The Art of Buying Stocks Condensed

By Mathew Kent

Introduction

It’s important to remember that not all stocks are created equal. Some are duds that will go down in value in the time that you own them. Some are disasters that will go belly up during the time that you own them, bringing the principal of your investment crashing down to zero. Some do okay, making you a little money, and a few are extreme winners providing enormous returns.

Getting to the Thick of it

Now, you might think that if we graphed all the publicly traded stocks, we’d get a distribution that is a rough approximation of the standard bell curve: most stocks sit in the mediocre middle, roughly breaking even, but as you move towards the edges away from the median, you get roughly equal amounts of winners and losers of varying degrees.

You’d be wrong.

Things that occur in nature tend to follow the normal bell curve distribution, think of a variable like the height of human beings. When you get in to the world of man-made endeavors, things fall into what’s known as a power distribution. In a power distribution, a few extreme winners have outsized effects on the attributes of the distribution.

Think of it like this, if Bill Gates moved into your neighborhood, the average height of the neighborhood would be imperceptibly affected, but the average net worth of your neighborhood would take a sudden and dramatic leap up.

This tendency for winners to dominate is why we have what is called the Pareto Principle, also known as the 80/20 Rule. This rule says that in man-made endeavors, we can expect 80% of results to come from 20% of the possible causes.

So in other words, we expect that:

  • 80% of the code to be written by 20% of our programmers
  • 80% of all books to be sold by 20% of all available titles (and by 20% of authors)
  • 80% of sales to be made by 20% of our sales force
  • 80% of our revenue to come from 20% of our customers (and 20% of our products)
  • 80% of complaints to come from 20% of our customers
  • 80% of the wealth to belong to 20% of our citizens
  • etc

By and large, this roughly holds true everywhere that we can see. Even more amazing than the 80/20 part of this principle is the fact that there is also a 50/1 component: we expect 50% of the wealth to be owned by the top 1% and 50% of all sales to be made by the top 1% of all sales people.

It’s a truly mind-boggling concept.

Okay, this is all very interesting, but what does it have to do with the stock market and investing?

It has everything to do with the stock market and investing. In the stock market, it’s only a small percentage of stocks that are “extreme winners” and most stocks under perform the average return of the market as a whole.

Take a look at this chart from a JP Morgan Chase paper from 2014:

What this is showing is how all the various stocks of the Russell 3000 Index did compared to the index as a whole. The Russell 3000 is a “total stock market” index.

What we see when we look at the Median (the red line that divides the distribution in half) is that most stocks had returns that were lower than the average return of the index as a whole.

In a normal bell curve, the Median and the average are the same, meaning that half are better than average and half are worse than average. But in a power distribution, the average is higher than the Median. This is because a few extreme winners are skewing the whole distribution.

This intuitively makes sense. Think about it this way, what is the most a stock can lose? Easy answer: 100%, or all of it’s value (the chart above shows the worst performing stocks as -450%, but that means they did 450% worse compared to the average of the index, the most that a stock can lose as a percentage of its own value is 100%)

But think about this, how much is it possible for a stock to gain? 100%? 200%? 10,000%?

There’s a natural cap to how much a business can decline in value, but in theory there’s no limit to how high it can fly.

This imbalance which is inherent in the nature of business itself leads to this glorious chart:

This is the famous Dow Jones Industrial Average, our most venerable index. You’ll notice two important features as you look at it:

  1. The market goes up over time. It’s a bumpy ride, to be sure, but the market has weathered crashes, recessions, world wars, great depressions, etc. and continued it’s inexorable upward climb
  2. It has gone up exponentially over time. This isn’t immediately obvious looking at the shape of the chart itself, but it does become clear when you look at the scale on the Y-Axis. If this chart has used a normal scale instead of a log scale, the chart would need to be much taller (or so squished as to render the Great Depression a meaningless blip) and you would see the normal hockey stick shape that you associate with exponential growth.

During this time, many businesses have come and gone, but the extreme winners keep pulling the market up.

Okay great, you might be thinking, I want in on some of these extreme winners, so get to answering the original question and tell me how to pick them.

Okay, here’s the rub: you can’t reliably pick the winners, and because most stocks under perform the market average, you’re more likely to pick a loser than a winner. The only way to reliably pick the winners is to invest in the whole entire stock market.

