Investing is an unusual field. As Morgan Housel noted in this interview, most people’s outcomes are far more attributable to their behavior than to their knowledge about investing. And as we discussed earlier, a large majority of professional active managers underperform index funds in the long run. This leads to the surprising conclusion that someone who knows only the basics but who exhibits great discipline can easily land themselves among the top 10% of lifetime investors. Housel's book The Psychology of Money is a great read on various foundational lessons at the intersection of money and human behavior.
Some of the advice dispensed here will be debatable. It reflects only one approach to investing, which might be called "thoroughly informed and thoroughly passive". It embraces the use of evidence to understand the nature of risk and potential return, while also recognizing that financial markets are impressive aggregators of information. I will not recommend trying to outsmart markets by timing strategic trades or betting that prices will fall at particular times. I will not suggest practices that require you to be more informed or smarter than everyone else (note that this is possible for only a few people, by definition). Instead, I will encourage you to capture the rewards of financial markets in ways that anyone can accomplish, with the right behavior.
Planning and enforcing your own rational behavior is perhaps the hardest part of investing. Understanding your investments, selecting a great portfolio, using the right tax-advantaged accounts — these can be less important tasks than reminding yourself to adhere to some essential guidelines and avoid common errors. We'll walk through those here.
Click to move to each section:
- Mistakes made when buying in
- Mistakes made once invested - Greed and fear - Write it down - Stop looking
- Mistakes made when exiting investments
- Why beating the market is fundamentally difficult
- Common fallacies for investors
When first investing or when investing a large amount of money, many people struggle psychologically with the idea of investing all of it at one time — in a lump sum. The main alternative is to invest it over some period — a practice called dollar cost averaging. It functions as a regret avoidance technique. People who do this are worried they're investing in the next May 2008, shortly before a major market decline. So instead, they might invest 10% on the first day of each month for ten months, so that they don't inject all their money into the stock market at the worst possible time.
The problem with dollar cost averaging is that it usually performs worse than investing a lump sum. This is true for a simple reason: the stock market tends to produce positive returns, and holding cash instead of investing usually constitutes a missed opportunity. Ben Felix conducted a study of dollar cost averaging, and he discussed it in this video. Vanguard also wrote a paper on this with a revealing title: "Dollar-cost averaging just means taking risk later". The bottom line of both of these studies was that in historical data, returns from investing a lump sum beat returns from dollar cost averaging about twice as often as the opposite occurred.
In addition to this empirical result: if the prospect of a market drop is so harrowing to you that you don't want to invest in a lump sum, then you should consider that your planned allocation may exceed your risk tolerance. If you're seriously considering dollar cost averaging even though you're aware that it's suboptimal, it may be a sign that you'll struggle to cope with the volatility of your portfolio once you're invested.
For more details, I recommend watching the video, which discusses a number of interesting points beyond the superiority of investing in a lump sum. If you choose to dollar cost average (DCA), make sure you have a disciplined schedule and that you don't attempt to engage in any further market timing. The shorter the period over which you DCA, the better. So if you feel more comfortable investing 10% each day for two weeks, go ahead — it will barely affect your expected return.
"Dollar cost averaging" can also refer to investing over time as you receive money, usually by earning income. This is, of course, unobjectionable. The form of dollar cost averaging I argue against here means that someone decides to wait before investing money they already have.
Another common attempt at market timing is to wait until markets crash and preserve your cash for the opportunity to buy at low prices. Some people insist that "keeping your powder dry" is a great idea. Buy the dip! Fortunately, Ben Felix has studied the data on this as well. I recommend this video and his more detailed discussion on the podcast. The problem with this strategy is similar to the problem with dollar cost averaging: holding cash instead of stocks is generally a bad idea. Major drops are rare enough that by the time they happen, you've missed out on so much growth that, on average, you've lost money compared to simply investing a lump sum right away. The other issue with this approach is that it's psychologically challenging to invest once the drawdown you've been waiting for arrives, since you'll likely be afraid of further declines and engage in more attempts at market timing.
