Authors Note: The more financially secure and free you are, the more autonomous your life can be. I enjoy reading financial books and spreading the knowledge to others. As always, if you enjoy this article then support Burton Malkiel and his book which inspired it.
A Random Walk Down Wall Street by Burton Malkiel
Despite what cynics might say and hear, the average individual can do well by following a specific set of principles in the stock market. “A Walk” in Wall Street refers to the idea that short-term markets are so unpredictable that professional forecasting amounts to nothing. The experts, the people often paid the most to make decisions with investment money, are not doing any better than the average person would by applying a principled, but varied investment strategy. The “randomness” in the walk is just that variability. Picking a broad index of the entire market, as opposed to focusing on a handful of blue-chip stocks, is the most effective approach to long-term investing.
A few terms to get started:
Investment: a long-term financial decision to purchase assets which will gain profit over time.
Speculation: a short term approach based upon the hopes of gaining money quickly.
It should be obvious which of the two Malkiel is suggesting to follow. Speculation is what the definition of the word implies: the forming of a theory without firm evidence. You may have a hunch, a tip, a gut feeling, but in the end you are hoping for better results than the market would predict. Investment is not infallible nor without risk, but is backed with a principled understanding and approach that is more efficient in making money–even if the process occurs over a lengthy period.
The drawback of long term investing is that it must combat the effects of inflation–a common argument that proponents of the high-risk, get rich now crowd often point to. If you invest your money over a period of 40 years, from 1970 – 2010, and inflation increased 4 percent during that time, your money would grow in quantity but decrease in value. As Malkiel points out in his book, the cost of a Hershey bar increased 1900 percent in the last forty years, and newspapers 4,900 percent. The purpose of bringing up inflation is not to scare you away from investing, but to point out a salient point. If you are unwilling to take any risk and wish to put your money into a savings account at the average going rate of 0.25% (a quarter of one-percent), you are losing money in the long term. Investing in a strong portfolio, one that can at least eclipse the rate of inflation (and hopefully much more), is safer than socking away money in an account that will not grow.
Investing Requires Work
While sound strategy involves investing your money and being patient for it to grow, you must work to keep your money. You are responsible for your money, not the markets, not your advisers or the people on Wall Street. Capitalism is an open market for all to enjoy but all to equally suffer from. However, keep investing fun. A common theme among some of the most powerful and wealthy people in the world is the joy they take from growing their money. You may think, “The rich are all greedy. They just want more and more.” These people are playing a game. At some point, they discovered success in the game of money and never looked back.
Money is a touchy subject. Finance makes people uneasy. But it doesn’t have to be that way. People gamble for the satisfaction of the act. You can invest with much less risk than gambling and instill enjoy the process. You are almost certainly going to lose money at some point, but don’t allow that to take away from the satisfaction of investing and making gains. A healthy view of investing is like gardening. You are taking the time to select your seeds, going through the process of planting, watering and fertilizing. You don’t give up gardening when one flower dies. You work harder to expand your garden and bask in the product of your development.
Two Theories of Wall Street
The Firm-Foundation Theory. All investments have an intrinsic value. When the market values an investment below its intrinsic value it’s time to buy; when the opposite occurs, selling will produce a gain.
Castle in the Air Theory. Investing is less about gauging the intrinsic value and of an asset and more about understanding the behaviors of crowds of investors. Smart investing involves recognizing situations that will be highly valued by the crowd and buying early. Consider an asset available to you for $2, that has an intrinsic value of $3, but in a year the market will value at $1. Despite purchasing a higher valued asset for less cost initially, this would still be a poor investment.
The founder of this theory, John Maynard Keynes, summarized his thinking in a useful analogy: investing is like participating in a beauty contest where you must select a handful of the prettiest contestants–only the concept of beauty is based entirely upon the mentality of the crowd doing the selection. Like beauty, intrinsic value is a conception of the people who place that value. Investing then becomes a game of perception, where the most successful participants can read the trends better in their fellow investors.
