Who do you expect to win in a race – Usain Bolt or Mo Farah? Naturally, to answer this question you would need more information, such as the distance of the race.
Clearly, in a 100m or 200m race, Usain Bolt would win, while over a 10km race, Mo would be the victor. Both are elite runners and they are very clear as to where their competitive advantage lies. They train themselves – both physically and mentally – to win over their respective distances.
When you think about investing, it is also important to decide the ‘distance’, or time horizon, of your investments. This will influence how you approach investing and the probability of success.
While people are attracted to the thrills and spills of the shorter distance, I think most individual investors should forego the shorter tenures, given the huge benefits of a long-term approach. There are two reasons why I believe this makes sense:
The longer race takes less effort.
If you are trying to make quick profits, you are likely to focus on narrower exposures such as individual stocks. The problem here is that you would have to identify which areas of the stock market to focus on, and then which companies to invest in.
Before we get onto the challenges of doing this consistently well, we can clearly see that this will take a significant investment of time.
Of course, there are potential shortcuts. You could, for instance, decide to focus on meme stocks. However, I would argue this is extraordinarily risky – more on this later. People can make and lose huge amounts of money in a very short period of time as stocks get pumped and then dumped.
How quick can you get in?
If you are late to the party, either entering or leaving, this style of trading can be hugely detrimental to wealth accumulation. Therefore, to even attempt it, you would still need to be constantly monitoring the news and social media, and accessing your brokerage accounts to trade. For those with full-time jobs, and intend to keep those jobs, this is not feasible.
Alternatively, you could ask your friends or colleagues for stock tips. However, you must be clear in your mind why you value their opinion over those of professionals, who themselves find it challenging to consistently deliver strong returns.
Any fund manager worth his salt will tell you they aim to outperform his benchmark over the long-term. However, it turns out that this is incredibly difficult to do consistently.
To put this in context, let’s look at the example of US equity fund managers. Using Morningstar data, we filtered for actively managed, US large cap funds that are available to retail investors. Of the 47 funds with a 5-year track record, 17 per cent of funds outperformed their benchmark on a 3-year basis and less that 10 per cent did so over a 5-year time horizon.
This is despite the fund managers having huge teams of equity research analysts and access to incredible financial tools to aid them in their investment decisions.
What makes you think, without all their resources, that you (or your friend/colleague) can do better?
All about time in market
One of our 5 key wealth principles is ‘Time in the market’. That is, the longer you are invested, the more you benefit from compounding returns. In the first few years, this barely registers.
Now a reasonable question is: surely compounding works the same way regardless of whether you invest in a diversified portfolio or an individual stock, assuming you pick a stock that performs in line with the stock market? Theoretically, you are correct.
However, once you factor in the journey you are likely to take and the potential reaction to the journey, then I think the outcomes are likely to be materially different and in favour of the longer distance.
For instance, if the overall stock market falls sharply, the rational response for the investor would be to hold on and, if possible, buy more as the market has gone on sale. However, the same cannot necessarily be said for an individual stock.
Check out these meme returns
Two meme stocks are good examples here. Gamestop once traded at over $80 per share, today it is at $20. Does this mean it is now a good investment? I have no idea.
Bed Bath & Beyond once traded over $50 per share, now it is below 10 cents, after having filed for bankruptcy. If you held this stock through thick and thin, you would have lost approximately all your investment.
These are obviously extreme examples, but even if there is a large very well-known company and its stock falls 40 per cent, does that make it a good investment? It might, but it also might not.
That uncertainty increases the risk that you sell when you shouldn’t have or hold on when you should have sold, and this can be very detrimental to the long-term performance of your portfolio.
As such, I believe strongly that for 99 per cent of individual investors, playing the longer race with a diversified portfolio dramatically increases the probability of you achieving your financial goals.