The Biggest Mistake Beginner Investors Make
Back in the day, Rochester's leading employer was named Eastman Kodak. Maybe you've heard of it. The venerated company made film stock that was considered the film for cameras for most of the twentieth century. In the 1970s, the company controlled almost the entire film market in the United States. Paul Simon named a song after one of its products—Kodachrome. Kodak was so iconic, so strong, it was made part of the Dow Jones Industrial Average of thirty stocks. If there was a sure bet, that bet would be Kodak, minting those little golden boxes of film. Many of the parents of Harold’s schoolmates worked at Kodak. Many had also loaded up on Kodak stock.
And then it all turned—to borrow a photographic term—negative.
First, Fujifilm and other international manufacturers discovered the film market in a big way during the 1980s. And then digital struck. Layoff after layoff roiled the iconic company and its hometown. The Dow Jones delisted the company in 2004. In 2012, the company declared bankruptcy. Oh, but surely, you think, I would have known to dump the stock in time. Or I would have recognized the film market had serious issues before I lost my retirement savings.
Maybe. You might not have thought to get out at the top, but you likely would have sold before you completely lost everything. But then again, we all think we're the person who would have bought Apple in 1980.
More likely, we'd be Harold's family friend Miriam.
Miriam was watching a lot of television in those days. Week in and week out, she heard respectable people on PBS name this stock and that stock, saying it was a sure thing. (This was before CNBC.) She almost certainly heard the legendary investor Peter Lynch’s philosophy that when it came to stocks, a good place to go looking for investments was the products and stores you know, use, and love.
Miriam’s family used to eat at a local pizzeria, which was expanding to other locations. The pizza was first-rate. The joint was always packed. This was not your random corner pizzeria. It was special. It was going places.
So when franchising that local pizzeria went public, Miriam, along with many other local customers, invested a chunk of her savings. Kodak wasn’t working out for them, but pizza sure would—or so they thought. For a time, it was a great ride. The pizzeria invited all stockholders, no matter how small, to the annual shareholders meeting. It was a heck of a lot of fun. Their wonderful "Any way you want it" pizza, lasagna, and all manner of goodies would be served. Rumors abounded that Sbarro or some other large chain was interested in buying in. The stock went up and up.
You can guess where this is going. The buyout never happened. That local pizzeria is still in business, but the franchising stock is almost worthless. The last Harold heard, the company had one employee, whose "duties do not require his full-time attention."
Miriam thought she was investing in a sure winner. Instead, she invested in a long shot that didn’t pan out.
So you think this won't happen to you? It was the 1980s, after all. Well, think again.
Helaine would like it noted that when it comes to investing in individual companies, she's Miriam.
Way back in the late 1990s, Helaine spent quite a bit of time thinking about investing. She was, after all, editing the Money Makeover personal finance feature at the Los Angeles Times. But the late 1990s was the time of the dot-com boom. Everyone was sure this was the one. All you had to do was purchase the right techy blue chip, watch it ascend into the stratosphere, and ka‑ching! And picking it—wow, that was easy. Anyone could do it.
And for a time, that was actually true. That’s the thing about bubbles and great market runs. Anyone can make money.
Until times change or the bubble bursts.
Helaine knew better. Helaine tried very hard to be the voice of common sense. Week in and week out, she told families who turned to the newspaper for help with their finances the same thing. Most of us don’t have the ability to really do this stock-picking thing very well. Whatever you do, stay away from individual stocks—especially if they are less than five or ten years old. They have no track record. Most of these companies are showing nothing in the way of profit.
But...it was so tempting.
There were two companies Helaine had more than a passing familiarity with that went public in those years. Amazon and AOL.
Let's just say she decided to invest in the one that brought you the memorable catchphrase "You've got mail."
What's the moral of the story? Yes, mutual and exchange traded funds are better. But even more important—one more time and this time with feeling—do not buy individual stocks.
Financial Advisors Don't Play This Game Much Better Than You Do (Though They Charge You to Play It) and Might Even Be Worse
Many people look at behavioral finance as a way they can learn to outsmart the markets. They are convinced they can teach themselves to be more rational if they know the irrational fears they could fall prey to. Financial advisors even market themselves this way: I know the behavioral quirks, so I can avoid them for you. "You might not be able to pick stocks, but I most certainly can" is how the pitch goes. When Helaine wrote Pound Foolish, she found marketing experts and even academic behavioral finance stars who told financial advisors to say such things.
Any five-minute reading of a behavioral finance expert tells you that this is unlikely. Many financial advisors can offer valuable insights for a variety of life situations. What they do not offer is superior expertise picking stocks. As the financial journalist Felix Salmon put it, “Trying to pick a winning money manager is even more of a losing game than trying to pick a winning stock.” Why? For starters, financial advisors are, like all humans, prey to their own biases. One of the most important biases is the overconfidence that comes with expertise. If anything, their over confidence and sometimes their skewed incentives can even lead them more astray.
