If you live in a big city then traffic is simply a part of your life. Probably a part that is a little bigger than you would like. Driving in traffic brings out the truth in people. Sometimes too much of the truth if you feel the need to strip down and dance on top of a big rig. Want to get to know your new girlfriend or boyfriend? Ask them to drive you through a congested part of town during rush hour and see how they act. It's a lot cheaper and quicker than spending months with someone only to find out they are a sociopath. Although I hate traffic with a passion it has allowed me to make the odd yet perfectly fitting metaphor to investing.
The Road To Financial Freedom...Literally
Before you hop in your metaphoric investment vehicle you need to have a destination. Driving around aimlessly during rush hour traffic is probably not the wisest choice. You may end up where you don't want to be and will probably waste a lot of time and effort. Similarly with investing you need to have a goal or destination. This will give you guidance on what to do and gives you a place to run to. It allows you to design your investments for your specific needs. So let's say your goal is to get your F.U. Money.
When you set off on your destination, realize that in this metaphor there are no google maps. All you have is a compass and you know you want to go north. There is also intense fog out so you literally can't see hardly anything ahead of you. The only thing you can do is see the paths behind you. Oh and one last thing, as you drive along your destination get's farther and farther away from you. So the longer you take to get to the destination the farther you have to drive. Seems scary right? Investing is the same way. There is no google map that will optimize your route to financial freedom. You know that you need to invest and that you need to earn a certain return to reach your goals. How to get to that return is the hard part. There is no way to accurately and consistently predict the future. Also, inflation is constantly eating away at the purchasing power of your money. So not only do you need to earn a return that is high enough to simply outpace inflation, but you also need to earn a return above that to have the joy of compounding over time. For some people the thought of having to take the journey into this scary world of investing is petrifying to the point where they will simply choose to do nothing. They just stuff their money under a mattress and leave it thinking that it is "safe". All the while inflation eats it away effectively guaranteeing that they will lose value on their savings. So choosing to simply not go on the journey will definitely not get you anywhere...literally.
When you set off on your journey you have a couple of different modes of transportation. First you could take a train. I am not talking the maglev trains that go 300 mph. I'm talking some old school diesel train that goes about 40 because the tracks are not in the best shape. Sure the train will get you there, but it is probably going to take a while. There won't be much traffic and the train will move along at a constant speed. Also, the likelihood of the train having an accident or blowing up is pretty low so there is less risk. But realize that the train may barely go fast enough to beat the rate at which your destination is moving ahead of you. That means that effectively you could be just inching along and sometimes you might even be moving backwards. This would be like investing in bonds. Sure they are the safe bet and low risk, but the returns are not going to be great. You will likely barely outpace inflation. So after investing for 20 or 30 years you might not see enough money to truly live off of. But if you are extremely risk adverse then this may be the only place for you.
Next is your typical car. Having the car gives you almost unlimited options on different routes you can take. You can drive down highways or skim along the back roads. Also, cars can go faster than trains, but they have to travel on roads so that means traffic sometimes. This is like the stock market. In the stock market there are an unlimited amount of variables to consider. We know that over time the stock market gets better returns than the bond market, but this is at the cost of sometimes having to go through downturns.
Then there are the planes. Now these aren't the nice 747s we are used to. Oh no. These are small little planes flown by a pilot that you can't really decide if they are high, drunk, having a bad day, or any combination of the three. Similarly the parachutes on the plane look like they have been drug through a bear pit. It's really quite questionable whether the parachutes have been taken out of the bags and used to smuggle cocaine for your high pilot. Sure, the plane might get you there and it may be a ton faster than the car, but if something goes wrong there is not a lot options that you have. And if you crash then you are almost guaranteed to die. This is the commodities and derivatives market. The realm of questionable deals and illogical valuations. It was this sector (namely mortgage-backed securities) that was responsible for the crash of 2008 which was like a very large plane that crashed into a major freeway and set off a nuclear explosion and took out the trains as well so everyone was pretty damn screwed.
So there we have it: a system of trains that represent bonds, your typical car that represents stocks, and drunk pilots flying questionable airplanes as the derivatives market. Now that we know what the vehicles are we have to talk about the drivers.