“Res tantum valet quantum vendi potest (A thing is worth only what someone else will pay for it)”–the battle cry of the Castle Theorist
Bubbles and Avoiding the Absurdity of Wall-Street
Investors establish the price of stocks, meaning (as in the Castle in the Air) value can be wildly inflated and imagined by the thought process of the crowd. When people speculate markets, when they make predictions, they are also acting in a way that is synonymous with what we now know as groupthink. The excitement of a growing industry, such as electronics in the 1960s and biotech in the 1980s, can lead people to make irrational decisions that they would not otherwise succumb to. Bubbles represent the greatest danger in investment, closely followed by chasing the next great stock, “Another lesson that cries out for attention is that investors should be very wary of purchasing today’s hot ‘new issue.’” As Warren Buffett put it, “Be fearful when others are greedy.”
It’s easy to be swayed by the mob mentality into falling for unrealistic investments and bubble markets, but it’s not impossible to avoid the frauds. When researching any potential investment, the most crucial factor is not a prediction of growth or how that industry will come to impact society (think of the current trend in Silicon Valley), but rather the ability for the company to create and sustain profits over a long period. Smart investing is as much about recognizing and limiting greed as it is making money. The greedy investor is looking for the “now” deal, the hot stock that is ready to take off and triple their money by lunchtime.
Ask yourself the old axiom, “Is this too good to be true?” If the answer is yes, then proceed with caution. Like gambling, some of the fun in investing comes from taking risks, and there are certainly large rewards to be made. Smart investing is staying removed from the waves that sweep the market. You want to be able to recognize castle in the sky for what it is, a fictitious hallucination the minds of many have tricked themselves into seeing. Playing the long-term game may be less glamorous and sexy in the short term, but it’s the best way to avoid the crash that follows when bubbles burst, “history tells us that eventually all excessively exuberant markets succumb to the laws of gravity.”
You Can’t Beat the Market
The takeaway lesson from the study of bubbles and market crashes over the last century is that no individual or financial institution can beat the market. The predictions of experts, parroted through popular finance-oriented television programs and websites, are short term speculation at best, and misguided made-up information at worst. The purpose of saying you can’t beat the market is not to disparage the experts, but to point out the fact that markets are volatile and unpredictable in the short-term. We all have a friend that is constantly referring to a “hot tip” they hold on an investment, or a great stock they know is about to blow up.
It’s empty talk.
You can experience intermittent and brief spurts that would seem to confirm some predictable nature to the market. That would be akin to purchasing a handful of lottery tickets from a specific gas station, winning a certain amount and believing in a correlation between ticket outcome and purchase location. But try doing it over the course of thirty, forty, fifty years of investing. Try picking stocks based off of speculation and you will soon find that your best efforts amount to little more than statistical fluctuations similar to any decision-making process. You can invest intelligently, but you can’t will yourself to riches through short term investing without putting yourself at significant, catastrophic risk.
How the Professionals Play the Game
There are two types of analysis, technical and fundamental.
Technical analysts predict the time to buy and sell stocks based upon meticulous researching of the market and interpretation of stock charts. They look at volume trading, both contemporary and in the past, to decide how a stock will function with the intention of buying at the most opportune time and selling at the pinnacle of a stock’s worth. This subset of analysts generally follow the castle-in-the-air theory of Wall Street, and utilize their knowledge of other investors’ habits to predict the effect on their investment of choice.
Fundamental analysts believe that the market is overwhelmingly logical as opposed to being held hostage by the whims of crowd mentality. They look solely at the proper value of a stock, what the investment should be worth (a combination of a company’s assets, profit and future growth), as opposed to what the market (made up of investors) predicts that value to be. Because the overriding belief is that markets will correct for any discrepancy between intrinsic value and perceived, these investors purchase stocks that are undervalued by the market and sell them when the inevitable correction takes place.
There are limitations to both methods. Technicians following the charting method are using techniques and trends available to all, creating a self-limiting practice: they same cues they are looking for to buy and sell may be artificially manufactured or avoided by a population that is also observing the same trends. Technicians are also myopic, looking for short term moves to make money from their investments. By the time the average person can act upon an investment it is often too late to ride the upswing and sell high.
Fundamentalists must engage in a difficult and variable examination of a company or industry when evaluating an investment. Growth rates are never set in stone, but represent best predictions. Likewise, companies follow natural life cycles guaranteeing that their lucrative run will come to an end at some point.