These data don't stop some people from encouraging investors to hold cash that they're considering investing. Justifications like "The stock market is near record highs" are often used, as in this Wall Street Journal article from November 2013. A supposedly informed portfolio manager said in that article, "I wouldn't call this a bubble yet, but we see just about all asset classes as expensive, and we see very few opportunities in equities." Unfortunately for those who found the article credible, the total US stock market returned more than 16% in the following year and a cumulative 27% in the following three years. There is a surprisingly large contingent of people who become nervous when the market begins reaching all-time highs. You might notice that all-time highs sound like a natural consequence of an asset class that rises over time, but some people think they're a harbinger of market declines. As Ben Felix mentioned in the podcast discussion, the US market has spent about one-quarter of its history near or at all-time highs, and this condition does not tend to presage major declines.
So please don't try to time the market. Keep it simple: do your research, decide on your portfolio, and invest in a lump sum. When new money arrives, usually through your income, keep adding to the portfolio without waiting for a moment that feels right. Once you accept that you can't predict what the market will do in the near future, this will make investing much easier! You can mechanically invest new money and rebalance without the psychological burden of wondering if each small decision will have positive short-term results. If you're investing wisely, short-term results should not be a source of concern.
Be the chad investor.
These two emotions can drive you to make unforced errors once you're invested.
If you read or watch financial news, it can be hard not to notice the people who are enjoying higher returns than you. Envy, greed, the fear of missing out — these are not known to promote rational thought. But they propel many investors to chase the recent returns of flashy investments, embrace extreme risk — sometimes without realizing it — or otherwise make unwise decisions.
Let this sink in now: there will always be investors with higher returns than you, and that's fine. You can remind yourself of a few principles. First, a vast majority of investors with unusually high returns at any given time will underperform the broad market in the long run. The stock market is a very noisy system, so it is utterly predictable that individual returns will vary widely (among people who don't simply invest in the cap-weighted global market). This would happen even if all investors were equally skilled, and all differences were due to luck. Because we can't assess the exact role of chance in any particular situation, it can be hard to appreciate that luck strongly influences the distribution of individual returns.
Second, many people have worse returns than you! Most investors under-diversify, pay too much in management fees, try and fail to time the market, panic sell after crashes, wait too long to re-enter the market, pay more tax than necessary, and make a hundred other mistakes. The small minority of investors who can consistently sit back and capture the rewards of low-cost, passive investing will perform better than almost everyone else.
And third, some people who appear to be outperforming your investments are not really doing so on a risk-adjusted basis. They are achieving great returns by accepting extraordinary risk. Bill Hwang was a hedge fund manager who became a billionaire during the long bull market of the 2010s. In March 2021, his overextended investments finally collapsed. In a matter of days, he lost many billions of dollars of his own money (and money borrowed from banks). For anyone interested, the link provides details on how this happened. The lesson for us here is that Bill Hwang became rich by tolerating a level of risk that would be unbearable to most people, and he lost everything for the same reason. It becomes easier to settle for normal returns when you appreciate that your boring diversified funds — which will never double your money in a week — also guard you against catastrophe.
The second major source of unforced error is loss — the panic, fear, and uncertainty that strike when your account is shrinking. Investors generally understand that volatility is an inherent part of investing in risky assets. It's easy to learn about past downturns and see that a globally diversified investor would have eventually recovered. It's much more challenging to plow through an unknown bear market day by day, with no idea where the bottom is or what bad news could be approaching.
This video on market crashes by Ben Felix was released in the midst of the 2020 COVID-related stock market crash. Its timing within the crisis endows it with the feeling of a coach giving a motivational halftime talk as the team is losing badly. Ben gives exactly the right advice for dealing with losses and provides historical background.
A major point he makes is that bear markets are frightening in large part because of narratives about whatever crisis is causing an economic downturn. Narratives allow you to imagine the worst and forget what you know about rational investing. If you pay attention to financial news, the information will make you even more capable of justifying fear-based actions. Even though global markets have endured world wars and major government collapses, scary narratives encourage you to think that this time could be different. Every downturn has distinctive aspects, but the impression of this time being uniquely frightening is nearly always wrong.
Most people want to react to a crisis with action. They feel the need to do something when they're losing money. That's usually wrong: risk management happens before a crisis. The first step in reducing fear is to build a portfolio that you can tolerate in all market conditions. If you've never invested before, it can be difficult to know the volatility you're willing to endure. A good test is to vividly imagine how you'll react if you're very unlucky.
