The Trillion Dollar Equation

The Trillion Dollar Equation - The Black-Scholes/Merton equation, etc. from Veritasium

Standard Investment Advice

So bear with me for the another step onto the soapbox, but after recently retiring I've been reflecting more than usual on the investments I've made (and not made) in my life, and it strikes me that, especially for my younger friends, some well-worn advice could nevertheless bear repeating, and some other common advice that could use some debunking. Here are the points I would like to make to people who are lucky enough to have a little extra income to invest (TL;DR if/when you can afford to, buy index funds -- as much as possible under 401(k) sort of instruments, but over and above that if you can -- and don't create reasons to delay.)

1. Your grandmother was right about the magic of compound interest/growth (although she was wrong/outdated if she said you should keep it all in the bank). The single most important investment decision is simply to do it as soon as you can possibly start, and to stick with it in a disciplined way. (And being disciplined includes things like paying off high interest credit card debt before putting any extra money into the market, and maxing out your 401(k) or equivalent as soon as you can.)

2. The financial media are doing you a disservice by using metrics like the Dow Jones and S&P 500, which radically underestimate the actual returns of the market. This makes most charts comparing stock market investments to other vehicles like gold, real estate, whatever virtually meaningless. Unless such comparisons are using a "Total Return" metric, which they typically do not, they are misleading and increasingly misleading over greater amounts of time, as dividends become the MAJORITY of growth in major indexes.

3. You should invest primarily in passively managed (with very low fees) leading index funds or ETFs. And leave it there. Vanguard has several great options, but pretty much every investment firm does now. Check the fees and don't get too caught up in recent performance. Another common and misleading bit of information is a chart of different types of funds on a straight line showing those with higher risk also having higher reward. While this may be generally true for various types of market investments, they do not include index funds because that ruins their chart (and sales pitch) -- as index funds are relatively low risk and always beat even the most aggressive funds run by the smartest fund managers over the long term.

4. Do not time the market. Do not time the market. Do not time the market. You do NOT know what one time is better than another to get in regardless of what has been happening. (And even among people who luck out and, say, pull money out before a big market drop, tend to lose more money by not getting back in in time than they saved by getting out.

5. Yes index investing is factually/historically/mathematically the best bet, but granted it isn't much fun. It's okay to take a minority of your money (an old CFO friend referred to it as "your Vegas portion") and see if you can't catch lightning in a bottle, like your friends who made a killing on crypto or who got in on Amazon on day 1. But just make sure the majority of your money is in smart/boring index funds.

6. Financial advisors can provide valuable services for things like balancing risk/reward, confirming your types of investments are sensible, managing tax strategies, etc. But if you are paying one to pick stocks and mutual funds for you, you are decreasing the amount of returns you are most likely to get in order to not have to think about it. Maybe that's a good trade for you. Just be aware that no expert in the history of stock picking has beaten the indexes except by luck or cheating (e.g. insider trading, super fast computer connections to the markets, etc.); and this includes Bill Miller, whose fund beat the S&P 15 years in a row (yes, by luck.) Your odds are literally just as good using an astrologer or a monkey throwing darts at stock symbols.

7. Human beings are intuitively bad at statistics, but massively skilled at inventing narratives to "explain" random chance. And few areas of life provide better examples of this than financial advice and reporting. And this is every bit as true about the most knowledgeable experts in the field, if not more so. E.g. if you don't understand why random chance predicted some fund manager like Miller would beat the market 15 years in row by chance, see links below.

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FOOTNOTES:

A. Here's just a couple examples of how the most commonly used market indexes radically under-report returns of the stock market:

"... the price return for the SPDR S&P 500 ETF (SPY) since it was introduced in 1993 was 789% as of March 10, 2021. The total return price (dividends reinvested), however, is close to 1,400%. The Dow Jones Industrial Average over the 10 years ended in March 2021 had a price return of 162%, while the total return rose to 228%."

https://www.investopedia.com/terms/t/total_return_index.asp

B. For a starter on how the massive role of random chance is massively underestimated by humans in all walks of life and investing in particular, I'd recommend this:

https://www.amazon.com/Drunkards.../dp/B001NXK1XO/ref=sr_1_2

C. Ironically, the unparalleled success of index funds relies on thousands -- probably millions -- of hard working investors and financial professionals not believing in it. If investment pros were not constantly researching companies and market conditions, if mathematical quants were not constantly searching for any tiny inefficiency or pattern, if the media was not continually trying to provide tips and insights, then the market would not be so efficient that indexes were the smartest strategy. While this is good for you as an individual, it at least has the potential to eventually cause problems. E.g. see:

https://www.lynalden.com/index-funds/
 

Bad indicators and ignoring dividends

The most commonly used market indexes RADICALLY UNDER-ESTIMATE market returns and distort investor views by not including Total Returns (e.g. dividends being reinvested).

Another View 

Total returns stand in contrast to price returns, which do not take into account dividends and cash payouts. Including dividends makes a significant difference in the return of the fund, as demonstrated by two of the most prominent.

For instance, the price return for the SPDR S&P 500 ETF (SPY) since it was introduced in 1993 was 789% as of March 10, 2021. The total return price (dividends reinvested), however, is close to 1,400%. The Dow Jones Industrial Average over the 10 years ended in March 2021 had a price return of 162%, while the total return rose to 228%.

The S&P 500 Total Return Index (SPTR) is one example of a total return index. The total return indexes follow a similar pattern in which many mutual funds operate, where all resulting cash payouts are automatically reinvested back into the fund itself. While most total return indexes refer to equity-based indexes, there are total return indexes for bonds that assume that all coupon payments and redemptions are reinvested through buying more bonds in the index.

Other total return indexes include the Dow Jones Industrials Total Return Index (DJITR) and the Russell 2000 Index.

https://www.investopedia.com/terms/t/total_return_index.asp

Recessions

A very common measure of whether we are in a recession is 2 consecutive quarters of negative GDP growth. 

However the stock market has generally risen after 2 quarters of negative GDP, so pulling out at that point will most likely miss out on gains.

Example of Timing the Market

"During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But [Peter] Lynch himself pointed out a fly in the ointment. He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery." -- Lyn Alden, based on Spencer Jakab's Heads I Win, Tails I Win