Fundamental analysis follows four rules. The First Rule: Rational investors should be willing to pay higher for shares that have larger growth rate in dividends and earnings. The reason being, as obvious as it seems, that these investments will continue to grow past the purchase price and reap long-term rewards.
The Second Rule pertains to placing a premium on companies who reward their investors with dividends: A rational investor should pay a higher price per share for companies who pay a larger proportion of their earnings in dividends or buying back stock.
While evaluating risk is largely difficult (if not outright impossible), the rule of thumb in investing is that risk applies to assets with greater volatility. A stock that swings in price year after year, including both dips and peaks, is considered a greater risk than one that is more stable. Stability in a company does not always equate to the better investment–as the growth tends to be capped along with dips in value. But lower risk does lead to a more efficient investment in the long-term and allows the investor greater peace of mind in their endeavor. The Third Rule applies to risk: A risk-averse investor should pay higher prices for a less volatile company’s stock. It’s important to remember that risk calculations tend on the subjective side and are inherently incomplete. What’s non-risky today, and for the last ten years, may be considered immensely risky a year from now if market conditions drastically change.
The final rule of fundamental analysis, the Fourth Rule, applies to seeking other investment opportunities outside of the stock market when conditions allow for it: A rational investor should pay a higher price for shares when interest rates are lower. Low interest rates create less competition for investing in stocks. The result is that the valuation of stocks increases as money flows from bonds into the stock market.
Malkiel’s Three Rules for Judging Individual Stocks
Rule 1. Only buy stocks that are expected to have above-average earnings growth for five or more years. Growth in stocks, while difficult to assess, is the single most important feature in long-term investment. A stock like Google or Apple is highly prized today because of the growth it exhibited over the last decade.
Rule 2. Don’t overpay on a stock more than its foundation value. Again, like predicting growth, judging intrinsic value is an imperfect art. Using the earnings multiple for the whole market serves for a benchmark.
Rule 3. Look for stocks where you can anticipate growth being buoyed by castle-in-the-air principles. “Good feeling” investments can sell at a premium regardless of the actual growth occurring in the company so long as the mob convinces itself the stock is a winner.
The human mind yearns to find patterns, particularly within data sets. For most people, to hear that there is no discernible pattern, no concrete system that can be applied to buying and selling stocks is anti-climactic. They want patterns. They want to see the coding of the matrix and use it to their advantage. But any proposed pattern is speculating on a short-term trend that will regress to the mean.
If you watch basketball you know of the “hot hand” effect. Fans, players and coaches all believe that when a player is making consecutive shots, they are more likely to make their next shot. The probability functions more like flipping a coin. That’s not to imply basketball is a game of chance and not skill–many players have varying field-goal percentages–but each time a player shoots the ball their success rate is independent of the outcome of their previous shot.
Behavioral psychology has swept the field of economics over the last several decades (Amos Tversky and Daniel Kahneman being the most obvious figures), precisely because we humans create fallacies in our own thinking to account for non-existent trends. When events cluster together, such as a stock rising for consecutive days, or a basketball player making two three-point shots in a row, we must accept that the outcomes are still random. Even as you cling to a predictable model of the market, keep in mind that such a model will inherently be self-defeating and therefore worthless, “If people know a stock will go up tomorrow, you can be sure it will go up today. Any regularity in the stock market that can be discovered and acted upon profitably is bound to destroy itself.”
The New Investment Strategy: Modern Portfolio Theory
The reason that buying and holding index funds is the most efficient route to investing in the stock market is because of the abysmal ability for individuals to accurately pick stocks over an extended period. As soon as any new information becomes available to persuade an investor to purchase an undervalued stock, the market quickly (sometimes within seconds) adjusts to reflect the new valuation. The idea of buying low and selling high is more of an enticing thought than a practical application.
While it’s true that some people beat the market–judging by the immense amount of wealth made through investment firms and hedgefunds–the tradeoff comes in the form of risk. The greater your risk, the lower your ability to play the game of investing. Human’s possess a sense of infallibility, a feeling of immortality, that makes them think when they hear risk, that it does not apply to them. If you lose it all, whether now or in ten years, you are out of the game. There is always risk in investing, otherwise everyone would do it. But the extreme level of risk required to beat the market in a significant way is not worth the effort.