One other thing we learn from behavioral science: Men tend to achieve lower returns than women. It's not because the ladies are better at stock picking. Rather, women are better at not picking stocks than men. As a result, ladies trade less, saving money on investment fees and boosting their returns. Your great advantage as an investor is that you can be boring and methodical, rising with the overall market and not wasting money on costly trading that tends to underperform the market.
Alternative Investments: Not Nearly as Fun as Alternative Lifestyles
If you are contemplating the individual investing route, you are also leaving yourself open to people marketing so-called alternative investments. Their appeals will often sound, well...appealing. Bitcoin is going to be the new alter‑ native currency! Get in on it now! Or whatever.
Alternative investments essentially mean any investment that's not a stock, a bond, cash, or real estate. Even the most out-there stock purchase is not considered an alternative investment. On the other hand, purchasing the Mona Lisa would be considered an alternative investment.
What could go wrong? A lot.
"Alternative" is not, like in music, simply an excuse to go to the desert, hold a festival, and get high. It's a nice way of saying "This is a really risky investment that is hard to transparently value and that is subject to great swings in price."
You don't need to learn what a European call option is and how it differs from an American one. If you knew, that knowledge would provide zero help to you as you devise a sensible savings plan.
Gold is an especially popular investment for those predicting imminent apocalypse. You'll need it—its prophets say—when oil runs out or when a cyber-hacker destroys our economic system. Well, maybe. But ask yourself this: How long do you think you will be allowed to live in peace in this postapocalyptic world once word gets around your neighborhood about the gold you have stashed in the basement?
Others will push collectibles, things like art and stamps. Or maybe investing in films and Broadway shows. They serve a double—nay, triple—purpose. You get to enjoy the hobby, show it off to your friends, and still make money.
Collectibles come with their own volatility. Today's hot young artist has the potential to be tomorrow's has-been. One year, antiques from the American colonial period are in, and then the tide turns and everyone wants Le Corbusier, whom Harold has never heard of. Then there are the trends and manias, like Beanie Babies.
Our advice: Collect stamps, coins, or Beanie Babies if that's your passion. Don't treat these hobbies as investments that will pay off someday. It's unlikely they ever will.
The bigger point is this: Alternative investments tend to be highly subject to trends, manias, and erratic or dramatic price swings. They bring unpredictability into your life. You don't need that.
Buy and Hold 'Em
Finally, buying individual stocks encourages trading, which will not only erode your profits in transaction costs but also encourage you to do all the wrong things with your investments. When you invest in individual stocks, you are essentially trying to time the market. You are try ing to buy assets when they are undervalued, holding on until they run up in price.
Once again, you—or anyone else—is highly unlikely to figure this all out and still come out ahead when accounting for transaction costs.
But it goes deeper. You might believe that you are a calm and rational investor. But when we invest in individual stocks, we are not engaging—no matter what we think—in prudent, reasonable investments. We are speculating. You may be researching your stocks and investing with caution and care. It doesn't matter. No matter what the financial services industry would like you to believe, most of the time you are a more respectable version of someone playing poker or craps in Vegas.
Even if you devote your days and nights to this, it's unlikely you can foresee and react properly to every change in consumer whims, every unexpected event, executive shake-up, or all the other factors that can affect an individual company.
So what makes sense?
Buy and hold a small selection of indexed mutual or exchange-traded funds for the long haul.
This is a tough-love moment for some of you. It's a bummer to give up on the prospect of a big win. Everyone knows of someone who knows someone who knows someone who bought Apple in 1991 and made a bundle. Relatives and friends tend to mention such things. They don't tend to mention the $5,000 they plunked down on Pets.com. It would be really fun to pick the right stock and get really rich.
But for others, this should actually come as a huge relief. You might be thinking, "I don't have to do all this stuff—watch business news, constantly monitor my investments— in order to get ahead?" Indeed, you don't. Once you realize that stock picking is a loser's game, you can get on with the rest of your life without feeling guilty about it.
There's no good reason to miss a child's bedtime story or an evening out with friends so you can read Facebook's annual report. There's no good reason to let something slide on your day job because you are working on your investments either. Your time is valuable. Your happiness and economic security depend on your marriage, your family, your success at work and in your relationships. Investments in those areas are almost certain to pay off.
Excerpted from The Index Card: Why Personal Finance Doesn't Have to Be Complicated by Helaine Olen and Harold Pollack, in agreement with Portfolio, an imprint of Penguin Publishing Group, a division of Penguin Random House LLC. Copyright © Helaine Olen and Harold Pollack, 2016.