A few years ago, a friend told me about a tiny pharmaceutical company that I might be interested in investing in. It was started by a guy that my friend knew who evidently turned any business he touched “into gold.” The friend who gave me this tip is an excellent investor and has generally given me great investment advice. He didn’t pressure me at all to buy this company—he just mentioned that he thought it might be a good company to keep an eye on. But of course I wanted to buy the company that was going to turn “into gold”!
We’ve all been there… Talking to a friend or relative, when all of a sudden, out of nowhere, someone drops a hot stock tip! If you’re not really into investing, this might not happen to you all the time, but I’m sure you still hear the news or occasionally find out about some stock that has gone up 30% in the last year, or is priced “super low right now” and is ready for explosive growth. I’ve been guilty of investing for both of those reasons (and for some reasons that make even less sense).
In fact, I still have some leftover stocks that I acquired before switching to a more passive investment approach. These stocks are in a relatively small account that I used to buy companies at what I considered “bargain” prices. I didn’t really do any analysis of whether they were bargains, but I bought stocks that felt like they must be a good deal. For instance, I bought stock in a couple energy companies when the oil prices plummeted earlier this year, and some tech companies when I thought they were “cheap.” I also bought a few stocks just because they were given lots of stars and positive reviews by rating companies.
This is no way to invest! But it’s how most people come up with an investment strategy to constantly try to pursue out-performing gains. If you’re a professional, you might be able to match the market’s overall performance over time using this type of strategy. The rest of us are just fooling ourselves into thinking we’re smarter than the market.
So what changed for me? Let me take you back to the “everything turns to gold” pharmaceutical investment (i.e., “The Great Debacle”). At the time, I was busy obsessively paying off my student loan debt, so I had virtually no money leftover to invest. I did scrounge up a whopping $100 to become the proud new owner of 555 shares of this company. I did virtually no research into the company or market sector, and I didn’t even really understand enough about investing to analyze the company’s fundamentals. But in case you weren’t listening, I bought more than FIVE HUNDRED shares of a company! For only $100! (Plus the $10 transaction fee.) All they had to do was increase their share price to one dollar, and my investment would be worth $500. If they got gobbled up by one of the big pharmaceutical companies, my shares could be worth thousands…
Fast-forward a few years, and I’m sure none of you will be surprised to learn that my $100 investment is now worth a whopping $3.39. (That’s a 97% decline in principal value in case you prefer percentages.) That’s right—no thousands, no merger announcement, and not even enough left over to cover the transaction fee I would be charged to sell the shares.
My eyes used to skip over this embarrassing eyesore in my portfolio, but lately, I’ve come to appreciate the valuable lesson I learned for the relatively cheap price of $100:
It’s really hard to beat the market.
No matter how good the tip, how intelligent the investor, or how strong the sector’s performance, it’s just super difficult to beat a well-diversified portfolio over time. That’s not to say that all individual securities are bad picks (I’ve had some increase 30-50% or more in a year), but over time, it’s a losing bet. Eventually, something catastrophic is going to happen to a company you bet a lot more than $100 on, and you’re going to erase your portfolio’s gains for years. In a diversified portfolio filled with index funds tracking thousands of companies, those catastrophic events are barely felt. When you do feel it, it’s because the entire economy is in turmoil, but you actually love that because you can just sit back and buy as many MORE shares as you possibly can while everyone else is irrationally selling off in hopes of “preserving their capital.”
All that to say, just find a low-cost, passive strategy for your investment. Diversification is one of the investor’s biggest friends, and nothing provides diversification more easily or effectively than a strong mix of passive index funds. Even investment companies with millions of dollars of resources are rarely able to beat the returns of an index-based approach, and almost never beat those returns consistently over time. Let my little $100 not-so-golden pharmaceutical bet be a free lesson on your path to financial independence. Stop making random and irrational decisions in the chase of alpha gains. You’ll only end up costing yourself money, and potentially years of financial independence in the process.