Risk, in terms of investing, is the chance of expected returns not occurring, such as a stock not paying expected dividends, or the chance of that stock falling in value. These scenarios involve a deviation from previous expectations. Therefore, a stock that loses value has no intrinsic risk, it’s risky because we believed it we be worth more in value. Risk in the wild, such as the danger that a bear will attack and harm you on a mountain hike, is very different from risk in the financial world. Stocks are not dangerous, but risk occurs in the form of very real deviation and unexpected consequences to the market and individual stocks. You can think of financial risk in terms of volatility, or as Malkiel says, “The greater the dispersion or variance, the greater the possibilities for disappointment.”
Modern portfolio theory is derived from the position of all investors being risk-averse. No matter your tolerance for risk, you would still prefer to avoid it over the alternative. The dream scenario of any investor is guaranteed, sustained high returns with no chance of losing money. To be clear, that is a dream scenario, and no investing can take place without varying degrees of risk. But considering we all hold the ideal of low downside with high upside, modern portfolio theory seeks to come as close to that proposition as the market will allow. The defining question is as follows, “What is the greatest return on investment I can expect given the amount of risk I am willing to endure?”
The Reward of Risk
Where diversity cannot mitigate risk, the best solution to increasing long-term returns is to increase the level of risk in the investment. Put another way, seek to reduce risk in your investment as much as possible through diversification, and increase the risk in the rest to maximize returns. If you must endure risk, it should be accompanied with the greatest upswing.
Diversification takes place through broad index funds and small percentages of international developed country stocks. International funds can help the soften the blow of domestic meltdowns. Consider the U.S. auto-market crash of the last decade. While domestic index funds took a major hit, investments abroad increased (as in the Japanese auto-market) that helped offset the losses.
Malkiel describes the metric of “beta” measurements in relation to risk. Beta serves as an indicator of a stock’s risk versus the expected of rate of return, with the idea being that riskier stocks should come with some increase in investment. While Malkiel admits that the numbers do not fully match up, and that more research into the concept is required, the idea is simple and effective. More volatile stocks, and therefore riskier investments, must be imbued with some premium in return by the market to justify their investment. Nobody would invest in a stock with 10% returns and a 5-point risk when they could put their money into a similar investment with 1-point risk.
The higher rate of return is the “carrot” to entice investors despite the greater risk of investment. There is always the possibility of market-wide risk. When the market crashed in 2008, all stocks could have been considered risky as many dropped in value. This type of risk is systematic. Systematic risk is nearly impossible to predict, therefore avoid, and is the cost of playing the game. Beta risk covers what we can account for. While the nature of risk is inherently difficult, if not impossible to quantify with precision, an intelligent investor looks for ways to balance risk with the greatest rate of return. Good investing is not about gambling and risking it all on big ventures. But there is a reward in higher returns that can be mined from riskier investments.
Behavioral Finance, or Why People Don’t Invest Rationally
Earlier theories and predictions of market behaviors discussed in this article have been under the supposition that people are making rational decisions. They are investing in a way to receive the highest return on investment while bearing the lowest risk they can stomach. Behavioral finance takes a different approach.
People are irrational. That’s not hard for the general public to understand. Think of all the people in your life, or even yourself, and you will soon have a laundry list of irrational thinkers. The problem with economists accepting that people make irrational decisions is the loss of trust in the market.
While the market may be a monolithic entity, it represents the collective action of many individuals. If a portion of these investors are acting in an irrational way (i.e. not in terms of what will create the largest upside for the lowest risk), then the market must reflect that decision process, and therefore the market is irrational. The tech bubble that burst in the early 2000s represents an irrational market landscape. Money was being pumped into the stocks of companies that had no revenue or business model for generating future revenue. The entire market became a product of hysterics, with people buying and selling on gut feeling rather than due diligence. Tech was in. Tech was big. Nobody was going to hear otherwise.