This isn’t the sexy answer, but it has two key advantages:

  1. This kind of “passive investing” saves you all kinds of time relative to trying to pick the winners and…
  2. Over the long run, you’ll make more money doing it—both because of higher returns and because of lower costs.

If you want to invest in individual stocks, consider the fact that next years winners are likely going to be companies that you’ve never heard of.

For instance, here are some of the extreme winners from the S&P 500 (and index of the 500 biggest companies) in 2016 and 2017:

  • Nividia (NVDA)
  • Oneok (OKE)
  • Freeport McMoRan (FCX)
  • Align (ALGN)
  • NRG Energy (NRG)
  • First Solar (FSLR)

I want to make it clear here that I am not recommending any of these individual stocks. They were big winners for a year, but they could very well be losers from here on out.

Rather, I’m trying to make the point, would you have picked any of these if you were thinking of investing in individual stocks over the last two years? Have you even heard of any of them?

Here’s a fascinating post where a blogger evaluated how various “best stocks for 2016” lists from publications like Time Magazine and Forbes actually performed in 2016. TL;DR version: none of the lists had any of the stocks that ended up being extreme winners that year and all of them under performed the stock market as a whole.

So what should you invest in? My answer (and what I’m currently investing in) is low-cost, broad based index funds.

An index fund is a type of mutual fund (sometimes it’s called an “indexed mutual fund”) that tracks a given stock market index like the S&P 500 or the CRSP U.S. Total Market Index. A mutual fund is a brilliant concept. Instead of only being able to invest in a few companies due to lack of funds, you are able to diversify your investments across a large array of stocks since you and many others are all contributing to one large fund that you each own a piece of.

By low-cost I mean that index funds typically have very low expense ratios (the cost of owning a fund, which is quietly taken from your account balance every year). A good index fund should have an expense ratio below .05%. It might not seem like a huge difference to pick an index fund with a .05% ratio instead of the .8% expense ratio that you might find with a traditional actively managed mutual fund, but that difference can compound over time and lead to a serious difference between the two down the line. By low-cost I also mean that the fund should be free of other fees and expenses like “load fees.”

By broad-based I mean you should own as much of the total market as you can. If you can get a total stock market index fund, great. If not, the S&P 500 is very nearly the same thing (this is again because of the 80/20 rule: 80% of the value of the stock market is found in the top 20% of companies).

Here are some particular funds that I think are quite good (Sorry to anyone who might be reading this outside the US, but for simplicity’s sake this post is very US-centric):

  • FZROX: Fidelity ZERO Total Market Index Fund (expense ratio 0)
  • SWTSX: Schwab Total Stock Market Index Fund (expense ratio .03%)
  • VTSAX (or VTI if you have less than $10,000 to invest): Vanguard Total Stock Market Index Fund, Admiral Shares (expense ratio: .04%)

Personally, I am invested in FZROX in my IRA, SWTSX in my Roth IRA, and Vanguard with my 401k (I’m actually in the Vanguard S&P500 fund, not the Total Stock Market VTSAX fund like I’d prefer, but this is out of my control since my company gets to pick which funds are available).

Any of these are good options. Based on expense ratios, FZROX is the winner, but all are below the .05% threshold I think you should be shooting for.

Personally, I still like Vanguard. Vanguard has a unique ownership model where the investors own the company. This means that there is no conflict of interest and they get to keep your best interest in mind at all times. Fidelity is privately owned and I believe Schwab is a publicly traded company, which means they both have to make profits for their owners. This means that I view Vanguard as the “rock bottom” of costs, because they don’t need to worry about turning a profit. For Fidelity and Schwab, these low-cost funds are a marketing gimmick. They put them out there so they could advertise that they had lower fees than Vanguard. That means that these funds are probably “loss leaders” which are designed to attract customers while losing money for the company. They are relying on you to come for the low cost, and stick around long enough to also buy some higher-priced offerings. Most of the time the loss-leader stuff backfires and people just take advantage of the thing that the company is selling at a loss, leading the company to abandon the strategy eventually. My best guess is that Fidelity and Schwab won’t stay at lower costs than Vanguard forever, but I think if you want to take advantage of them in the meantime, it’s a pretty good move.

If you have access to a tax-advantage retirement account like a 401k or an IRA, I recommend starting to invest there. Once you hit the annual contribution limit, you can open a regular taxable brokerage account with Vanguard and start investing in VTSAX (or the ETF version, VTI if you don’t have the $10,000 minimum to invest in VTSAX).

