I often talk to people that are constantly chasing the latest hot stock that doubles or triples in value within a short period of time. This results in some interesting conversation which typically goes like this:
Pro stock picker: What do you invest in?
Me: I’m invested in broad based index type funds
Pro stock picker: Oh, what sort of returns do you get with those?
Me: In our modelling we use 7% as our expected return
Pro stock picker: Oh, that’s pretty bad, did you know stock X shot up 20% last week?
Proceeding this, conversation I usually try to highlight the fact that it’s really hard to beat the market; this is usually followed by some disbelief on the pro stock pickers side and a parting of two people with differing opinions.
It is at this point that I will admit I shared similar beliefs prior to doing my financial analysis unit during university. It took me a long time to accept the fact that it is incredibly difficult to beat the market over a period of tens of years.
When it comes to building wealth and financial independence, I believe that consistency over the long term will beat sporadic massive gains the vast majority of the time. However, as humans, I believe we crave excitement and action over small wins and consistency.
To illustrate this, I will create 2 examples; Slow Sarah and Pro-stock picker Pete.
Slow Sarah
Slow Sarah is a long-term investor that starts investing in July 1984 and finishes in June 2009. She will invest $5000 a month ($60,000 per annum) into Australian All Ordinaries and the MSCI World Ex Australia at a 40/60 split. Her annualized return is 6.79%.
Pro stock picker Pete
Pete is better at picking stocks than Sarah and can identify Australian resource industry 10 baggers on occasion. Once he buys the stocks, he waits 7 years for them to reach ten-bagger status and sells for a healthy profit – 7.4 years this is considered an average length of time for a resource company to achieve this (Xie 2018). The remainder of Pete’s portfolio will be invested in a variety of stocks and cash which we will assume to return a 0% return. Like Sarah, Pete also has $60,000 per annum to invest.
The results
At the end of the 25-year period both Pete and Sarah have invested a total of $1.5m of their own capital. Pete has finished with $3.87m and Sarah has finished with $3.81m.
Pete has identified and capitalised on 3 stocks that have grown by a factor of 10, which is very impressive and been able accumulate more wealth than Sarah. A win for stock picking and active management! Passive index investing is dead. Not so fast…
Pete’s story is very unrealistic
There are many assumptions that I’ve made for Pete that make him far better than the average punter. Let’s break them down:
Capitalizing on ten baggers
Even though about 1 in 7 stocks in the Australian and New Zealand stock exchanges grow by over 1000% within a 35 year period (Xie 2018). It is very difficult to identify them and actually profit from their rise. Not only are the statistical odds against the individual investor, but also a range of cognitive biases. I’ve discussed this previously in my post about why stock picking is really hard.
The rest of his portfolio achieves zero returns
Pete would undoubtedly need a portfolio of very risky stocks to allow him to hold his very high performing stocks. Take a look at the first year where he puts $20,000, or one third of his portfolio into a 10-bagger stock. For simplicity I assumed that the rest of his portfolio did not lose money for 7 years; in reality there would be very high chance that the underperforming stocks would lose money. This assumption is then repeated in 9th and 18th year.
The amount invested in Pete’s 10-baggers is high
For any investment to have a substantial impact a significant amount of capital needs allocated. For example, investing $1,000 in a 10 or 20 bagger is hardly going to be life changing. In the above example, Pete has successfully done just that; however most average punters aren’t willing to invest $100k or $150k into a potential 10 bagger stock. They often lack the confidence that their own analysis or choices will deliver a positive outcome.
Holding on is very difficult
As stated earlier, on average it takes about 7 years for a Australian resources company to become a 10-bagger. Since people crave action, 7 years is a long time to just sit around and wait for a stock to rise. When most people look back on stocks like ARB group or FMG and say “if only I had invested $10,000 when they were 20c I’d be a millionaire”. Such statements are often made while compressing the time period in their mind – thinking that could go back in time, invest and wake up today as millionaire. They forget that during this time the company would have faced numerous business ending hurdles that would compel many of them to sell their positions prior to making any significant returns. In addition to this many investors would have closed out their profit positions well before the stock value multiplied 10x. For example FMG was a 1c stock from 2000 until about 2003 when it shot up to 7c. Few penny stock investors have the foresight hold on for 3 years with zero returns and even fewer hold on for 10 or 20 years to reap the 100x times returns that FMG has delivered. Yes, if you invested $10,000 in FMG at 1c, and held on for 20 years you’d be a millionaire but the majority of people’s foresight and patience is nowhere near that good.