Say the stock allocation in your portfolio drops by 3% the first day, and 30% in the first six months. Would you seriously contemplate selling? If you would, why? And what if you were lucky, and your stock funds returned 20% in the first year? Would you increase your stock allocation and embrace risk? If so, does that make sense? Remember that each scenario would be accompanied by a narrative with specific details we can't fully anticipate. In the first scenario, you'd likely be in the grip of a frightening economic narrative, fearing further price drops. In the second, you might be hearing nothing but good news and expectations for more positive returns. Giving in to the pressure to change your portfolio merely based on recent returns and the economic mood can be tempting.
Imagining these scenarios before starting is essential. Too many people wait until they've lost money to realize they have no idea why they bought an investment. If you buy something you don't understand or don't believe in, that will become clear when it's performing poorly. You need to have a certain amount of faith in your investments. It makes no difference to their returns, but it does determine whether you'll stay invested. Paul Merriman is a former financial advisor and current educator with a warm and reassuring presence. He articulates the need to believe in your investments throughout good and bad times in this Rational Reminder interview. Once you have a portfolio you're comfortable with regardless of market conditions, you'll be able to focus on the soundness of the process no matter what happens.
How can you resist the temptations of fear and greed? One of the best methods, in my view, is to write a mission statement for your investments. There's an example in this footnote[1] for a young person about to start investing.
The statement should be detailed, ideally describing how you'll invest your money and the specific allocations in each account. The example statement doesn't just explain what the person will do, but also what their financial goals are and how the actions in their plan will support them. Your justifications and goals may be quite different than theirs — it's just an example. Whenever you feel doubts, you can return to your mission statement and reassure yourself that however you may feel about the state of financial markets, you carefully considered your plan before you wrote the statement and made commitments in writing. This doesn't mean you can never change your plan, but you should do so only with a calm mind after significant thought. Let the mission statement represent the conclusions of your most reflective self.
Mobile devices have made it possible for any investor to access real-time market data at any time, and to trade at a moment's notice with no human intermediaries. Is this good for you? Only if you can handle it.
Some people respond to this access by checking their investments multiple times a day. This will tend to make you think about altering your portfolio, and is more likely to depress your mood than if you check less often. Why? If you check the stock market once a day, you'll see red almost half the time. If you check once a month, you'll see green in perhaps two-thirds of cases. Checking once a year increases that probability to roughly three-quarters, and checking once every 20 years should always show positive results for a diversified portfolio. Checking less means you'll see more green!
So I have two suggestions.
(1) Check your portfolio as infrequently as possible. Unless you're different than most people, and you can watch volatility with no thoughts about tweaking your allocation, it's healthy to exercise restraint. For some people it may be hard to limit themselves to once a day. Others may reach Friday evening and realize they haven't checked in two weeks. If you're the former type, you may be at risk of stressing yourself too much when your investments are performing poorly. You should be investing some portion of your paycheck whenever you receive it weekly, biweekly, or monthly. So you'll view your account at that time, and it's good to do so occasionally.
(2) Don't look at your actual, hard-earned money too often. When you're curious about market movements, I think it's better to view a third-party website or app like Yahoo! Finance. You can create a custom watchlist with the funds you want to be able to check. The advantage is that when you open the Yahoo! Finance app, you won't have immediate access to trading and you won't see the actual dollar amounts. It's easier to see that VT is down 1.3% today than to see how much money your account just lost. Just remember that on ex-dividend dates for an ETF, the share price will drop by the amount of the dividend in addition to whatever market movements occur.
These habits are meant to make you feel less concern about the volatility of your investments, and to help you avoid changing your investments for emotional reasons.
In my view, there are only about five rational reasons for a passive investor to exit a position:
- You need to liquidate your investments to spend the money in the near future.
This should be clear: sometimes you need to raise cash by selling your investments. It can be as simple as selling shares of a money market fund to pay your mortgage or rent in a week.
- You need to adjust the level of risk in accordance with the intended purpose of the asset.
This is related to your risk tolerance and intended time horizon for a portion of your assets. If you have money earmarked for a down payment on a future home, you wouldn't want it held in risky assets while you're touring houses. Risk should be reduced as you approach the target date. There are varying types of target dates: buying a home entails dispensing a lump sum for a down payment, whereas reaching retirement age means you'll spend only a small fraction of your savings in the first year. De-risking should be moderate as you approach retirement, since you probably plan to keep investing some portion of that money for decades.