Irrational behavior in the market is the result of five factors:
- Overconfidence. Individuals overestimate their own abilities and have a too-optimistic outlook on the future. Students given surveys about their own future report a better experience than when asked to predict the future of their roommates. Investors, as evidenced by the work of Kahneman and Tversky, are susceptible to overconfidence by exaggerating their ability to pick winning investments while downplaying the role of chance. The effect is a group of people, brimming with a sense of quasi-invincibility, making decisions with their money in a game that often rewards rational thinking. One way to combat the effects of overconfidence is to remind yourself that you cannot beat the market. Of course, some people manage high returns against the grain–for a short period of time–but there is a correlation between investors who trade the most often and the worst returns on investment.
- Biased Judgements. It is hard for people to accept the reality of statistics. If I were to present you with the outcomes of two imaginary coin tosses, “HHHHHHTTTTTT” or “HTHTHTHTHTHTHT,” the majority would conclude that the latter was more accurate. There is a 50% chance of flipping heads or tails, therefore the more plausible outcome would be the one that reflected that equality. In reality, the first scenario is much more likely to occur. Apply this thinking to the stock market. A stock that consistently grows for 90 days is on a “hot streak.” People start clambering to invest, industry talking heads begin rating it as a ‘buy.’ But these claims are unsubstantiated. A biased take on probability will lead a person to discern pattern out of chance occurrence.
- Herd Mentality. A central argument to Malkiel’s book is that the market does not act within a vacuum. Therefore, the interactions of the crowd can have a massive influence on the price of stocks and fluctuations in the market. Many investors are enticed to follow the herd. They read a tip online, or notice a trend in their stock market charts, and start pumping money into an investment that has many others following suit. The result is artificial inflation in a way the market would not normally dictate. The impact of herd mentality upon the stock market stems from groupthink. People in groups–in this case investors–reinforce the beliefs and decision making of the group to a more radical extent than they would otherwise (interestingly, this concept is featured prominently on the Behavioral Sciences section of the new MCAT). A gradual building occurs before eventually hysteria ensues. Every bubble in the history of markets can largely be attributed to the ill effects of groupthink. When we watch others making irrational decisions it becomes plausible for us to do the same. This effect is compounded when money is involved. As the economic historian Charles Kindleberger stated, “There is nothing so disturbing to one’s well-being and judgement to see a friend get rich.”
- Loss Aversion. Loss aversion, simply put, is the idea that humans weigh negative outcomes more heavily than favorable ones. When asked to take a proposition where you have an equal chance of winning or losing the same sum money, most people refuse. The emotional and psychological input of losing far outweighs the elated feeling of winning. The same applies to the stock market. People are unwilling to invest in propositions that offer high upside if the risk is unpalatable, even if the investment may be tilted in their favor. Loss aversion is pervasive and lasting. Even for a person with substantial assets, the experience of losing a $100 is overwhelming.
- Pride and Regret. The result of these two pervasive human emotions is investors selling early when a stock is on the rise and late when it is on the decline. The pride and bump in self-esteem of making money leads people to sell a stock. This could also be attributed to short-term greed: wanting to reap the rewards now instead of waiting to see where a stock will peak. The other impact is on investors holding failing stocks longer than what would be considered rational. A person invested in a failing stock has a twofold worry: they want to recoup their losses, and believe that holding out will lead to a turn-around; secondly, they do not want the feeling of failure and regret that accompanies selling at a loss.
Using Behavioral Finance to Avoid Bad Decision Making
- Avoid the Herd. When the investment community moves together in one direction, be wary of the fallout. Remember the principle of reversion to the mean. When a stock has above average returns for an extended period, it is most likely to underperform during the next quarter. Bubbles are created when irrational behavior and investing practices infect more and more of the investment community. Warren Buffett’s timeless wisdom again, “Be fearful when others are greedy.”
- Avoid Overtrading. Trading often accomplishes two things: you incur a higher rate of fees with each transaction and pay taxes on any short-term gains. Investing, like other activities, can create the itch to do something. The average investor yearns for an active role in the creation of their wealth. They want to be meticulous in their stock selection, putting money into potential winners and cutting out the decay from their current portfolio. Malkiel and the current academic research supports a style of investing that refrains from trading as much as possible. The idea is simple. Put your money into a broad index fund and leave it there as long as possible.