For the rest of the post I will focus on the stock market (roads) since most people will not deal with derivatives and commodities and bonds are pretty straight forward.
It's Not About The Vehicles, It's About How They Are Driven
When you are driving through traffic you encounter all kinds of different people. Some you really want to pull out of the car and beat the crap out of them. Others you just want to smash into so that maybe they will move out of your way. But you typically do neither of those things and just grit though it. Now that our metaphor is set up it is time to make an observation.
Realize that there are almost an unlimited amount of possibilities. So many different routes and different things to look at. Not to mention that you can't see anything ahead of you and only things behind you. Trying to find the most optimum route to your destination is next to impossible. If you do happen to get it for a little bit then it was probably due to luck. Also, what was optimum in the past is probably not going to be the optimum in the future. Yet we know we need to do something. The best thing you can do is to layout a plan that you can stick with through thick and thin. By definition this means that some people may get ahead of you from time to time. But that is okay. The goal is to find the surest way to get to the destination in a reasonable amount of time. In investing the same is true. Trying to find the most optimum strategy that is going to get you the absolute best returns possible over the next 10 to 30 years is next to impossible. The best thing you can do is find a strategy you believe in and stick to it. Now let's talk about some different people we see on the road.
First you have the Traders. We have all seen them. When you are on the highway they shoot from lane to lane trying to dodge cars. When you are on the side streets they do the same and race from red light to red light. From time to time they might get ahead and beat a light. But every time they zoom between lanes or beat that light they get a little more confident in their ability to drive. Little by little they start to increase the speed and cut it closer and closer to hitting another car. As their confidence goes up so does their propensity to take on more risky behavior. One day their luck may run out and they may smash into someone. Sure some can go the entire way to their destination and not get a scratch. But that might have just been due to luck rather than skill. These people might get news stories written about them and people might put a lot of faith in their abilities. They think they can "predict the road" or "see through the fog". People begin to believe they have god like abilities. More and more people see the traders making great times and think they can do it too. So with less experience and insight they buy themselves a fast car and start zooming around. But it only takes one bad accident to kill them or permanently disable them. The truth is all of these people may have been driving down a road that just had no traffic. In a wide open road it is fairly easy to make good times. All you have to do is drive fast and dodge a couple of cars. As time goes on the traders think that it will last forever. They will say things like "there is never any traffic on this road". It is hard to really argue with them. Maybe they start taking things off their cars to make them go fast. Some might even remove the brakes because who needs to stop on a road that has no traffic. Unbeknownst to the traders, a great wreck lies ahead. The entire freeway is shut down. But they just can't see it. Inevitably, the traders who have removed their brakes and aren't paying attention will immediately smash into the cars ahead of them. All the lane switching in the world couldn't save them from this crash. Many die and are never heard from again. Many more are permanently paralyzed and left stunned by what has happened.
This exact scenario has played over and over many times in the investment world. In a market that is going up it is pretty easy to make money. Frequent trading can look very attractive. As they have success trading over a couple of years they really think they are able to outsmart the market. They little by little start to engage in risker behavior. They might start to use a little leverage (getting a faster car) or neglect to use stop losses or other hedging strategies (removing brakes). For a while these things work and they are able to make even more money. Then it all comes to an end. For one reason or another the market falls off a cliff. The people using lots of leverage can lose everything they own and more. Many people who have put all their savings into this can wipe out years and years of returns. Many do some much damage that it is almost impossible to return from. They ask themselves what went wrong and why they couldn't see it coming. The reality is that just about no one could. None of the "experts" in the world saw it coming which kinda makes you wonder how they became "experts". Need a case study? Look at the recent crash in oil prices. Since it's highs in summer 2014 oil has lost about 70% wiping out trillions of dollars. Yet no one saw it coming. Not the analysts or the oil companies or me who worked for an oil company during much of the crash. We were just producing as much as possible and weren't thinking about anything else. The truth is we must always protect the downside. Most of the time it is the most unsexy and boring thing in the world. It will mean that sometimes you have to miss out on some potential returns. People will laugh at you from their mountain of money. But you have to know deep within your bones why you are doing it. You are doing it because no one can see the crashes coming. Not you. Not your adviser. And for damn sure no freaking reporter on TV. You have to always be ready and have a plan for when the shit hits the fan and that plan shouldn't be "oh I am going to watch the market every day and sell when it gets to bad" because that is very subjective. What is too bad? What if you don't have internet access? What if you are too late? Those people will end up like everyone else and blame the government for their shitty planning. Your plan for the crash has to be systematic. Your plan might be just to ride it out. Or maybe you use a stop loss of 15 or 25%. Or maybe you do something more complicated. Either way it needs to be something you can stick to no matter what.
