By Dr. James M. Dahle, WCI Founder
Q: My friend put all of his money into big tech stocks and Bitcoin a year ago, and his returns are absolutely smashing mine. I thought diversifying my portfolio was the smart thing to do, but now it feels like I will have to work forever compared to him. Any recommendations?
A: The bad news with a diversified portfolio is that it will never be the best portfolio over any given time period. The good news is that it will never be the worst portfolio over any given time period either.
It's the Long-Term Investing Returns That Count
While awards might be passed out to professional investors for accomplishing superior short-term returns, for the individual investor trying to build a retirement nest egg, only long-term returns count. In fact, there are no rewards passed out to individual investors, and investing is a one-player game. You are not competing against your friend or any other investor. You are only competing against your own financial goals, and success is only measured by whether you accomplish them.
Diversification is a critical principle of investing. When building a portfolio, your goal is to select a portfolio that is highly likely to accomplish your goals given a wide range of potential future scenarios. Of course, only some of those potential futures will materialize.
Given the plethora of gamblers and speculators in the market who make large bets with their portfolios, surely a few of them at any given time will have made the correct bet on which investments will outperform. In this case, your friend is one of them. He gambled and won. What you are not seeing, however, is the number of investors who made similar gambles but lost. Undiversified investors take massive losses and even go broke all the time. There is good reason for the old adage, “Don’t put all of your eggs in one basket.”
The Fear of Missing Out
Often when we see another investor who has bet correctly on a short-term market movement, we feel a sense of loss, of what could have been. This is often called “fear of missing out”, or FOMO. FOMO can, unfortunately, lead investors to abandon well-thought-out plans in hopes of also making the right bets and getting rich quickly. In many ways, the investor matters more than the investment. Your ability to follow a reasonable, written investment plan through thick and thin is far more important than which of many reasonable investing plans you have chosen to follow. [Editor's Note: Get a written financial plan in place at no cost during our “Refi and get FYFA for free” SALE. Refinance $100K+ using our links before October 31, 2021, and our Fire Your Financial Course is yours for FREE. See here for details.]
Cocktail party and water cooler investing conversations are incomplete by their very definition. As humans, we like to look good and appear intelligent to our peers. This leads us to share our winners but not necessarily our losers. It would not be uncommon for a friend who made three or four big bets to only tell you about the one or two that paid off. You do not have access to the investing records of friends at a party or the talking heads on financial television shows. If you did, you could calculate their overall long-term returns. You would likely not be impressed.
Another downside of making frequent bets by changing your portfolio holdings frequently is that it introduces additional costs. These may show up in the form of trading commissions or bid-ask spreads. It also commonly shows up in the form of additional taxes due from unqualified dividends and short-term capital gains. These costs produce a drag on long-term portfolio returns that can add up over the years.
Outperformance of the most well-known stocks in the world (Facebook, Tesla, etc.) leads many investors to adopt a gambling mentality. New app-based brokerage companies such as Robinhood encourage the trend by making investing feel like a game. The closure of casinos due to COVID-19 and more people sheltering at home have likely accelerated the trend. Day trading seems to be back in vogue as it was during the late 1990s until the tech bubble burst.
Long-Term Investing Is Boring but Works
None of this should matter to the long-term investor. Investing is not supposed to be fun. It is supposed to be boring. It is a critical, lifelong task to ensure financial security for yourself and your family, not a lottery or source of entertainment. Some investors attempt to control their gambling tendency by assigning 5 percent of their portfolio as “play money”. This is unlikely to do much harm, and if it helps them to stay the course with the rest of their portfolio, it may even assist them in reaching their goals. However, investors need to realize that investing is serious business and playing with any significant portion of their portfolio can have a serious impact on the length of their career, the freedom they have to pursue their dreams, and their standard of living during retirement.
Index funds own all of the stocks in the market, both the good and the bad. Perhaps it might help your mental FOMO when you hear about a friend’s good fortune to comment, “Oh, yes, I own that stock as well. In fact, I have owned it since 2006 [or whenever you first started investing or the company went public].” The advantage of index funds is that they guarantee you will achieve the market return. You will never underperform the market, unlike the 80 to 90 percent of active mutual fund managers who will do so over the long term. And that’s before tax.
The record of individual investors is even worse than that of professional investors. In fact, studies are clear that the more an investor trades, the lower their long-term returns are likely to be. Just like a casino, the fewer trips your money makes through Wall Street, the more of it you are likely to keep. In essence, it is not the buying of the shares of profitable companies that is gambling—it is the frequent trading of those shares. When you buy and hold shares of the most profitable companies for the long term, you will receive your share of their earnings. That’s investing, not gambling, especially if you spread your bets across all of them using an index fund.
Many investors believe that somebody else can predict the future. However, studies are clear that the gurus and talking heads on TV are no more accurate at predicting the future than you are. Long-term studies of their predictions of future market direction show that you would have been better off flipping a coin than following their recommendations.
FOMO is a natural human sensation. However, whether you are disciplined enough to avoid its downsides is in your control. Get a sensible, written investing plan in place and continue to follow it, no matter what happens in the markets.
Today's post originally published at ACEPNow. What do you think? How has FOMO driven your investment decisions? How do you stay the course? Comment below!