- If you are going to sell, focus on losers and not winners. The reason being that people have a greater aversion to loss than they do to gaining money. Therefore, it can be tempting to hold onto a sinking stock in the hopes that it will one day rebound and recoup the loss. While you do risk the chance of the stock coming back, it is better to cut away the weak points in your portfolio if you are feeling the itch to intervene. Selling at a loss in taxable accounts will allow you to claim a portion of that money as a deduction. Selling stocks on the rise will have the opposite effect.
- Avoid IPOs. Initial Public Offerings occur when a company issues a portion of stock to be sold to the public. Often people think that getting in on the ground floor of the IPO stock price is the fastest way to massive riches. Some recent examples include Facebook and Twitter, which were almost assured to continue growing past their IPO date and in theory increase the worth of the stock. History has proven a different story with IPOs, “In measuring all IPOs five years after their initial issuance, researchers have found that IPOs underperform the stock market by about 5 percentage points per year.” The best IPOs at ground-floor price are only offered to power-investing institutions and extremely wealthy clients. By the time the public can partake in the purchasing frenzy, the price has already been inflated beyond a good return on investment.
Beginner’s Guide to Investment
Save What You Need. The first lesson is to avoid the get-rich-quick-mentality that will have you hunting down experts on individual stocks and mutual funds. We have learned that the market is not beatable in the long-term. Any attempt to accumulate wealth quickly through investing in stocks primed to take off is myopic and unsustainable. Instead focus on saving.
Everyone hates the idea of saving. You are setting aside money that could be enjoyed now in the hopes of gaining greater value in the future. Instead of saving, think of it as investing, which is the end-goal. There are no free lunches in investing. Like poker, you can’t start making money until you have the chips to get in on a table. Malkiel (and many other financial minds) recommends a consistent approach over a lump-sum value. If you have a regular income your goal should be 5-15% of that amount. For the over-achievers, you can go higher.
But there are two points of caution in saving money for investing: First, don’t go overboard in sacrificing your present quality of life. There are no guarantees, no matter how cautious you are. You need to remember what I call the pedestrian effect. At all time, you are just one step away from being hit by a car while crossing the street. You can’t predict the future. You can’t know if you have five or fifty years left, so try and enjoy them all. If that means putting a little extra money in your pleasure fund each month, at the expense of investing, then go for it. Regardless of the riches obtained, a miserly life is always looked upon with regret. There are many things you can only do when you are young, regardless of how little money you have.
The second point is to practice sustainability. Saving money for investing is like studying for the MCAT, too much, too soon will lead to burnout. To paraphrase Tim Ferriss, “A mediocre plan that you can stick with is better than a perfect plan you will give up on”. Find a number that works for you. That may be 5% of your income. It may be 20%. Compound interest heavily rewards individuals who invest more at an earlier point in life, but don’t bankrupt yourself financially in the pursuit of larger investing capital. Pay your bills, settle your debts, and take what’s left to invest in your future. It may be fun to buy odds and ends today, but don’t do it at the expense of a comfortable future lifestyle.
Be Competitive. If your investment strategy cannot beat the rate of inflation, then you are actively losing money. For all the people turning to the safety of one-quarter-percent interest rate savings accounts, that is money being lost. Nevermind the waste and lack of returns, you are outright losing money over time compared to inflation. Risk can be healthy, and you have to be willing to undertake some in order to come ahead. There are other options than the stock market: Bank CDs, treasury bonds and money market funds. The point is to change your mentality towards your savings account. Savings accounts are useful for accumulating an emergency fund for the random occurrences in life, but they are not for investing. Put your money in a place where it can grow in value.
Paying the Minimum Amount in Taxes. People have an emotional response to paying taxes, that ranges from a deep-hatred of the government to viewing tax-dodgers as money grubbing cheaters. We all owe a piece of our well-being to the government to maintain the current country we thrive in, but that doesn’t mean we are required to pay more than our share. Discovering legal ways to reduce your tax expenditure is a way to create greater financial freedom for yourself. Rather than having the government choose where to put that money, you can decide. If you believe in autonomy, both in personal and financial decisions, you should support the idea of reducing tax expenditure.
