Editor’s note: This article was first published in June 2022. The fund manager pay of up to 15 million a year and the fee figures it cites are the author’s general estimates.
What is the secret to investing in the stock market, the winning strategy? Let’s start with three questions.
Can an investor like you earn higher returns than most of the world’s best-paid fund managers? Can a 12-year-old earn higher returns than fund managers who make up to 15 million a year? And finally, can a monkey picking stocks at random do better than the best fund managers?
The answer is yes to the first question, absolutely yes to the second, and a resounding yes to the third, and that is what we are going to show, beyond any doubt.
First, let’s see why you should lose your fear of the stock market. These figures were published by Peter Lynch in his famous book One Up on Wall Street.
If, starting in 1940, you had invested just $1,000 in the stock market on 1 January every year, that is, regardless of whether the market was expensive or cheap (just $1,000 every 1 January), by 1992 you would have ended up with $3.5 million.
In other words, over those 52 years you would have invested a total of $52,000, which is less than $100 a month, and you would have ended up with $3.5 million.
And what if, every time the market fell more than 10%, you had invested another $1,000? You would have invested a total of $83,000 and ended up in 1992 with more than $6 million.
Peter Lynch noted in his book that in the 70 years before it was written, the market had 40 declines of more than 10% and 13 severe declines of more than 33%.
Even so, despite all the crises and recessions, investors who stayed in the market and kept making regular contributions have made a great deal of money, because the stock market rises over the long term.
The secret to making money in the stock market
Investing by the calendar pays off better than following your investing instincts and your sophisticated analyses. Put another way, investing with a method or strategy that ignores the metrics professional investors analyse will let you beat the professionals. It sounds counterintuitive, but that’s how it is.
What does investing by the calendar mean?
It means saying: I’m going to invest 1,000 euros on 1 January and another 1,000 euros on 1 July, every year, whether the market has gone up or down.
That way you don’t have to keep an eye on the economy and the noise of the markets, because even the best investors fall for that noise.
And you can add variables to any investment strategy, such as always keeping cash ready. If the market falls 10%, instead of investing 1,000 euros, you invest 2,000.
If the market falls 40%, it might be a good idea to go in with all the money you have available for investing.
Do it this way and within 20 years you will have beaten the returns of the best fund managers. And there is a very logical explanation for that.
First, a manager running a 100-billion fund can’t invest the way he would like to. In some cases they can’t put more than 5% into a single stock, or more than 30 or 40% into growth companies. They have to diversify excessively, and in the end that is what stops them from beating an index fund.
See also: Inflation-linked bonds: what they are and how they work
And even if they do beat the index, you, as an investor in the fund, earn less because of accumulated fees.
Let me explain. If a fund charges you 2 or 3% in fees, it will charge you in the years when the fund does well, but also in the years when it doesn’t do so well.
Well, 3% in fees accumulated over 20 years means that even if the fund had returned 20% more than an index fund, you as an investor would have earned less than if you had put your money in an index fund. That’s just maths.
So we have the first thing sorted. If you follow a calendar-based investment method in an index fund, with the variables that go with it, you will beat the returns of the best-paid fund managers in the world. And all of that without having to pick stocks yourself.
But what if we decide we want to beat not only the best fund managers but also the S&P 500? We can only do that by picking individual stocks.
Supposedly, a guy who makes 10 or 15 million a year picking the best stocks and analysing companies to invest in, with a whole team of analysts behind him, would be pretty hard to beat, right? Well, that isn’t entirely true either.
In various experiments, monkeys picking stocks at random have achieved better returns than most of these managers. But it goes further. Twelve-year-olds have beaten these managers’ returns with a method you can use yourself.
Peter Lynch tells the story of the children of St. Agnes.
The St. Agnes children beat the returns of 99% of all investment funds. They analysed the companies to invest in all by themselves and achieved a 70% return over two years, and they beat the S&P 500 too.
What method did the St. Agnes children use to beat the funds and even the S&P 500?
Despite their limited financial knowledge, they focused only on companies with little debt and a rising trend in earnings, and also on some of those companies having increased their dividend payments.
Analysing just these two metrics already gives you an edge, but the icing on the cake is using the representative sample. You won’t hear about the representative sample in any course, but it’s such an effective method that it was what led me to predict that VOX (a right-wing party) would become Spain’s third political force at a time when that result was very hard to foresee.
If we look at the stocks these children chose, they were basically what they had at hand, what they could see, what they saw around them.
They saw the company Pentech in the reports and said, “Hey, the pens we use at school are made by this brand, and they’re good. Other schools must think the same!” And they chose to invest in Pentech.
They also chose Walt Disney, for obvious reasons. They chose Nike because they saw that its trainers were good, and so on. But notice one thing. They chose stocks whose products they knew, and they more or less understood what those companies did.
And you might say, “Well, they could have been lucky.” But it wasn’t luck, because this was the group in the class that won, and the other groups that didn’t win also did better than most investment funds.
