How to Invest in Stocks. 1 – Getting Rid of Bias

Welcome!

Are you thinking of investing in stocks but don’t now where to start?

You have landed on the right page.

This series of articles will provide you with the necessary knowledge to start investing with confidence.

Today, we start by asking ourselves: Why are people hesitant to invest in the stock market?

There are many reasons why.

Some reasons are perfectly valid: People are tired of seeing incompetent executives receive unjustified golden parachutes; bankers paying themselves billions in bonuses despite engineering a global financial crisis; companies laying off workers to boost the bottom line and please shareholders… There are plenty of reasons to denounce the excesses of financial capitalism.

Other reasons are not so valid: Claiming to live paycheck-to-paycheck while spending hundreds of dollars a month on “non-essential” purchases; adopting the YOLO mentality which encourages immediate rewards over delayed gratification; the “stocks are only for the rich” mindset; refusing to give up that expensive coffee habit to save more for retirement…There are just as many invalid reasons for not investing as there are valid reasons.

However, you need to realize that the stock market can benefit you greatly if you know how to use it to your advantage. In order to do so, you must rid yourself of unjustified biases.

Thus, the first part of this series is dedicated to refuting the negative preconceptions that discourage potential investors from starting out.

Bias n°1:
The stock market is too complicated

Professional financiers are renown for using intimating insider jargon: Trackers, puts, P/E ratio, spread, calls, DRIP… These specialized terms serve the nefarious purpose of obfuscating relatively simple concepts in order to encourage people to “let the experts handle it”.

Indeed, wealth management and financial advisory are big business: The Boston Consulting group estimates that, in 2018, there were more than $70 TRILLION of global assets under management (AUM). Of that, more than $45 trillion, or 60% of the total AUM, were managed by professional investors.

This means that investment professionals have a vested interest in convincing you that managing money is a complex affair that requires their expertise.

Don’t fall for this ploy: The truth is that the nine out of ten fund managers fail to beat their benchmark index over the long run. That’s right, the vast majority of fund managers glorified by Hollywood actually under-perform compared to someone placing their money in a financial product that simply tracks the performance of the overall market (I will explain exactly what this means later on in the series).

To add insult to injury, fund managers charge you exorbitant fees even when they lose your money! How twisted is that?

The sobering reality doesn’t stop there: A famous study conducted by Princeton University professor Burton Malkiel has shown that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts“. In many cases, the monkey’s portfolios considerably outperformed the experts! Why would you pay top dollar to receive financial advice from someone who can’t outperform a blindfolded monkey?

In sum, the simple truth of the matter is that you don’t need a financial advisor to be successful in the stock market.

Bias n°2:
Investing in stocks is gambling

There are two main actors on the stock market: the SPECULATOR and the INVESTOR.

• THE SPECULATOR: PRICE-MOMENTUM INVESTING

The speculator, also known as the trader, is a risk-taker who bets on the short term price fluctuations of stocks. His strategy is based on the “greater fool theory“: He buys an asset not because he believes in its underlying value, but because he is convinced that he will find someone foolish enough to buy it from him at a higher price. Speculation can be very lucrative if your timing is right; if it’s not, you can lose everything.

Think of the Dutch Tulip Mania of 1637: The introduction of the tulip, a rare and exotic flower unlike any other in Europe at the time, created an irrational speculative frenzy. Tulips became so coveted that people started buying them for higher and higher prices until, ultimately, everyone realized they were just flowers. Then, the price collapsed and some fools were stuck with tulips they had purchased for ten times the annual salary of an experienced craftsman – with nobody willing to buy them.

In sum, speculation is a high-risk high-reward endeavor that should only be pursued by those with a long experience of the stock market.

One example of a successful speculator is George Soros. You can read more about his investment philosophy here.

• THE INVESTOR: VALUE-DRIVEN INVESTING

The investor, on the other hand, minimizes his risk by carefully analyzing companies to calculate their intrinsic value. Rather than speculating that the price of a stock will increase based on euphoria, he analyzes the fundamentals of the company: Its business model and competitive advantages; revenue growth and profitability; debt burdens and cash flows, etc. He studies these elements in order to form a clear picture of how the business operates and if it well positioned to continue growing and generating profits in the future.

Once he has analyzed the business, he determines whether the current stock price is undervalued or overvalued compared to his evaluation. If he believes that the fundamental value of the company is greater than the current stock price, he will invest his money in that stock. If not, he will pass and look at other opportunities.

Over the very long term, informed investors rarely lose money.

One example of a famous value-focused investor is Warren Buffet. You can read more about his investment philosophy here.

Bias n°3:
The Stock Market is only for Rich People

It is true that rich people make more money in the stock market than ‘average Joes’: A 10% gain on 1000€ represents a modest 100€ but on 1,000,000€ it represents a more attractive 100,000€…

Although the rich will more money than you, this does not mean that you won’t make money.

This is true of all investments: If a rich person buys a bigger house than you in a nicer neighborhood, he will make more profit then you when he sells it. However, this doesn’t mean that you won’t make any money when you sell yours, just that you’ll make less money.

This fact doesn’t stop people from investing in real estate so why should it stop you from investing in stocks?

