the meanwhile.

Posted by MacCruiskeen | Report as abusive


Bonds certainly aren’t systematically overpriced. In a panic, there can be a bond bubble and a stock trough, just like 2009. Even now, stocks may be a good buy because they need to get up to a P/E of 50 before their earnings yields goes down to the levels of 2% Treasuries.

But yes, it is indeed incompatible with the strong forms of the EMH, which is why I don’t really believe the EMH. It definitely is a fool’s game to try to beat the market in the short-term, but if your horizon is on the order of years and not months, it’s not THAT hard to beat the index through changing allocations between stocks and bonds. Of course it is by nature contrarian, which many people have difficulty doing.

Your horizon may also not really be years. Don’t play in the market if you’re not willing to get burned in the short-term, including interest rate risk for bonds sold before maturity.

Posted by mwwaters | Report as abusive

@mwwaters, I would argue that the best way to beat the market is to not try. If you approach investing with an eye towards achieving a modest return at a modest risk, then you have a good chance of achieving those goals. (And yes, a modest return beats the market when the market is flat or down.) If you instead try to “beat the market”, and checkpoint yourself weekly, then you are forced to take on excess risk at the worst possible times, resulting in large losses.

Felix wants to beat the market, or at the very least match the market. I don’t care what the market does, as long as I get my 7% long-term ROI. Give me a 3% dividend and 4% earnings growth and I’m happy.

Posted by TFF | Report as abusive

I’m happy to share with you!!!

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