How to Make Money
In the stock market, there are a variety of ways to make money. What’s interesting is that once an individual identifies as a certain type of investor, I’ve noticed that there seems to be a general tribe mentality of right and wrong ways to make money. Whether you are a high frequency day trader or a traditional buy and hold investor, I’m here to tell you that you are correct if it works for you. Finding a method that suits your personality and schedule is the key to long-term success. There are a million different strategies I could touch on, so I’ll just highlight the major ones along with some pros and cons.
Buy and Hold: The classic. Everyone is familiar with this in some form as well as the mantras that accompany it like, “don’t time the market” and “don’t put all your eggs in one basket.” In 1990 Harry Markowitz won a Nobel Prize for his work on Modern Portfolio Theory which is the foundation for how a lot of portfolios are constructed to this day. By combining different assets with different risk/return profiles, one can mitigate the risk of choosing the wrong horse in the race. The math behind it is somewhat complex and involves a lot of Greek letters, so let’s focus on the big picture. The reason this is so popular is because it doesn’t take much time to set up and maintain and it has shown itself to be profitable over long periods of time. There are some drawbacks, however. During periods of market stress (see: March 2020) the correlation between the investments in a normally well-diversified portfolio becomes high. Said differently, investments that were previously marching to the beat of their own drum are now all moving in the same direction (down, unfortunately). The drawback during good times is the tendency of an investor to focus on the worst-performing investments in their portfolio rather than looking at the portfolio as a whole. This is a feature of diversification, not a bug. Investments go through cycles and the laggards eventually become the leaders and vice versa. As mentioned in a previous blog, The Fear of Missing Out is a powerful force that will cause well-diversified investors to abandon the strategy to concentrate in the “hot” investment style or stock du jour. More often than not, this does not end well.
Factor Investing: A different spin on Buy and Hold. Factors were made popular in 1992 by Eugene Fama and Ken French when they tried to explain what causes stocks to perform the way they do. Their research postulated that relatively cheap, smaller companies tend to outperform the broad market over long periods of time. By starting with a broadly diversified portfolio and “tilting” towards companies with those characteristics, an investor should see meaningful outperformance. Here’s the rub: the academic community can’t agree on how to define those factors and more factors are being added seemingly every day that claim to explain outperformance. Confusing, isn’t it? Wall Street did their part to capitalize on the factor craze by labeling them “smart beta” (after all, who wants dumb beta?) and selling products to capture these factors. Customers ended up buying the sizzle without doing any research on the steak. The biggest drawback to factor investing is the relative underperformance over sometimes long stretches of time that one must endure. For reference, imagine reading about the small/value premium ten years ago and allocating money to that strategy. The chart below shows the relative performance of Small Cap Value vs Large Cap Growth over the last 10 years. Ouch! Even the most ardent supporter of value investing has had their mettle tested.
Picking Stocks: The sexy pick. Like a siren’s song luring sailors into the rocks, the allure of making money by picking stocks is almost irresistible to some. There are many methods to this madness, some of which are legitimate, most are not. The guy on his YouTube channel hawking a strategy that promises steady gains with minimal risk? You guessed it, not. The legitimate strategies have one thing in common: risk management. Knowing when you are wrong and fighting against human impulses to hold onto losing investments or to sell winners too soon is what separates the wheat from the chaff. However, the challenges of active management and stock picking are well documented. S&P publishes a running track record of institutional money managers and mutual funds versus the standard S&P 500 benchmark. As of the end of 2019, a whopping 89% of funds failed to outperform their benchmarks net-of-fees during a trailing 10-year period. I understand that in the face of all this data, people still want to test their acumen or are just interested in researching companies and like holding individual stocks. This is completely fine. First, I would suggest setting a limit in your portfolio on the amount of stocks held versus the overall portfolio (think 5-10%). Second, if venturing into these waters, be sure to have a system in place with a well-defined risk management strategy. Spoiler alert: watching Mad Money and following his picks does not satisfy either of these requirements.
As I said at the outset, there are a variety of ways one can choose to invest their money. Identifying as a long-term value investor doesn’t mean that day traders are wrong. They are just different. At our firm, we advocate for a combination of buy and hold with the factor tilting because that is what fits our clients’ needs best. The most important thing is choosing a style that works with your personality and your ability to dedicate time all while being aware of the potential pitfalls. Warren Buffett said, “investing is simple, but not easy.” I couldn’t agree more.