It is much easier to recreate Slow Sarah’s story
In my article, that illustrated the variability of market returns, I highlighted the fact that the median annualized return for historical dollar cost averaged portfolios sits around 8%. This means that you actually have a greater than 50% chance of outperforming Sarah’s 6.79% return. The fact that Sarah’s investment journey finished during a market downturn 2009 actually disadvantaged her significantly. If Sarah had started in October 1984 instead of July 1984, she would have outperformed Pete with a 7.3% annualized return, resulting in a $4.11m portfolio.
Further to this, substandard returns tend to be the result of finishing an investment journey during a market downturn so simply holding on an additional 4 years seems to vastly increase the annualized portfolio return. As a reminder, Sarah’s strategy requires far less work than Pete’s as it does not involve choosing stocks or trying to time the market.
While 6.79% seems like a paltry return, consistently adding to it and having it compound over a multi-decade period yields amazing results. The major contributing factor to this is having your entire portfolio compound for you. Punting 10-bagger stocks is fraught with downside risk and few investors will take full advantage of the upside due to a lack of foresight and poor decision making. Also, for an active stock picker, it will often be the case that while a few stocks will provide amazing returns, a large proportion of their portfolio will provide very low or negative returns due to holding cash and failing to avoid underperforming stocks.
Mental accounting
Another issue that I encounter during these conversations is mental accounting. When I say my portfolio grew by 5%, 10% or even 20% (thank you 2019!). I’m referring to the entire FFE portfolio, not just a small part. However, when people that I’ve talked to say they doubled or tripled their money, they tend to be referring only to a single stock/investment. They tend to ‘write off’ the underperforming portion of their portfolio. So, while a portion of an active stock pickers investments will likely outperform the market, the remainder is probably underperforming and create a drag on total portfolio returns.
Pete’s portfolio produces similar results to an index
In Pete’s portfolio 1 stock approximately every 7 years is responsible for driving his portfolio gains. Funnily enough, this similar to an index, where a small portion of stocks are responsible for the returns of the entire index. For example, in 2019, Apple and Microsoft were responsible to 14.8% of the S&P500’s gains (Lewis 2019).
Concluding thoughts
While this example is not scientific, it should highlight what a successful journey for an active stock picker might look like. It should also highlight how difficult stock picking is, as well as the high success rates and amount of capital that need to be risked, in order to match a dollar cost averaging strategy over a 25-year period. I accept that there would be many changes to Sarah’s or Pete’s examples allowing him to outperform such as:
- What if Pete went for stocks that only rise by 200% instead of 1000% and doubled up every couple of years?
- What if Pete buys low and sells high frequently, capitalizing on smaller market movements?
- What if Pete put his entire portfolio into the ten-baggers?
The fact still remains that Pete needs to be able to do 3 things numerous times, with increasingly large amounts of capital:
- Pick stocks that outperform the market
- Avoid underperforming stocks
- Be able to time the investment such that it outperforms the market
Overall, the approach that fits our risk tolerance best, and likely most other retail investors, is to dollar cost average into a variety of index type investments so that all our entire portfolio is being compounded. We also get to own a bunch of 10 bagger stocks without having to any analysis whatsoever! The incredible irony I have witnessed is that, in many cases, people seeking huge returns to build wealth quickly tend to be outperformed by those that set out to achieve the market return and build wealth slowly.
Engineer your freedom
References
Xie, W, 2018, 10-baggers are everywhere (so are 100-baggers), Livewire, available from: <https://www.livewiremarkets.com/wires/10-baggers-are-everywhere-so-are-100-baggers>
Lewis, A, 2019, The stock market boomed in 2019. Here’s how it happened, available from: <https://www.cnbc.com/2019/12/31/the-stock-market-boomed-in-2019-heres-how-it-happened.html>
Dimensional, 2020, MSCI World ex Australia Index (net div. AUD), Dataset viewed 3/9/2020 <https://returnsweb.dimensional.com/>
Dimensional, 2020, S&P/ASX All Ordinaries (Total Return), Dataset viewed 2/9/2020 <https://returnsweb.dimensional.com/>