Take a quick walk down memory lane with me for a minute; I promise it will pay off, investment-wise.
When I was in college, I was given the ignoble pleasure of looking after a very drunken friend. Let’s just call him Todd…
Todd clearly had too many dribbles off the tipple, and had rendered himself completely wasted by 9 o’clock.
Since I had agreed to watch after him, I did what any fun-loving college student would do: found a quiet place to park him while I went about enjoying my evening. I gently laid him on the seat in a bar booth, whispered “goodnight sweet prince” and went on with my own shenanigans.
Everything was going great until I went back that night to recover Todd, and he was nowhere to be found.
I had to wander aimlessly from bar, to greasy restaurant, to park bench looking for him. He wasn’t easy to find, to say the least.
What does any of this have to do with investing?
I was reminded of the whole ordeal when I recently revisited one of the all-time greatest investment books ever: A Random Walk Down Wall Street by Burton Malkiel. The investment tome has set the standard for sober, smart investing in any market. The entire premise is based on what social scientists call the “random walk theory”…
The theory is essentially what I described above: you leave a drunk in the middle of a field at midnight, then you try to predict where you should look for him the next day. Being that he was drunk, he wouldn’t be acting in a logical manner.
He wouldn’t be cognizant enough to find his way home…
He sure wouldn’t be walking in a straight line…
And he assuredly wouldn’t just stay in the place you left him…
In fact, it would be almost impossible to predict where the drunk ended up by the time morning rolled around. The same could be said the stock market. So where do you look for the drunk? And where in the world do you place the stock market?
Here’s how the researchers in the first popular examination of this theory in the journal Nature look at it. “In open country, the most probable place to find a drunken man who is at all capable of keeping on his feet is somewhere near his starting point!”
So, the best place to start is looking at the place you left him. Makes sense. Here’s how Malkiel described how to time stocks to NPR this week:
If information arises about a particular company or about an economy, that information gets reflected in market prices without delay. … You won’t have time to read the news and get in. The market is very efficient at digesting news.
Now, that doesn’t mean that market prices are always correct. In fact, they’re far from perfect. But the point is, it’s very efficient at reflecting news, and if they’re incorrect no one knows for sure whether they’re high or low. Therefore simply buying a portfolio of stocks, given the tableau of market prices that you have at any point in time, is likely to give you a better performance than trying to go and pick stocks and buying one stock and selling another.
While it seems obvious, it is something that 90% of traders have serious trouble learning. We often assume that a stock that has been going up will continue to do so. We see a stock that just tanked as a sell-off loser. We try to look so far into the future despite the fact that the fundamentals will radically change. Or we invent huge fish tales in our heads that have no basis in reality.
I did all of those things while looking for Todd, and you’ve probably done all of them while trying to manage a stock portfolio.
The idea here is the market is an irrational beast, a drunken lunatic, and a schizophrenic monster all rolled up into one. It needs to be treated with patience and care.
There are two very easy ways to tame the beast and protect your money…
1) Buy Index Funds
Index ETFs are basically a tracking device for the drunken market. They just follow it around everywhere like a bloodhound. They are also easy, they’re cheap, and they’re diversified.
Best of all, they actually beat the returns of most money managers and financial advisors. While these guys are moving around stocks each and every day, a trusty market index is faithfully chugging away, making you easy money while the “professionals” spin their wheels trying to juggle hundreds of stocks.
And while they are juggling, it is costing you a fortune. If you have a financial advisor, they get paid each time they buy a stock. So riding a consistent portfolio doesn’t make them any money. All told, the average American spends around $150k over a lifetime on these types of fees. While they are just charging you to move paper around, they aren’t even bringing home the bacon. In fact, over the past five years, two out of three actively managed mutual funds failed to beat the S&P 1500 total stock market index.
Take a look at a few index funds and pick your favorite. I like Warren Buffett’s choice…
2) Buy Dividend Stocks
The stock market over the long term is actually quite predictable…
If the company you buy grows over time, so will the stock. In that respect, the market has had a predictable long-term growth rate. That’s why I like dividend aristocrats — stocks that have raised their dividend for at least 25 years. These are companies I can trust for the long haul.
If you are just buying and selling the news, I would warn you that thousands of others — insiders, high-frequency traders, and black pools — have already made their moves. At best you’d be collecting their crumbs, at worst they have already eaten your lunch.
Dividend aristocrat stocks are designed for all types of markets — bull or bear — to help serious investors reach their goals quickly. In the last decade, these stocks have returned an outrageous 183% — that’s almost double the return of the S&P 500. And as I mentioned, they work in good times and bad when you plug them into an IRM(72) program…
You actually gain more when the market tanks. As Malkiel says:
While everyone prays for higher stock prices, you actually ought to pray for lower stock prices. … So, for people who are accumulating a retirement fund, it’s just fine if the market goes up and down. Yes, you’ll buy some things at the top, but then you’ll also then buy some stuff at the bottom.
The only people who should pray for higher stock prices are people who are in retirement who are liquidating their portfolios. Everybody else should actually be very happy when stock prices go down.
Be warned: these stocks won’t make you rich overnight. But they’ll let you sleep soundly knowing your money is growing and paying you constantly whether the stock goes up or down.
Now, to sum things up, I eventually found Todd screaming at a homeless guy by a 7-11 payphone (not somewhere I initially thought to look). But considering that the payphone was just around the block from the bar we started at, in hindsight it was a pretty solid place to start.
At first I hadn’t given Todd enough credit: I figured he’d stay passed out on that bench for the rest of the evening.
When he wasn’t there, I jumped way ahead and invented a number of scenarios that could have been: i.e. what I would have done if I found myself that drunk. Giving into confirmation bias led me astray and kept me from soberly considering my options. In the end I had given Todd too much credit to think he had the wherewithal to make it to a restaurant. I didn’t give him enough credit to think he would stay passed out on a bar bench.
Such is life, he was exactly where I didn’t think he’d be…
That is the rub with the stock market. You can’t trust it to follow any set path, you can’t rely on it to act rationally, and you certainly cannot plan on it doing what you want it to do.
So, thank you Todd. I never knew how much you taught me that evening. Let’s raise a toast to the random walk… and never speak of it again.