Next we have the indexers. Now these guys are the chill ones of the bunch. The basic mentality is this: pick the biggest highway there is, put on some good tunes, and just go with the flow. No switching lanes. No racing around. Just chilling. The idea is that most of the time you will do pretty well. Sure sometimes the traders might get ahead, but then again they waste a lot of energy. Most of the time you will probably end up right next to them or worst case they might crash and burn while you are still out there moving. Sometimes you hit traffic, but you just stick it through believing that eventually it will clear up and you will be moving again. Best of all, your life is much more simpler. No stress of worrying about which lane to pick or which way is faster. You just pick a lane and drive. No fuss.
This is the path of the passive investor. You pick an index fund or multiple index funds and just ride it out for better or for worse. It's simple and easy to do and data has continuously proven that this strategy can outperform most people in the market. If fact, there is currently a million dollar bet going on with Warren Buffet and a hedge fund manager from Protege. The bet was that over a ten year period that a portfolio of hedge funds picked by Protege could not outperform the S&P 500 represented by the Vanguard 500 Index Fund Admiral Shares (VIFAX). We are now 8 years into the bet and one side has a stark lead. The S&P 500 has a total return of 65.67% while the hedge funds are at 21.87%. Still think they are worth their enormous fees? This is the pure essence of the argument. It is very hard to beat the market over the long term. If you don't then you wasted a lot of energy and time when you just could have bought the S&P 500 fund and be done with it. If you read about my Simplest Investment Plan Ever then you will see why.
Finally we have the Fundamentalists. Now these guys are quite the group. Their method is simple: perform a deep analysis on the different roads and how many vehicles are driving on them in an attempt to identify the roads that are most likely to yield the fastest times. They will spend hours upon days gathering and analyzing the data. There are thousands of roads to choose from so this analysis is no small feat. They must be systematic and diligent in their analysis. They have to put their emotions aside and pick the roads which the data says are the best. Once they have their choices the work is usually not done. They continue to check the fundamentals and make sure that their choice is paying off. If the fundamentals start to turn then they move on to a different road. This means you will do a ton of work, but if you are good and can be disciplined enough then it can pay off with a much quicker route. Although it is not hard to derail from the fundamentals even for a little bit and undo everything you worked so hard on.
This is what we would call Value Investing. Value investors do a ton of analysis and research into stocks and other investments. They look at the underlying businesses and attempt to assess their intrinsic value. They then look to see what they are trading for. If they are trading at a discount to intrinsic value then they might buy. Once they are invested they continue to watch the fundamentals. If the stock begins trading at above intrinsic value then this might be a time to sell. Many people have made billions of dollars using this strategy. It has proven to be a strategy that works. The problem is it is one of the most difficult ones to implement. It usually involves always going against the sentiment of the market. Buying things that most people deem as bad investments. It means having to ride out large losses from time to time. It means having the intelligence, experience, and skill to be able to accurately place intrinsic values on complicated businesses. But in the end if you can do all of this then you stand to make a good gain.
How Do You Want To Drive
I hope you take a few things away from this analogy. First, that nothing in investing is a sure deal. There is always uncertainty and risk. You can never get away from it and if you try then you might end up getting scammed. The best thing to do is either accept it and face it or just do not get into the game at all. Second is that trading is really a losers game. Some make it, but the vast majority fail and whither away. You will just be spinning your wheels only to end up either underperforming a simple index fund or losing everything you put in. Lastly is that if you want to put in the extreme amount of time it takes to learn fundamental analysis then you can stand to outperform the market. But this takes a dedication and discipline that is extremely hard to achieve. You will need to think of investing like a sport and be willing the put in the time it takes. That may even mean you need to do it nearly full time. For most people this is not an option. Indexing is always a viable alternative. If you liked this and want to learn more about investing make sure to read through the Finance Series.