What does investing based on a representative sample mean?
I’ll explain quickly. In the case of VOX, I saw interest in VOX gradually growing in my closest circle, then I saw it growing in my wider circle too, and then I saw that a large group of very different people (women, business owners, workers), people who used to vote for the Partido Popular or the PSOE (Spain’s two traditional main parties), were also saying they would vote for VOX. That was my representative sample of the rest of society.
In other words, if I know 100 or 200 people who are very different from one another and their interest in a political party is rising, the same thing must be happening in other places exposed to the same messages.
The stock market works the same way. All you have to do is look around you and notice interest in certain products before they become mainstream.
Following this, it was easy to see that Tuenti (a Spanish social network) was living on borrowed time, just by seeing how 50% of my contacts on Tuenti moved to Facebook.
If you are a schoolteacher, and there is a company that sells something, and one day you see two children bring that product in, the next month it’s 15 children, and soon after it’s 40, that is a trend, and your representative sample tells you the same thing must be happening elsewhere. After seeing that, you look at the company’s balance sheet, and if the basic numbers add up, you have found a gold mine to invest in. As Peter Lynch would say, you have gone one up on Wall Street.
In other words, everything you need to do your own investment analysis is right in front of you, in your day-to-day life, in the consumer habits of your representative sample, which today is wider than ever thanks to the internet.
What does the rule of five say about stock market investing?
In the stock market you can make two contradictory mistakes. One is putting all your eggs in one basket, that is, not diversifying. The other is diversifying too much, because if you’re going to diversify that much, I can tell you right now that you’ll be better off simply buying the index.
What made investment clubs beat most fund managers and even the index? They had only one rule, which was to hold at least five stocks.
Investment clubs are where amateur investors get together to learn how to invest.
Ironically, these investment club amateurs get better returns while they’re still learning than most of the managers who are paid fortunes to pick stocks.
The rule of five says that if you carefully choose five stocks to invest in, expecting them to do well:
- One of them will do much better than you expected.
- Three will do about as expected.
- And one will do much worse than you could have imagined.
But since what matters is the average return of all of them, five stocks seems to be the ideal number when picking individual stocks.
See also: 7 safe stocks to invest in during times of crisis and inflation
So what matters most when learning to invest in the stock market?
I hope no one takes offence at this. I once put together a very basic explanation of how to analyse the stocks you might invest in. And some people told me exactly that: that it was superficial and that I could do another one going into more depth.
But my question is: why do you want me to go into more depth?
There was one thing we said in that explanation:
Take a company and plot three numbers on a chart covering the last five or ten years.
- Sales: the company has increased its sales every year. Rising.
- Earnings: the company has improved its net profit every year. Rising.
- Debt: the company has less and less debt. Improving.
If you like, we can add whether dividends have also been rising. What more do you need to know about that company?
You really don’t need to know how to calculate certain metrics. It’s enough to understand them. You don’t need to calculate a company’s P/E ratio or its operating margin yourself, or anything of the sort. There are people who already do that work for you. You just need to understand what those numbers mean without getting too lost in them.
In other words, if you want to learn something about the stock market, it should be how to take a company’s balance sheet and understand it. Don’t waste much more time on anything else, unless you want to learn it for the sake of learning.
But be clear about this when investing in the stock market
Until you pick up Benjamin Graham’s The Intelligent Investor and fully understand everything Graham is saying, you won’t be technically prepared to invest by picking individual stocks. Investing by following a method or strategy like the one we discussed earlier is another matter.
Then there are people who study the stock market a great deal and are extremely well prepared. The moment one of these people has learned so much about the market that they conclude Graham’s book is outdated, I would advise them to start learning again, because the one who is outdated is them. In the stock market, fundamentals still rule, and whoever forgets that ends up getting into trouble.
Fundamentals and common sense are what make you money in the stock market. The long term and patience are what multiply your investment considerably.
So treat the stock market for what it is: a way to multiply your money. Spend your time getting ahead in life and increasing your income so that you can put more money into the market. And avoid at all costs playing the market by trying to predict what a share price will do in the next few hours.
And remember that with how easy it is today for young people to get into the stock market through apps, this is ending in gambling addiction. That risk exists in the stock market.
As a famous investor once put it, more or less: if you’re having fun in the stock market, you’re not making money, because the most profitable investing is like watching grass grow.
In other words, good investing is boring.
So just think about it.
If 12-year-olds do better than the professionals, if amateurs in investment clubs do better too, if an index fund does better, what is the secret to stock market investing?
The secret is that in a market full of noise, once you strip that noise away, we are left with one lesson:
Having a system is better than having a good analysis. It leaves you more free time to earn more money from other sources. If on top of that you diversify your individual stock picks following both the rule of five and the representative sample, you get an extra return. But the secret, in the end, is that the stock market is a long-term game.
If anyone tells you otherwise, it’s just hot air.
Featured image: Rod Waddington from Kergunyah, Australia, CC BY-SA 2.0, via Wikimedia Commons.
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