- You decide that your investment choices were unwise in the first place.
This has many potential origins: you'd like to change your asset allocation after learning more; you realize your portfolio is too risky or not risky enough; you'd like to diversify after losing money due to concentrating too much in certain assets. Be conscious of tax implications, but you should be willing to update your portfolio as you gain new information about markets and about yourself.
- Your personal ability to accept risk has changed.
There are many potential reasons why your general ability to accept risk can change. Perhaps after marrying and combining finances with a long-term partner, the two of you feel able to take more risk in your portfolio because income generated by two people is more robust. Or maybe you move to a less secure job because it pays a higher salary, so you reduce your portfolio's risk in case you lose your job in a recession.
- You identify an opportunity for tax loss harvesting.
Tax loss harvesting is the conscious use of realized losses to offset realized gains for tax purposes. There are misconceptions about its proper use, which are discussed in the section on taxes.
For an investor committed to being thoroughly informed and thoroughly passive, any other reasons for exiting an investment are questionable. Deferring tax by holding investments for as long as possible is an important part of optimizing your returns through tax-efficient investing.
"Beating the market" can be defined in various ways, but here I'll define it as outperforming the risk-adjusted return of a potential passive benchmark, which might be composed of multiple asset classes. An asset class — like stocks or bonds — is a group of investments that exhibit similar behavior and draw on the same sources of risk and expected return. It's not hard to outperform the aggregate bond market: just invest in long-term bonds or high-yield bonds, and in the long run your riskier investments will beat those of the average bond investor. The same goes for outperforming the cap-weighted stock market: as we'll discuss in a later section, you can increase expected return by investing in riskier stocks. The question is, why is it so hard to select investments with higher long-term performance without taking higher risk? Why is it so rare that active managers beat broad stock market indices at all?
We could discuss proximate reasons for why it's hard to outperform passive investors: the positive skew of stock returns, the high fees charged by active funds, the tendency for higher turnover to lead to less tax-efficiency, or the difficulty of maintaining outperformance as your assets under management grow larger. But I think it would be most useful to describe why prediction in financial markets is fundamentally different than prediction in many other domains.
Consider the prediction of solar eclipses, a phenomenon that is unaffected by human action. Prediction of solar eclipses is so enviably accurate that I already know the locations from which my descendents could view a total solar eclipse on July 16, 2186. We know it will be the longest total solar eclipse since the dawn of written history, and for thousands of subsequent years as well. Sometimes prediction works like this: gather enough accurate information, apprehend the pattern, and you can make reliable forecasts of the far future.
Prediction of financial markets is totally unlike prediction of natural phenomena. If everyone agrees that an eclipse will occur on July 16, 2186, the agreement itself has no effect on whether it actually happens. But markets are adversarial environments. If new information reveals that a company's stock is undervalued, all participants are incentivized to buy shares, driving up the price until it's no longer judged as undervalued. So agreement that a stock is undervalued causes that fact to become obsolete. New public information tends to be factored into the market's judgment of a fair price very quickly.
This implies that outperformance has nothing to do with how smart or informed you are from an objective perspective. Smart, informed people can reliably predict eclipses and other phenomena that stand still while you inspect them. But investment performance is a relative game: what matters is how smart and informed you are relative to other participants. The passive investor — before trading costs, fees, and taxes — gets an expected return in proportion to the risk they accept. Active traders win or lose relative to the market return. Some of the losers are bright people equipped with knowledge and rarefied data. They don't lose because they're objectively bad players. They lose because their trading is largely a competition with skilled active investors, and someone has to lose. Note that "losing" doesn't always imply a negative return; it implies a worse return than the market.
Some people comprehend this and decide they're going to risk underperformance for the possible glory of outperformance. In my view, most people should recognize the merits of passive investing. After trading costs, fees, and taxes, the passive investor who accepts "average" performance is actually far above average. They're also likely to spend much less time deliberating and stressing than the active traders they're outperforming. As explored in other sections, seeking higher return by accepting more risk is a much more reliable method in the long run than attempting it through exceptional skill. This method of outperformance is available to anyone who can stick to their portfolio and plan for the risks of their own circumstances.
