For some time now, I’ve been pondering the kind of portfolio talk championed by, for example, Rahapodi and many investment bloggers. According to this view, investing is always worthwhile, and stock markets yield 8% compound interest. You might have seen a bar chart illustrating how an initial capital grows by 1.08^40, proving that with a little monthly saving, each of us will be a millionaire in retirement?
Stock investing is definitely not risk-free interest investing without taxes. The compound interest phenomenon exists if a stock acquired at a low price continues to grow towards the upper right corner. CAGRs go haywire as soon as a stock encounters economic realities and drops. This bull market wouldn’t even exist if the ECB hadn’t pumped insane amounts of money into the markets.
Index funds are not some magic tool, but rather a collection of stock investments. You get a diversified portfolio of stocks, meaning you probably don’t even know what you’ve bought or at what price. The risk isn’t that your stocks fluctuate, as modern portfolio theory claims, but that you don’t understand what you’re doing. Familiarizing yourself with the company, its customers, and its industry helps in managing risk. Once you’ve done this, you can ask yourself how risky the company is and at what price you’d be willing to participate. You need to get a premium because an equity investment is in a weaker position than a comparable interest-bearing investment with a similar return. When valuation is done correctly, a stock can be held in the portfolio without worry, and a price drop is at most an opportunity for additional purchases.
Have you ever spoken to a bank clerk who asked about your risk tolerance? If you answered that you don’t want to lose your money, they recommended interest-bearing investments. Interest rates are at zero, and while the average stock investment of a couple of years ago has yielded nicely, the return on bond funds has most likely been negative. Such a reliable investment that destroys your capital? No investment advice can replace independent thinking.
The average Joe enters the market at the peak of a boom when they have a lot of work, money, and an optimistic outlook for the future. Social support is truly deceptive in this field. The same type will liquidate their portfolio at the latest when layoffs hit them personally. Isn’t that quite human, even logical? It doesn’t help at all that stocks are considered some kind of money-making tool. Not all companies even make a profit, and even fewer pay dividends. Lottery with a positive expected value. That blinds people. Pay attention to realities. Those who love realities make better decisions.
Especially regarding the “bubble” caused by the ECB’s stimulus, I’m on the same page. Everyone has gotten cheap loans, and money has been spent generously on both stocks and consumption. Thus, company profits have also grown, and stock market valuations don’t seem unusually high. The question mark is whether the situation can be normalized in a controlled manner or if something surprising and unpleasant will happen. I don’t think there are examples of such situations in history? Because of this, over-optimism can lure future predictors into a trap.
I imagine I see the effects of cheap leverage most clearly in the Finnish housing (investment) market. New landlords have sprung up like mushrooms after rain. Most people’s view is that you can’t lose in the housing market. At least not me, because I’m a smarter housing investor than average. DayTrader recently wrote about this self-confidence in his blog: Mitä markkinoiden voittamiseen tarvitaan? | Sijoitustieto.fi
I am certainly a worse investor than average, but an even worse lottery player. That’s why I’m eagerly following the ongoing stock market downturn with over 50% cash.
This euphoria has slowly started to reach my circle of friends, as there’s work and my own financial cash flow is positive. Which is good, as long as one doesn’t go into this blindly. An acquaintance of mine just recently started investing in a Finnish forest company and immediately took a hit. Perhaps it’s good that it happened now rather than when all the chips are in the market. When the economy turns downwards, jobs start to decrease, layoffs are happening, and at the same time, the markets fall as fast as they can, many might lose interest in investing for the rest of their lives at that point. I hope I don’t belong to that group. Pessimism reigns, prices fall, people forget their position, prices fall further, and the spiral is complete. Stock markets do not offer stable returns.
Otherwise, there seems to be a good buzz going on, even when you go to the shops. Shopping centers are full of people and increasingly unique stores popping up everywhere. People are wealthy and happy. I’ve been spending quite a lot of time in children’s clothing stores lately. Are these many clothing stores sure that people will buy children’s beanies and mittens costing over 50 euros during a recession, when they should have money to fill the fridge? I don’t want to be skeptical, but when purse strings are tightened, many probably won’t care if a beanie is handmade from merino wool, as long as there’s something to wear.
That’s what I’ve been thinking about. Every now and then, one should do a stress test for oneself before things go wrong. The future hasn’t looked very bright from an investor’s perspective, but I still believe in the rationality of stock investing in the long run. It’s quite pointless to expect steady going.
