“Don’t look for the needle in the haystack. Just buy the haystack.”Jack Bogle
In the mid-1970s, the late great Jack Bogle introduced the first index fund, which allowed investors to buy the market as a whole, instead of purchasing individual stocks or actively managed funds. This new investment option was met with relatively little fanfare, and many mocked the idea of wanting “just average returns.”
It took a while, but the passive index fund has become the investment vehicle of choice for the lay investor. According to Morningstar, the percentage of U.S. equity assets in passive funds has grown to over 45% in 2017, up from approximately 20% ten years earlier. This number is expected to continue growing.
Among FIRE bloggers and enthusiasts, passive index investing has garnered almost a cult following. “Give me VTSAX, or give me death!” could be the tagline of many.
So, why, when faced with this mountain of evidence and pervasive advice on index investing, did I buy individual stocks for nearly the past 10 years?
It’s part of being human.
My Investing History and Overconfidence
When I started my career in 2005, I didn’t know crap about investing. I didn’t take a single course in college that covered anything practical about money or finance. However, I did enroll in Dinosaurs and The History of Rock & Roll. I wrote a five page analysis of the Strokes’ Reptilia, yet I didn’t know what a cost basis was.
I digress. Thankfully, I wasn’t allowed unfettered access to my investments in the early years. The money I put into my 401k and Roth IRA went into a selection of mutual funds with moderate fees. Those were the dark ages on my path to FI, and I didn’t think about money much then.
Around 2010, our company granted us access to a self-directed investment option, and I signed up. I could now do anything with my money!
Soon after, I began to buy individual stocks in earnest. One of my first purchases was General Electric, which was around $14 at the time. In a matter of a year or two, it nearly doubled. Cha-ching!
I was a victim of my own overconfidence.
My stock picks kept doing relatively well. I was hitting 2- and 3-baggers left and right. In retrospect, almost everything did well in the post-crisis recovery. But I, of course, assumed that I was just a great stock picker, and my copy of The Intelligent Investor was guiding me to the riches.
At some point, I started playing with options as a way to leverage my ‘bets’. Initially, I was just buying covered calls and selling puts. But it quickly devolved from income-enhancing strategies to straight up gambling. Needless to say, it didn’t end well. I remember distinctly one day in June 2015 that I lost 5 figures (!!!) in minutes because of a lousy earnings report from a chip company.
Beware the Survivorship Bias
“The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently”Warren Buffett
After the options trading debacle wiped out a chunk of my Roth IRA, I quit trading such risky assets. I resolved to stick to buy-and-hold investing, and to invest in solid, steady corporations.
I bought mostly large and mega cap companies, almost all of which you’d recognize the name. Buy what you know, they say. Honestly, it’s not a bad strategy, certainly not one that will kill your investment returns.
But it suffers from one major flaw.
The Dow Jones Industrial Average is an index that tracks the value of a group of 30 large public U.S. companies. Typically these represent the creme de la creme, and are moderately safe investments. I say “moderately safe” because it doesn’t mean these companies are immortal.
Let’s take a look at the current lineup of corporations in the Dow Jones Industrial Average.
A list of stalwarts that will stand the test of time. I’ve owned 16 at one point or another. Why not just buy some of these so-called “blue chips” and sleep well at night?
Now, let’s turn back the clock. Here is the same list of Dow components from 10 years ago. Green means they are currently healthy, successful public companies today. Red means they have either gone out of business, gone through a major transition/buyout, or have been on the brink of bankruptcy since the time of their Dow status.
Not so bad. 90% of the companies on the list are still major, healthy components of our economy. How about 20 years ago?
Hmm, only 77% still exist in their current form. Well that’s still roughly three out of four.
What does the Down Jones look like 40 years ago?
Uh oh. Only 37% of the 1979 Dow Jones components are still recognizable today.
The 40 year figure is important, because it represents the traditional length of an individual’s working (and investing) career.
A lot can change in 40 years. If you bought the S&P index 40 years ago, you would have done really well. If you randomly chose 20 of these stocks in 1979, not so much.
This is the survivorship bias in action. We only see the companies that exist today. When we look at their long and storied history, we think they are infallible. In fact, they are just the survivors, and there were many companies that looked like them before.
A similar phenomenon occurs with actively managed funds. When you read a prospectus and see that the fund has outperformed the industry average for the last 5 years, keep in mind that it’s quite likely the reason they’re still in business. Every other fund that suffered 2 or 3 consecutive underperforming years has vanished.
Predicting the Future
“It’s tough to make predictions, especially about the future.”Yogi Berra
Here’s one more personal example. In early 2018 I began to feel uneasy about my stock positions, so I started to get more conservative. I sold riskier, high-beta names and put more money into defensive companies, including utilities and consumer staples stocks.
I couldn’t decide between investing in Clorox and Kraft Heinz, so I bought both. Here’s the relative performance of those two companies since the time of my investment.
Clorox actually performed quite well, with a return of more than 20% in that time period. But Kraft Heinz took a nosedive, and was down more than 40%!
Of course, you could make specific arguments about Kraft concerning their debt, mismanagement, dying brands, etc etc… but the point is this: it would not be obvious to a novice individual stock investor to avoid Kraft, or to buy Clorox for that matter.
I Saw the Light!
“People who worry about pennies instead of dollars can be dangerous to society”Nassim Nicholas Taleb
The final piece that convinced me to ditch individual stock investing was reading The Black Swan by Nassim Taleb. The Black Swan is about the occurrence of highly unlikely (and unpredictable) events that have disproportionate impacts on our world.
I will cover this book in more detail in another post, but here’s one major takeaway from reading it: economics is a pseudo-science, and the ability to predict the economic/financial future of anything is garbage.
Think about it. Economists and fund managers make predictions every year about the strength of the economy and expected growth of markets. They’re somewhat wrong almost every year, and they’re grossly inaccurate every few years.
Why? Because you can’t predict such a complex system as the world economy. I’ll spare you the talk about Gaussian models and Modern Portfolio Theory.
I’ll share one analogy from the book, which talks about a famous calculation done by Michael Berry in his paper Regular and Irregular Motion.
Say you want to predict the trajectory of a pool ball on a billiards table after it is hit. By knowing the basic properties of the ball, the table surface and sides, and the nature of the impact, you can reasonably predict what would happen after the first hit. The second impact, though more difficult, can also be predicted, although it would require more precision. To predict the ninth impact, you would need to take into account the gravitational pull of someone standing near the pool table. And finally, the 56th impact would require knowledge of every elemental particle in the universe.
I think you see the point here. The world economy is an incredibly complex machine, with literally trillions of inputs: why do we think we can know what will happen in 1, 2, or 40 years?
One thing we can rely on? The stock market (as a whole) will go up and to the right. Why bet on anything else?
Summary: Breaking the Habit
“The beauty of investing is that if you keep it simple, it doesn’t have to take up much or really any of your time, very little of your time, and unlike many things in life, the less effort you put into it, once you understand and implement a few basic concepts, the better your results will be.”JL Collins
Individual stock investing was originally part of my financial self-education, which was necessary and useful. It became a hobby, and then it was an obsession. At some point it bordered on addiction.
I really enjoyed investment research, but I could never learn enough. In fact, no one can. Why try so hard, when the payoff is not proportional to the input, and is inherently driven by luck?
For me personally, individual stock investing no longer aligned with my personal goals. There are only so many hours in a day, and I have better things to do than read hours of individual stock analyses and still underperform.
What do you think about individual stock investing? Does it have a place in the modern FIRE seeker’s portfolio?