Yesterday I thought of this metaphor, then spent most of my Thursday night photoshopping tiny little logos onto a roulette wheel to make this post. So I hope it hits home for you.
The stock market is considered “efficient”. While it’s pretty easy to look at the fundamentals of a company and tell a good company apart from a bad company, everyone else can do that too. That means that information, and in fact the sum total of public human knowledge, is constantly and instantly “priced in” to each stock. The good companies get bid up SO high until finally some people are like “whoa, that’s too high” and the efficient price is found.
Picking a winning stock isn’t about identifying a good company, but about identifying which companies are going to do BETTER than the sum total of human knowledge EXPECTS them to. That’s a hard task. In fact, study after study show even the best stock pickers perform about as well as randomly picking stocks.
So when you pick stocks, you’re not likely to outperform the market, rather you’re just adding randomness to your portfolio performance. Sometimes that works out of course, like when you’re temporarily up in Vegas, but over time you’re just adding volatility without higher expected returns. In investing, that’s a bad deal.
Index funds, on the other hand, simply own ALL the stocks (in proportion to their size). In roulette it’s like being the house. No matter which numbers hit, the house gets their take and the index fund is guaranteed the entire growth of the stock market.
And man, do people like gambling. And so do they like picking stocks. It SEEMS like you should be able to beat the market. Everyone has a system. Trailing stop losses, momentum swings, limit orders, cut your losses, lock in gains. But here’s the thing. It’s all nonsense gambling advice. Ignore it. You’ll be the most wealthy if you buy and hold index funds.
As always, reminding you to build wealth by following the two PFC rules: 1.) Live below your means and 2.) Invest early and often.