Bias n°5:
Saving beats investing

Some people prefer to save all of their money because they perceive it as being safer than investing in stocks. While this is true, the long term opportunity cost of this decision is extremely costly. Opportunity cost refers to the losses incurred by choosing one alternative over another more lucrative one.

Savings accounts are useful and should be used for achieving short-term goals: Creating a 3-6 months emergency fund, saving for a large purchase, keeping ready access cash, and earning some interest to offset inflation are some great examples of a savings account’s utility.

However, stashing money in a savings account is not investing.

Keep in mind that you must deduct inflation from the interest your earn on your savings account to obtain the true appreciation of your money over a given period of time. If you earn 3% yearly interest when the yearly inflation rate is 2% (which is roughly the average annual inflation rate of the past 20 years), then your actual return is 1%. You will not get very far making a 1% annual return.

In sum, when it comes to long term investments, nothing beats the returns of the stock market.

Bias n°6:
The stock market will crash and I will lose everything!

The stock market is cyclical: Boom cycles are followed by bust cycles. However, over the long term, the market keeps going up.

Let’s analyse the S&P 500’s history and calculate the potential returns of a $1000 investment.

As you can see on the chart below, the market is on a continued upward trend. You’ll notice three significant dips: the “dot-com bubble” of 2000-2002, the Financial crisis of 2007-08, and the current “coronavirus crisis” of 2020.

Although the market dipped significantly because of these events, it has always recovered.

• SCENARIO N°1: BUY THE PEAK, SELL THE PEAK

Imagine you had invested $1000 at the height of the dot-com bubble, just before the crash. You bought $1000 worth of an S&P 500 ETF in July 2000 when the index was at 1480.11, near its peak. You then forgot about it for 20 years. You wake up in February 2020 when the market reached its all time high of 3380.16. You decided to sell everything and lock in your gains.

Despite buying at the all time high in 2000 and experiencing two severe crashes, your initial investment generated a total return of 128.3%. Over 20 years, this represents an annualized average return of 6.4%.

I know, you think this is low, especially when we factor in the average annual inflation rate of approximately 2.16%. Once inflation is factored in, your total return is only 4.3%.

However, compare that to the 1% return of your savings account and 4% doesn’t seem so bad. Also, consider the fact that most people bought in at much lower levels than the peak of the dot com bubble. This is the second scenario we will consider.

• SCENARIO N°2: BUY THE DIP, SELL THE PEAK

Imagine you invested $1000 in January 2003 when the market index was at a low of 861.40. Again, you forgot about the money until February of this year and sold when the market reached 3380.16.

This time, your total return is 292.4%. Over 17 years, this represents an annualized average return of 17.2%. Adjusted for inflation, this represents an average annual return of 15%. Not bad.

• SCENARIO N°3: BUY THE PEAK, SELL THE PEAK & BUY THE PEAK, SELL THE DIP

Here are two scenarios for the younger investors out there: What are the total returns since the 2007 crisis?

1) You invested $1000 two months before the collapse, when the market neared its all time high of 1552.50 in July 2007: You decide to sell everything 13 years later, when the index reaches its high of 3380.16, locking in a total return of 117.7%. Your average annual return is 9.05% (approx 7% per year inflation adjusted).

2) You bought the 2007 peak and panic sold the recent coronavirus dip when the market hit a low of 2237.40: Your total return would be 44%, or 3.39% over the 13 year period (1.2% inflation adjusted). Your poor timing would have resulted in a measly return.

One lesson we will cover later on is never to panic sell during a market crash.

• SCENARIO N°4: BUY THE DIP, SELL THE PEAK & BUY THE DIP, SELL THE DIP.

1) You bought the March 2009 dip of 756.55 and sold the February 2020 high of 3380.16: Your total return would be 346.78%, or 31.5% over the 11-year period (29.4% inflation adjusted).

2) You bought the March 2009 dip of 756.55 and sold the March 2020 dip of 2237.40: Your total 11-year return would be 195.73%, an average annualized return of 17.79% (15.6% inflation adjusted).

As you can see, average returns can vary considerably depending on when you enter and, more importantly, when you exit the market.

In reality, the average index fund investor’s inflation-adjusted return over the past 30 years is closer to 8%. This means that keeping your money in a savings account with a 3% interest rate costs you 5% a year. Over a 30 year period, that’s an expensive loss.

However, upon analyzing the data, it’s abundantly clear that investing in stocks would have resulted in gains superior to any savings account irrespective of your entry and exit timing.

The only way you would have lost money is if you bought at the very top and sold at the very bottom. However, this is a basic mistake that you will not make after reading this series!

I hope that the brief explanations provided above dispelled some of the basic biases you may hold against the stock market and reassured you as to your chances of make money.

Let’s summarize the conclusions:

• The stock market is not too complicated
• The stock market is not only for rich people
• A savings account is for short term financial goals,
• Long term, stocks are the best investment

Let me know in the comments if any of these points remain unclear and I will do my best to clear up the confusion.

We can now move on to the second part of the series: How does the stock market actually work?

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Disclaimer: This is not financial advice. Do your own research before investing in any asset.