How (not) to invest

Beginning of university is a magical time in many different ways, some start exploring their social life after finally moving out from their parents, some decide it’s high time to start taking things seriously and think about their careers, while others still have no clue what’s going on. The groups aren’t necessarily mutually exclusive. This article is for those ambitious, young people who decide to take destiny in their own hands and build towards financial freedom through investing. All of you have probably heard tales of successful investors earning unimaginable amounts of money through their brilliant insight. The likes of Mark Baum, George Soros or some random guys making fortunes from their basements. Success is definitely possible. There is just one thing to keep in mind, if you think you’ll be one of them after watching The Big Short, reading two books on investing strategies, and maybe even buying this expensive course online, you’re delusional. We will analyse why that is in the next paragraph. 

The crucial thing to understand is how the stock market and markets for any other financial instruments really work, and why it’s virtually impossible for an individual investor to make excess - above average - profits. Consider a situation where you’re pondering whether you should buy a certain asset. To make it simple and understandable for all the investing bros, let’s say we’re thinking about buying a stock. To get a clear view of the situation and estimate whether the stock is over- or underpriced, we analyse all the important indicators P/E, P/B, P/S, historical performance, dividends, maybe even the most recent financial statements if we can actually read those (unlikely). Now with all this extra information, we put it into our model, which hopefully is not our gut feeling, compare to other stocks and make our decision. While all of this seems very fancy and professional, we’re still delusional. To understand why, let's think about the moment the financial statements are published. The very second this happens hundreds of investment funds, teams of MIT graduates and super computers, placed conveniently close to the source of the light-speed travelling information just to save a fraction of a second, are already on it. Even if you were waiting with them, before you manage to open your excel spreadsheet on a laptop you got as a christmas gift from your parents, tens of thousands of trades are executed and all the new information is already included in the adjusted price of the stock. Therefore, the only price you’ll ever be able to buy a stock for is the price that all of those above-mentioned believe is unattractive (new PC and extra monitors also won’t help you, just in case someone missed the point). The same logic holds for shorting, so don’t get me started on this one; it’s even worse. And for someone who would like to brilliantly point out that prices don’t change only when financial statements are published, thank you for your inside, you’re obviously right. The number of potential sources of relevant information is virtually infinite, probably beyond your imagination and surely beyond your analytical capabilities, which is less so the case for major investment funds and institutions alike. 

One could also argue that it’s not just about statistical analysis of the financial statements or speed of reaction, but understanding the market behaviour and seeing the bigger picture. After all, the price doesn’t depend on any ratio directly, but on how much people or institutions are willing to pay for it. That might be a fair point, and to those raising it I would say that I’m not sure if your two-decades-long life, half of which you spent unconscious or doodling in your school, makes for a great asset.

That being said, I wouldn’t want to make an impression that all individual investments are pointless. In fact, investing might be greatly beneficial both for people investing and society as a whole, but for that to be the case one needs to be wise about it. Firstly, all the criticism above regards the idea of making ‘excess profits’ - in simple language: making a lot of money quickly. And while this might not be possible for an individual investor, investment is still an investment, and you do expect to have a certain return, which in economic theory is called ‘normal’. This term, as most ideas in economic theory, is pretty vague, so let us now consider how, in reality, make your ‘normal profit’ as large as possible.

Profit always comes down to costs and benefits analysis, and when you can’t do much about increasing your benefits, there’s always the cost part that you can try to optimise. The trap that many overly ambitious investors fall into is the transaction fees. Very often each transaction in form of buying or selling an asset occurs with a tiny fee paid to your broker for executing the transaction, and while this might not seem like much, when you’re investing with an idea of making some extra money in the long term it’s clearly counterproductive to just throw some of it away. And considering that the current price of any asset is the best estimator of the real value you can realistically get, in general selling and buying stocks will only cost you both time and money. So the fair conclusion seems to be: buy something and let it work for you. 

Another important factor to consider is the rocky relationship between risk and return. One could expect that the higher the risk the higher the expected return should be, and that indeed seems to be the case. There is plenty of data to support this claim, you can easily check it yourself by comparing average return of stocks and bonds over the last 50 years. The implications of this relationship need to be considered carefully. The crucial aspect is when do you plan on using the money you’re investing. If there’s a real possibility you’ll need to withdraw it in the near future, safer assets might be the way to go, as they increase the minimum amount of money you should have on your hand in a short to medium term. On the other hand, if you expect to withdraw the money in 30 or 50 years you might be more willing to accept greater year-to-year fluctuations, as over a long period the greater average returns should have time to make the difference. I need to mention however that the risk and return relationship applies best to conventional financial instruments, like previously mentioned bonds and stocks, especially in developed countries. Assets like cryptocurrencies are extremely risky, should be considered individually, and there is no real historical evidence for them resulting in higher average return, so I will let you draw your own conclusions. There’s a difference between risky and stupid investments. 

The last fundamental aspect of wise investing, we shall consider here, is diversification - the old as the world “don’t put all your eggs in one basket”. Without going into any statistical analysis, it makes intuitive sense that spreading your investment between 50 different companies might be safer than betting everything you have on just one. To harvest the full potential of diversification, it’s good to buy assets from different sectors of the economy and different countries, to minimise the correlation between them. You could also consider investing in passive funds like ETFs (Exchange-traded funds) which are in themselves collections of many different assets providing an easier diversification, for which they gain a small commission. Small at least in comparison to actively managed funds where you basically pay the large investment funds to try to beat the market for you, and maybe they do, maybe they don’t, but you won’t get a large part of the excess returns anyway. 

Now, this article could seem pretty pessimistic for some people. On one hand, I could just say that life is tough, and you have no real choice but to deal with it. On the other hand, however, I wouldn’t say that it’s not impossible to make some excess profits in general, you just need to get very creative and put in a lot of effort. Financial assets market could be characterised as very highly optimised. This isn’t the case for all the markets, though. Think about LEGO sets, all sorts of collectors items or CS:GO skins (yes, I said it). These markets might have huge evaluations and because the competition is much less intense, no huge investment funds and probably lower, but non-zero number of MIT graduates, it’s relatively doable to master them, become a relative expert and harvest some above average profits because of that. It will still be terribly difficult, require a lot of effort and might involve even more risk, but it leaves you with a bit more control over your success (and failure). 

Investing is a lot like sports. Almost everyone can enjoy the benefits of staying in a good (financial) shape, but if you want to do it for a living you have to be the best, sacrifice virtually everything else and most likely you’ll not make it anyway. Also you won’t get invited to any parties if you talk about it too much. And with this lovely metaphor, I will conclude my rant. 

About this article

Written by:
  • Oliwer Wirkus
| Published on: Nov 08, 2023