The same reasoning applies to timing the market. Predicting when (say) the US stock market will rise or fall is a game you play against others. Fundamentally, this is why it is hard to anticipate the direction of the market. If you think adverse future events will cause the market to fall, existing prices may already reflect the public knowledge of that risk. Many people sabotage their investing returns by selling due to bad news and staying out of the market for too long — sometimes for years. However, I want to address a common argument against market-timing behavior that I don't find convincing. A Wall Street Journal article pointed out, "The returns of a hypothetical investor who put $10,000 into an S&P 500 index fund at the start of 1980 and missed the market’s five best days through the end of August 2020 would be 38 percentage points lower than those of someone who stayed invested the whole period". Missing the best ten days would have cut their returns by 55%.
Those who remind investors not to miss the best days tend to ignore two points. The first is that movements on the worst historical days have been slightly larger than those on the best days, which means that selling out of the market could allow you to benefit by missing some of the worst days.[2] The second is that the best days are not scattered throughout different parts of the market cycle. They occur in the midst of turbulence during and after market crashes. As you can see in the table below, the two most positive single-day returns since 1950 were in October 2008. Would you want to miss those? In a sense you would, because you would’ve been better off not holding a stock fund at all than holding one throughout that month, which saw an overall 17% loss.
Again, I warn of the difficulty of outsmarting the market through timing. If you've guessed right a few times and think you have a talent for anticipating the market's direction, try to write down each day at 4pm what you think will happen the next day. Or if you think it's easier, try predicting next week's movement each Friday. Do this every day for a few months, or every week for a year, and I think you'll learn how difficult it is. In my view, a thoroughly informed and passive investor should buy and hold until they can invoke one of the five reasons discussed above for exiting an investment. More info on the table is in this footnote.[3]
We'll conclude with some widespread psychological pitfalls that I think investors should be careful to avoid.
It's widely said that you should own stock in "good" companies, and not "bad" companies. There are also, reportedly, "good" and "bad" countries to invest in. Arguments for these labels tend to rely heavily on past returns, especially recent past returns. Let's review a few examples of why essentializing narrow investments as good or bad is not sensible.
Between 1970 and 1989, the MSCI Japan index delivered an average annual return of 22.4%. Some quick math shows that 22.4% annual returns for 20 years lets an investor multiply their money by 1.224^20 = 57! For comparison, a typical 8% return delivers a measly 20-year multiplier of 4.7. These gains were staggering. Japan had the largest stock market in the world in 1989 and, especially for domestic investors, Japanese stocks were a "good" investment. You can probably guess the outline of what happened next: Japan's market crashed in 1990 and suffered through two decades of very poor performance, followed by middling performance in the most recent decade. So is Japan a good or bad country to invest in? This example is meant to illustrate why essentializing a single country's stock market as good or bad is misleading. This is especially true if someone points to recent past returns to justify it, and says that they're likely to continue.
Let's try a more fun illustration: Monster Beverage (MNST). MNST has the best average returns of any stock I'm aware of. Someone who bought $10,000 of shares at the beginning of 1996 and touched nothing would have held over $60 million of shares by the early 2020s. However, shortly after going public in August 1995, MNST suffered a 58% drawdown before its legendary performance commenced. Even the "best" stock ever has experienced terrible returns during some periods, and some investors surely lost money on the stock.
Note the distinction between these two statements: (A) "Monster stock has great returns" and (B) "Monster stock has had great past returns". Statement (B) is an objective observation, but statement (A) implies properties about an investment that do not reliably persist. Monster stock may or may not perform well in the future. Narrow investments do not follow predictable patterns that we're accustomed to in many other domains. If we've been happy with a carpenter's work in the past, we can hire him again with an expectation that the quality of his work will persist. Or if last season, a baseball player hit a record number of home runs, we can reasonably predict that he'll perform well again this season. I can't emphasize enough that financial investments are just not like that — their returns don't have persistent properties. The entire Japanese stock market can deliver two decades of eye-watering returns, followed by two decades of malaise, and that is totally normal.