When it comes to investing, there are lots of risk, but in my estimation, two are the most significant: individual stock risk and market timing.

With index fund investing, you completely eliminate individual stock risk. Any individual stock you buy might go to zero causing you to lose all your principal, but the only way an index fund can go to zero is if every company in America goes under. If that happens, it’s not going to matter what kind of investments you made or didn’t make, we’re all screwed.

Not only do you eliminate individual stock risk, you eliminate all the work of picking individual stocks.

When it comes to market timing, remember, the market goes up over time. This isn’t just some historical fluke, it’s a direct effect of the fundamental imbalance inherent in the nature of business where the extreme winners have more of an impact than the extreme losers.

Invest as much as you can, as soon as you can, and don’t panic and sell when the market dips (I realize that this part is easier said than done) or when everyone is saying that we’re headed for a crash or a correction (spoiler alert: we’re always headed for a crash or correction, but no one knows when. All we know is that we’re one day closer than we were yesterday. Don’t try to time the market).

Remember that nice purple graph of the Dow Jones Industrial Average from earlier? The one where we saw that the market always goes up? Here was Warren Buffet’s insight from that graph that should stop you in your tracks if you ever think about trying to time the market:

“The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did, because they tried to dance in and out.” -Warren Buffett

Unfortunately as humans, our emotional nature causes us to disregard the most basic rule of investing: buy low, sell high. When you are running on emotion (especially fear and greed), you end up buying high and selling low. When the getting is good, you greedily show up for a seat at the table (buying high). When everything collapses, fear drives you to cut your losses (selling low).

You could say that you can time the market if you took emotion out of it, if you bought when things were going down and sold when the market was soaring, but there’s two huge problems with this:

  1. You can’t predict the future. Seems obvious, doesn’t it, but it’s not at all obvious to you in the moment as you make investment decisions. In 2014 lots of people were saying you should think twice about putting your money in the stock market since it was due for a crash or correction. That crash/correction still hasn’t come. There have been a couple small dips (we just had one that scared a lot of people), but if you had held off on investing in 2014, you would have missed some serious gains. The fact is, when the market is rising you don’t know whether it will keep rising and for how long, and when it starts falling, you don’t know whether it will keep falling or for how long. You can’t reliably predict the future
  2. When you try to time the market you have to be right twice. Once when you buy and again when you sell (if we really want to be accurate here, we should say you need to be right three times: once when you buy, once when you sell, and then when you buy again since presumably you want that money to keep growing)

There are other forms of market timing risk as well. One is called “sequence of returns risk.” Put simply, this means that if you leave a lump sum invested, it doesn’t matter in what order you experience investment returns (e.g. -5% in year one, 20% in year two, 7% in year three, etc.). But if you are adding money (the time you are investing), or withdrawing money (when you are ready to spend your money), the order of returns matters. In a perfect world you’d want the bad returns first and the good returns later while you are investing, and the good returns first and the bad returns first when withdrawing money.

This is where the concept of asset allocation comes in. Once you are ready to withdraw your money, it helps to have some money in stocks and some in an asset class whose movements aren’t correlated with stocks, bonds being the best example. You pick a certain percentage of your portfolio to invest in stocks and a certain percent to invest in bonds, and then once a year you “rebalance” you portfolio, meaning if you have more stocks and less bonds than your original allocation, you sell stocks and buy bonds to get get back to your target.

This forces you into a “buy low, sell high” transaction every year when you rebalance. It also helps in part to protect you from the sequence of returns risk, since a drop in the price of stocks can be offset by a rise in bonds.

Personally, I plan to be invested 100% in stocks for a long time and to not worry about asset allocation until I start to draw down my investments. I have my regular contributions right now to smooth the ride a bit, and since my investment horizon is long term, I can deal with the ups and downs of the stock market.

Anyway, the core message is this: Invest as much as you can, as quickly as you can into low-cost, broad-based index funds, starting in any tax-advantaged accounts that are open to you.

Simple, right?

I view the stock market as the greatest wealth-building tool of all time. Starting a business and investing in real estate are fantastic wealth-building tools, and they can even exceed the rate of return of the stock market, but they have their own risks and—more significantly—involve a lot more work than passive investing in the stock market. Because of this, if I had to pick the one perfect wealth-building tool that was the best for most people, I would say the stock market hands down.

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