Let’s quickly recap what we’ve learned so far about money:
- Money doesn’t have to be used as a medium to exchange for junk, but can instead be used as a tool to give you freedom, flexibility, and financial independence.
- In order to be financially independent, or not dependent on an income to survive, your money should be invested.
- The stock market provides the best avenue for investing in terms of performance and convenience, both of which are maximized by buying the entire market rather than individual companies.
Wow, it’s crazy how so much wisdom can be distilled down into a few basic concepts. This is part of the reason I love personal finance!
Which way does the stock market go?
It goes up! That’s right–you heard it here first (maybe not first, but you did hear it here!)–the stock market goes up. Recall that buying the market means becoming a partial owner of 3,700 quality US companies. These companies are not your neighbor’s crazy idea. They are well established, successful, profitable companies. Can they fail? Yes, and sometimes they do. But when they do, stronger, better companies emerge to take their place. And until there is literally no more room for innovation (look around you, there’s room) or aliens come and destroy our society, this pattern is very likely to continue. Hooray for us!
As you may have noticed from the featured image/sneaky lesson about dividend reinvesting above, however, the stock market does have periods of sideways or even extremely downward motion. Why does this happen? Well, people get excited and greedy when things are going well1leading them to purchase stocks even when they are very expensive, and scared and irrational when things are going poorly2leading them to sell stocks even when they are very cheap. This creates volatility, which can exacerbate fear, which can exacerbate volatility. Thus, in your lifetime, it is not unlikely that you’ll watch your net worth get cut in half at some point. Maybe at multiple points. You might face a five to seven-year period where you barely make any money in the stock market. But in the long run, this is all just noise. Underlying all of this noise is the actual ownership of 3,700 quality companies that will make you rich over the course of your life.
Timing the Market
I wrote previously about how people unsuccessfully try to outperform the returns of the market by picking individual stocks. Another way people try to beat the market is by timing it. When they think the market as a whole is overvalued, or when they think the future doesn’t look bright, they sell. When the market appears undervalued, they buy. As it turns out, predicting the future of where the market as a whole is headed is just as impossible as predicting the future of individual companies. Like picking individual stocks, trying to time the market is a fool’s errand. There are a couple of reasons why this is the case. First, people who time the market are generally driven by emotions rather than rational thought. If the market starts to crash, they get scared and sell, often when the market is down. Then they wait to buy until the market has been going up for a while and they feel comfortable enough to jump back in. Unfortunately, selling low and buying high won’t really make you a lot of money. Second, in order for someone to be successful as a market timer they have to be right twice! They have to first predict the top–when the market is about to crash–and then predict the bottom–when the market is about to recover. Getting each of these predictions just right is virtually impossible, since they are essentially both forms of trying to predict the future, which we haven’t figured out how to do yet.
But let’s say, as it’s safe to assume with all of our readers, that we aren’t really driven by emotion and tend to make completely logical, rational decisions all the time. Maybe we can use some sort of predictor or metric associated with stock market returns to time the market. According to this amazing Mark Housel talk, average Price to Earnings (PE) ratios are in fact somewhat correlated with stock market returns3r = 0.38 for those of you who care..Interestingly, other seemingly logical predictors of how the market might do, like expected GDP growth, are completely meaningless predictors of stock market returns. So meaningless, in fact, that market returns correlated better with something as random as annual rainfall! So what if we took PE ratio as our metric, and only bought stocks at low PE ratios and sold them at high PE ratios? A man named Ben Carlson ran this analysis for several time periods including 1928-2016, 1970-2016, and 1990-2016. If the PE ratio was above average, he assumed the investor put his money in US Treasury bills (a debt-based investment). If it was below average, the investor put his money in stocks. For ALL PERIODS TESTED, just leaving your money in the stock market performed better than jumping in and out based on PE ratio. The reason for this is that the market can spend significant amounts of time at a high PE ratio, continuing to go up as your money sits there in cash.
But what if now is the peak?!?!?!
So you’ve started making money, reading a nice blog, and now you’re ready to buy some VTI. You look at a long term chart and think, “Man, this thing is sky high right now! What if it’s about to crash?!”. Well, even if it is, you should still buy it now and hold on to it. If it crashes, great! Keep buying and enjoy those discounted prices. In fact, even if you’re like Bob (thanks again, Ben Carlson) and somehow manage to only invest right at market peaks, you’ll still do quite well in the long run. In the linked analysis, Bob invested a total of $184,000, exclusively at market peaks, between 1970 and 2013. How much did he end up with? $1.1 million. How did he do so well? He never sold. Even though Bob made one timing mistake–trying to time when he bought in–he avoided making the second mistake of selling his stock. In reality, you’ll be investing every month, which will ultimately include both extreme highs and lows, and never selling. And what if Bob had done this instead? He’d have ended up with over $2.3 million.
Conclusions, Picture, and Quote
I hope that with these last couple posts I’ve convinced you of the merits of a very basic, sound, and profitable investment strategy: whenever you have money (which will be often since you know about playing good Defense), buy the whole stock market with the Vanguard Total Stock Market Index Fund (VTI) and never sell until you retire. You’ll experience ups and down, plenty of bad advice (check out the August 1979 BusinessWeek cover below), and probably moments of doubt. But do yourself a favor and stay the course! You’ll be glad you did in the long run.
“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know…Then again, there is actually a third type of investor—the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” –William Bernstein
PS Do you have questions, criticisms, comments, or suggestions for future blog post topics? Let us know in the comments section below!