A common debate among investors is about whether to overweight the US stock market given how well it performed between 2012 and 2021 — 16.3% average annual returns, compared to 7.7% total international returns. In my view, the tendency to essentialize investments as good or bad has caused many people to see US stocks as inherently better than ex-US stocks. For some, it is almost impossible to look at the radical US outperformance of the last decade and imagine ex-US stocks performing better in the future. The US market is "good", international markets are "bad". I think this is reinforced by home country bias, which is the tendency of people everywhere to overweight investments in their own country. But in efficient markets, we wouldn't expect a country's stock market to have higher expected return unless it carried higher risk. The US is certainly not a high-risk environment compared to emerging markets like China and Russia. Of course, markets like the US and Japan can have unexpected returns, and unexpected returns are the norm in stock markets! But that doesn't mean we should bet on unexpectedly high or low returns persisting in any market, just because they happened in the recent past. In the section on stock portfolios, I elaborate on why home country bias or bias toward recently high returns is not a good idea.
Mental accounting is the tendency to mentally group your money and treat those groups in different ways, even if there is no real distinction between the groups. A common example is that people treat money with less care if they received it unexpectedly — perhaps from a tax refund, a lottery ticket, or a performance bonus at work. People are often more willing to spend this money or, when investing, take high risk with it.
Here's another one: would you drive 30 minutes to a distant vendor to save $100 on a $300 kitchen appliance? Many people would. Would you drive 30 minutes to another dealership to save $100 on a $30,000 car? Many people would regard that difference as a rounding error in the context of buying a car. But in both situations, you have the chance to be paid $100 for two 30-minute trips.
Mental accounting can produce more harmful financial behaviors. Imagine someone in $20,000 of credit card debt with 22% interest. There is nothing better they could do with their money than to pay off that super high-interest debt. Yet many people with significant credit card debt accumulate savings. This person might feel that having $7,000 saved in the bank is an important goal, because it makes them feel secure in case of emergency. The goal of maintaining a minimum savings is mentally separated from the goal of paying debt. But what is the worst case scenario for someone in credit card debt who plows almost all their savings into paying the debt? If they ended up needing the money in an emergency, they could use the credit cards to take out more debt, ending up no worse (and probably better) than if they had kept the savings. Unfortunately, some people experience such negative feelings about having no savings that they're willing to pay 22% interest to keep money sitting in the bank.
Although mental accounting can be irrational, some people prosecute the issue too zealously. It is not true that "all dollars are fungible", as is often stated when discussing this fallacy. Tax laws are the main reason why money can legitimately be separated into different buckets. The dollars in my checking account can be freely accessed if I need to spend them. If I were to withdraw the money in my traditional IRA because I needed to spend it, I would pay income tax as well as a 10% tax penalty on that withdrawal. Those dollars are not fungible! The psychological isolation of retirement accounts from normal money is actually one of their great benefits. You can invest in a retirement account knowing that you won't touch the money until old age. Hopefully, this improves your tolerance for volatility and makes it more bearable to invest in risky assets with high expected return.
The endowment effect is the tendency to value things more highly merely due to owning them. In many studies, the lowest price at which a person offers to sell an item is higher than the price they're willing to pay for the same item. It has some overlap with status quo bias, a potentially irrational tendency to favor current circumstances over alternatives.
This can present itself in investing, sometimes with large financial consequences. Some employees, especially at public companies, receive stock in their employer's company as part of their compensation. Although it can come with strings attached, many employees keep their stock long after they could've sold it and bought shares of a diversified fund. For some people, company stock eventually becomes a significant portion of their net worth.
Deciding exactly how much company stock to keep is a decision that depends on many factors. I will suggest that there are ways of approaching it that help counter our natural status quo bias. You can ask yourself, "If I didn't own any company stock right now, would I sell my index funds to buy it?" Or, perhaps more neutrally, "If I were currently holding my entire net worth in cash, how would I choose to allocate it?" Often, when asked from this perspective, people realize that they would never choose to invest 20% or 50% of their net worth in a single company's stock. In fact, they never actually chose to do that. It happened to them, and they accepted it. This practice is even riskier given that your company's prospects are linked to the stock price and your job security. If your company flops, the stock price could plummet at the same time you're laid off. On top of that, your company's failure could be linked to a general downturn in your industry, potentially making it harder to find a job elsewhere.
This approach of taking an impartial perspective helps in many other situations. Perhaps you've learned something new about investing and begin to doubt that your current portfolio is ideal. Perhaps you inherited an investing account from a parent who recently died, and you're deciding whether to change the investments. Of course, there are tax consequences to adjusting a portfolio in a taxable account, and this should be considered. But whenever you find yourself trying to make a decision, make a point of framing it in a way that does not privilege the status quo. Your mind is already doing that for you.