Dollar-Cost Averaging and Long-Term Investing. One of the most important principles you can follow in investing right now is the practice of dollar-cost averaging. Dollar-cost averaging is simply investing a set amount of money at regular intervals, regardless of the market conditions. For example, if your take-home pay each month is $2,000 and you want to invest 10%, following DCA would mean investing $200 at the end of each month, or $600 if you follow a quarterly schedule. Simple to follow, but the value comes from consistency. Most people like the idea of setting aside money for investing, but when the time comes to pay bills and other expenses they look longingly at that $200 to be put towards other needs.
The second important concept for DCA is investing regardless of market conditions. This may seem like a strange practice if the market is in a slump. Conventional wisdom would tell you that a recession is the worst time to be putting your money in the stock market. But under DCA, investing in bear markets (downward trends), means purchasing more stock at cheaper prices. Compare this to a market that is on the rise: while the money you currently have invested is reaping the reward of steady increase, that $200 you invest each month is going to buy a lot less stock. The result is not necessarily an averaging effect, but a benefit to those following DCA even in a market experiencing slumps–a guaranteed occurrence during your investment life.
DCA cannot protect you from all the risks in the stock market. A systematic collapse like the one experienced in 2008 is going to hurt your portfolio no matter what you do. But DCA provides two powerful practices. 1) A simple, a consistent method to follow. You invest the same amount (or more should you choose), at regular intervals and don’t worry about the market. This is so simple to follow that anyone can do it, and removes much of the fear and uncertainty new investors have over dipping their toes in the market. 2) You are somewhat protected against dips in the market, or at the very least you have something to gain. While a decline in the market signals that your current investments are losing money (a hard concept to stomach in the short term), you can rest easy knowing that your future investments will bring in more stock at lower prices. Assuming the market returns to form, which all investors inherently believe, you should come out ahead in the long run.
I hope by now it is becoming clear the importance of a long-term investment strategy. Short-term play can lead to an abundance of quick riches, but it’s like playing poker where you go all in each hand. The reward is great, but the risk is immense.
While Malkiel offers a lot of advice on how and what to invest money in the market, the primary aim of the book is steering away from the mistakes most individual investors make by giving a crash-course education on market pitfalls. The message throughout the book is simple: invest your money regularly in broad, diverse index funds and resist the temptation to move it.
The average investor is not going to beat the market. Professionals, in the long run, don’t beat the market. Therefore, the most cost effective method and efficient use of your money is simply to play the long-term game. It’s not sexy–few of the most beneficial ways to conduct life are–but it’s the smartest and surest way to get ahead decades from now. However, the problem with any investing advice is that it is highly subjective to where you are in the natural stages of life. This is where most people begin rolling their eyes and turning their backs on investing. Younger people, students and recent college graduates would rather put that 10% of their income into vacations, alcohol and commodities. Older readers, people who have been working for several decades can see the error in this short-sighted thinking.
The earlier you begin reaping the rewards of investment the greater your outcome will be. It’s often quoted that Albert Einstein said compound interest was the greatest invention of mankind. Investing in your early twenties versus your early thirties can mean the difference in hundreds of thousands of dollars–a far greater sum than the money you blew at the bar with friends. Many readers of this website are pursuing medical school or some other form of education that will cause their finances to be tied in debt through the first decades of their working life. Even so, it’s never too early to begin. One hundred dollars a month, right now, gets you in the habit of putting your money to work and establishes a comfort with the process.
Most people avoid investing outright because they are afraid of the market. They hear only about the risk. They watched the crash of 2008 and the internet bubble of 2000 and think the stock market is for the rich and those who can stomach substantial loss. But the stock market is for everyone. The rich continue to stay rich because they know how to use the market. The poor and the middle class perpetuate their position in society because they never put themselves in the game to begin with. You don’t have to be a novice. You can learn a handful of investment techniques that make the process fun and simplistic, while bringing in steady returns. But you have got to get started. Education, an investment most of us recognize as fruitful in today’s climate, is all about deferring immediate gratification for long-term gain. It’s not always apparent, particularly when you have large student loans, what the benefit of your education will be. However, in the long run, by working hard and following certain principles, you go much further than the average individual who did not commit to education. Investment works in a similar manner. You don’t need to be rich to begin investing, you just need to get started.