Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).
From YOLO to Picking to Indexing
Conventional investing wisdom has evolved a great deal over the last century, starting with the Roaring 20s. Irrational exuberance ruled the day, and YOLO (you only live once) would have been the perfect descriptive term for the sentiment in the market. All you needed to do was to put your money into the market by buying a company's stock, and eventually, everything would go up.
Naturally, this led to a startling crash after which many speculators were completely wiped out, and the general public sentiment about the stock market became very negative for a very long time. The public perceived stocks as extremely risky and only worthwhile for investors with a lot of money (or an insanely high risk tolerance).
While Ben Graham, the godfather of value investing, first revolutionized the concept of risk-averse, thoughtful stock-picking all the way back in the 1930s, it took a later generation of investment thought leadership in order to make this concept accessible for the everyday investor. Graham described a process wherein a diligent individual investor could pick stocks based on business fundamentals, but he made a distinction between an investor who might have the time and desire to pick individual stocks and one who doesn't have the time (or desire) to go through this process: the classic active and passive investor archetypes.
Graham's original observation implied that a passive investor could simply "buy the whole market" instead of picking individual stocks, and they'd very likely do very well over time with very little work. In fact, studies over the years have shown that average investors typically do worse than the market—not better—contrary to what might seem intuitive to a would-be stock picker.
While Graham's thesis was earth-shattering, it was a later generation led by Jack Bogle, legendary founder of Vanguard, who made this process accessible to the everyday investor by creating the first index fund. Bogle describes this process in perhaps the most influential book on investing from the last half-century, The Little Book of Common Sense Investing.
Index investing, commonly thought of as passive investing, has gradually gained steam ever since Vanguard's first index fund was created, eventually coming to dominate how most individuals buy stocks. Index investing is very much today's main paradigm, meme stonks notwithstanding. It has become conventional wisdom to think of this as the safest way to invest. But . . . is this still true?
Swimming With the Herd
Given that the return for the average investor buying index funds has been better over the last few decades than that of the average stock-picking investor, and given that only a very small percentage of investors have been able to do any better than this over long periods of time, isn't it much easier to just swim with the herd?
Well, yes . . . it's much, much easier to just "buy the market" and sit back, waiting for the wonderful snowball effect to compound your cash. Unfortunately, reality has a funny way of rearing its ugly head, and it's important to validate assumptions, even when the wisdom of the crowd is screaming that you don't need to do any actual thinking.
Easy doesn't always correlate with most effective, and there may be good reason to believe that what has worked well in the past may not work quite as well in the future. Let's take a look at why this might be the case.
Which Is Worse: A Crash or a Lost Decade?
If you zoom out far enough, the stock market looks like an upward slope, and this supports the index investing argument completely. However, if you take a closer look at this upward slope, you'll notice that there can be extremely long periods of time where there are zero returns.
Read More From Toughnickel
1999 through 2009 is probably the easiest example of a situation like this: if you simply bought the S&P 500, it would have taken you about 10 years to get your original investment back. That's not how this is supposed to work, you're probably thinking, but if you look back through history, you'll see that these so-called "lost decades" are more common than you might think. Even worse, it took the market around a quarter of a century to get back to 1929 levels. Ouch.
However, some of this is mitigated by a crash, assuming you're using a dollar-cost averaging and continuing to buy (through thick and thin). When a crash happens, stocks become much, much cheaper, of course, and so you buy much more of the underlying businesses during this time.
A crash, then, is something you can benefit from a great deal. When the market eventually recovers, the shares you were able to buy during the downtimes will be worth a great deal more. You'll do amazingly well if you keep buying during a crash. But what happens if there's not a crash, and it just takes a long time for the market to go anywhere? When the market is flat, you're not going to be able to buy businesses for any cheaper than you're buying them for at the market's peak.
What to Expect
If you're invested in the market at an all-time high, it's worth taking a look at the P/E ratio for forward-projected earnings. In April of 2021, this number approached 25, which implies a return of around 4% per year (the inverse of price-to-earnings will give you the expected yield for any stock).
The forward P/E is this high because stocks have continued to go up in price, whether or not the prices are supported by the data. It's not as simple as concluding that the market is overpriced just because the economic data doesn't seem to correlate (after all, the stock market is not the economy), but it's still a valuable observation to make when you're deciding what to do with your portfolio.
Assuming the projected earnings actually come to fruition, this does support the idea that the market will be a lot more flat than it has been throughout most of its history, over which the average annual return has been around 10%. If you invest in something that returns 10% a year, it will take you a little over 7 years to double your money. On the other hand, if your yield is 4%, you can expect to double your money a little after 17 years. Now that's motivating.
Another phenomenon is driving the market even higher, and this brings our investing story full circle—back to Bogle. Because index-fund investing has become so popular, there's a great deal more influence from the funds themselves. When people buy into a market's index fund, this usually means that the bigger the company, the more of its shares the fund will buy (this is called market weighting).
The law of supply and demand dictates that more people (or funds) buying a company's stock leads directly to a higher price for the company's stock over time, and this can operate as a vicious cycle—a perpetual motion machine that drives the price ever-higher and your expected return ever-lower.
The Squishy Balloon
If the stock market as a whole is about to give us a lost decade (during which we see very low—or even zero—real returns), does that mean that investing is hopeless? Certainly not. It does, however, mean that you need to think of the stock market itself as a market of stocks. This means that platitudes like "the market is expensive right now" are useful guidelines, but it doesn't mean you can't find good deals on individual businesses. Conversely, you can find very expensive stocks even in "cheap" markets.
Think about a balloon that has been blown up halfway. You can squeeze the balloon all you want, but there's never going to be any more or less air in the whole balloon. However, you can clearly manipulate the air so that one area bulges dramatically, concentrating a great deal more air in that one particular spot.
This can be a really useful analogy for thinking about how the stock market works during a lost decade. Sure, the market itself doesn't go anywhere, but there are pockets of excitement in various different places at any given time. All you have to do is find those spots.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.