In most domains, we assume that it is wise to learn from the outcomes of our actions. If you study for an exam and fail, you should adjust your study habits. But in order to learn from experience, feedback has to be clear and the reasons for success or failure need to be identifiable and repeatable. Ideally, the feedback is also fairly prompt: it doesn't take years to gather a meaningful amount of information. In the domain of selecting good investments, all of these factors are lacking, making it unusually difficult to learn from experience.
The first issue is that feedback is not clear — it's extremely noisy. If you carefully select a particular investment that performs well in the first year, how can you know whether it was due to your skill, or due to good luck? The evidence indicates that while some active funds outperform their benchmark in any given year, nearly all of these funds eventually underperform on a longer timeline. Luck feels like skill until it runs out.
The second issue is that it's extremely difficult to identify the variables that need to change to improve your outcome. If you gave yourself time to study only half the material for an exam, you can infer that giving yourself more time to study would've improved your score. But human intuition is a feeble tool for some uses. If your portfolio has disappointing results, what could have altered the outcome? If certain variables would've improved outcomes in the past, will the behavior of those variables persist in the future? Many people regret not picking investments that performed well in the past, and often change investments on this basis. This leads to the unfortunate result that many investors experience returns that are worse than those of the funds they invest in, because they buy after periods of very positive return and panic sell after downturns. Chasing the high past returns of particular investments is a great way to underperform in the future.
Many people assume that they can learn a great deal from their personal investing experience. After observing their portfolio for a year, perhaps they should change it based on all the data they've collected. Maybe they should eliminate the funds that performed poorly in the time they've held them, and double down on those that performed best. The point here is to emphasize that a long-term investor can learn virtually nothing from a year of performance. Even ten years of performance gives us very little information. This statement would probably sound absurd to some people — in almost any other domain, ten years is a long time. But you should think about market returns almost as a geologist would think about Earth's history, or an astrophysicist would think about the history of the universe. In those contexts, a decade of data is uninformative, because meaningful patterns are observable only on scales of thousands, millions, or billions of years.
Financial markets are not quite as remote from human experience, but consider how much ten-year periods can differ from one another. Investing $10,000 in the total US stock market at the beginning of 2000 would have left you with $9,847 at the end of the decade. Investing in the same fund for a decade at the beginning of 2012 would instead have turned $10,000 into more than $45,000. Should we learn from the first decade that US stocks are a terrible investment? Or should we learn from the second decade that US stocks are a miraculous way to generate wealth, with little potential downside? The actual lesson is that, in systems as noisy as stock markets, even a full decade of information does not help us learn much about what to expect in the future.
If financial markets are as mystifying as I say, how can we learn anything from history? Instead of using narrow personal experience, I would advise using sources of data that are as broad as possible. Depending on the form of data, we have access to a few decades to a few centuries of information about financial markets. We also have data from dozens of different countries, not just the United States! We should use these data to form testable theories about how markets work, and only then can we make well-grounded projections about the future. The section on stock portfolios discusses how to combine theory and data to build evidence-based portfolios.
Finally, even though you can't use your personal experience to pick better investments, there are a few ways you can learn from mistakes. Let's say you were invested in stocks in the late 2000s when the market crashed. After watching the terrifying news on CNBC every day, you sold at a major loss, trying to protect yourself from a total collapse. Even though the market was on a general upward trend after March 2009, the wild volatility of the next few years kept you on the sidelines. After that, there were still people predicting crashes every month on the news and social media. You were so rattled by your experience and frightened by the possibility of buying right before another crash that you didn't invest much money again until 2016. You missed out on years of gains. Can we learn from this mistake? Yes, we absolutely can. The cause of failure is identifiable — selling due to loss and waiting a long time to re-enter. Should we expect the same variables to cause success or failure in the future? Yes, staying invested instead of panic selling is expected to be a successful approach in the future for a diversified investor. This expectation is based on long historical data and the persistent tendency for returns to be very high right after downturns.
Click here for the next section — Investing for retirement
All sections:
- Cover page
- Introduction to index funds
- Thinking about risk
- Tax-advantaged accounts
- Your psychology
- Investing for retirement
- Guidelines for personal finance
- Building a stock portfolio
- Fund proposals
- Advice
- Practical information for execution
- Taxes
- Vocabulary and further resources
- Advanced topics
Footnote:
1 A mission statement example:
I believe that passive, low-cost investing in diversified funds is the best practice for me, because the evidence indicates that this is the most reliable way to produce good investment returns. I'm saving and investing with the goal of financial independence between the ages of 60 and 65, which means that I'll be able to live indefinitely on my investment earnings combined with Social Security benefits. Even before I reach financial independence, saving and investing consistently will give me more freedom in how I choose to spend my time. I'll invest in an allocation that meets my risk tolerance for each portion of my assets. The money I may need in the near future will be in low-risk funds, while the money I'm setting aside for the long run will be in high-risk funds. I'm committed to not altering my risky, long-term portfolio beyond basic rebalancing. It will be tempting to change my long-term portfolio or even sell all my shares when it's performing poorly. But I understand that downturns are inevitable, and that my investments will eventually recover, because I selected a diversified portfolio that I'm comfortable with regardless of market conditions.
Not only will I not change my long-term portfolio when it's crashing, I will not stop contributing to it, because changing contributions in response to market movements is another form of ill-advised market timing. From each after-tax paycheck, at least 5% will be contributed to my Roth 401(k) account, and I'll transfer at least 10% to my taxable account. I'll also contribute enough to max out my Roth IRA and HSA by the end of each year. I'll buy shares as soon as the money becomes available, and won't try to time the market. This is not only optimal, but investing mechanically reduces my stress because I don't have to constantly make decisions. I'll rebalance my accounts semi-annually every May 15 and November 15 (or the first business day after those dates). Not much rebalancing will be required because I'll continuously rebalance through dividends and earned income. If rebalancing would require me to pay needless tax, I'll consider not rebalancing perfectly.
My Roth IRA, Roth 401(k) account, and HSA will all be invested in the long-term portfolio. At least 40% of the money transferred to my taxable account will be invested in the long-term portfolio, but that account will also contain low-risk bond funds for more immediate financial needs. Any money I don't need in my checking account will be placed in suitable funds in my taxable account, and I'll transfer money back to my checking account only if I need it. This will encourage me to save it. I won't withdraw any money from my retirement accounts before age 59½, except as a last resort. I'll move money out of my long-term portfolio into less risky funds only when the need for that money is approaching. For example, one of those needs might be a down payment on a home. I'll also begin gradually de-risking my retirement portfolio at age 50. Whenever my income increases, I’ll increase my savings rate in my taxable account and Roth 401(k). I’ll also evaluate whether I should shift partly or completely from Roth to traditional retirement contributions.
My risky, long-term portfolio is the complex portfolio here. I'll do my best to approximate that portfolio in work retirement accounts, but I most likely won't have access to all the funds I want. For low-risk investing, I'll use a combination of Series I savings bonds, the short-term US Treasury bond fund SCHO, and the moderately risky bond fund DFCF. If there is money I want to preserve without risk because I may need short-term liquidity, I'll use SGOV or a money market fund. ↩
2 It may appear that the best days have larger movements than the worst days, but we should understand that there's an inherent mathematical imbalance between gains and losses expressed in percentage terms. The best day was +28.6% and the worst day was -25.5%. If a $100 investment loses 25.5% and gains 28.6% — regardless of whether the gain or loss happens first — the investment will be worth $95.81. The only two pairs in the table where the gain is slightly larger than the loss are rank 12 — +11.4% and -10.1% — and rank 22 — +9.1% and -8.3%. The loss wins in the other 20 pairs. ↩
3 The event groupings are slightly arbitrary: World War II and the Great Depression encompassed many events, of course. The largest upward move on Apr 9 1943 appears to have been triggered by the announcement of post-war economic plans from US and UK leadership (sometimes known as the "Keynes plan"). These proposals led to the famous conference at Bretton Woods, which established many aspects of the post-WWII global financial system, including the International Monetary Fund.
As far as I can tell, the drop on Sep 13 1946 was caused by contradictory statements from the White House on the fundamental foreign policy of the US. This event was mentioned here in Wikipedia's historical daily timeline and in a TIME Magazine article entitled "THE PRESIDENCY: What I Meant to Say...".
The S&P 500 data were downloaded from Yahoo! Finance here with the yfinance Python library. The S&P 500 index launched in 1957, but the S&P Composite index was its predecessor. Yahoo's data on the S&P 500's total return extends only to 1988. ↩