That “6%” or “8%” (everyone can choose for themselves, there’s no single truth there either :D) annual return from now until forever has been a catchy and easier-to-grasp message. In itself, it’s quite valuable, because for many, the hurdle to start investing is high precisely because they imagine it’s very complicated.
Your obvious main point, that those percentages and CAGRs are out of reach for the average person because they always only enter the market at the peaks, has unfortunately been true so far: private investors’ returns, at least in American studies, have been startlingly low in the average portfolio, mainly due to buying at peaks, unnecessary trading, and exiting the market at the wrong time. Long-term CAGRs don’t offer much comfort in a bear market.
Hopefully, we can instill a culture in Finland where stock saving is ideally a normal financial management process throughout life, and people don’t jump out of the market at the first sign of panic.
Addition: This topic doesn’t seem to touch on portfolio theory, as the title might suggest.
Investing itself is easy, as you showed in the video where Yu bought Verkkokauppa at a price that had 1 part substance and 9 parts future expectations. A good company, but not a very good investment.
I wanted to discuss modern portfolio theory (MPT) precisely because understanding other investors depends on whether they are MPT supporters. MPT says that the risk of individual investments should not be assessed; rather, the overall risk of the portfolio is more important. MPT considers portfolio volatility as risk, meaning that if the expected return of a stock is 6% but it yields 10%, this is a risk. I don’t see the logic in such an idea. On the other hand, the concept loses its interpretation if it’s a question of a loss-making investment.
MPT encourages diversification to reduce stock risk. This idea is consistent with not needing to research any investment target, as all investments are correctly priced. Otherwise, the investor’s workload increases linearly with the number of investment targets, returns decrease due to increasing commissions, and you give your best ideas as much weight as your worse ones.
What does stock investing mean? You give up your money now to get a share in a company that you believe will generate more for you in the future than you have invested in it. A constantly loss-making company is heading towards bankruptcy, and investing in such a company is like buying an option that this won’t happen. An unlikely event must happen for the investment to be profitable. The same applies to high-multiple growth companies: growth must occur.
Why do you say it’s not worth jumping out of the market at the first sign of panic? As a nation, we live on borrowed money, with household debt increasing to such an extent that even the Bank of Finland warns about it. Households are depleting their savings, and stocks are historically expensive, whether calculated by Shiller P/E or Warren Buffett’s preferred Total market cap to GDP. These are facts of the reality we live in. It’s also a fact that if the stock market crashes, the best allocation is 100% cash, 0% stocks, unless one wants to dabble in precious metals or derivatives. Whatever an investor owns, their return from profitable companies is double when bought at half price.
My comment was meant to be general: “don’t jump out at the first sign of panic.” One of the most common mistakes, I believe, is that private investors enter the market when everything is going well, and then panic-sell their stocks at the first dip. Getting back into the market then takes years, and they manage to avoid good returns in the meantime. Since timing the market is quite difficult, for most people the best option would probably be to just stay in and steadily save more into index funds.
(I wouldn’t panic-sell now either, even if this year might turn out to be a bit of a hurly-burly)
In my opinion, clinging to a certain theory and either supporting or not supporting it is too black and white.
However, everyone here generally follows the same investment philosophy: everyone diversifies.
A stock picker, in principle, should never invest in more than one stock, namely the one that yields the best returns, right? Why invest in the second-best?
In practice, however, A) no one is completely sure of their own competence or analyses, and B) randomness has an impact in every case.
So, everyone here follows the same philosophy of diversification, some just less than others due to their assumed competence.
Are you absolutely sure about this and dare to go either 0% or 100%? Almost no one is, and for this reason, everyone tries to avoid timing. Some more, some less.
It takes a strong self-deception to recommend all-in timing. Of course, almost everyone makes small reductions, adjustments, and other tweaks.
So, everyone invests following roughly the same principles when it comes to diversification and avoiding timing. The emphases differ depending on how much confidence they have in their own abilities.
Nice to have a proponent of the theory join the discussion. You asked if it wouldn’t be better to invest all money in one best company instead of diversifying. Entrepreneurs do this. To me, it feels natural, because an entrepreneur knows their own company and area of expertise better than industries they don’t have particular experience in.
You are right that no one knows for sure if an investment is profitable. But how does this lead to diversification? Diversification occurs as the situations of different companies change over time. At the moment when one company’s return relative to risk is higher than others, it’s worth buying that company. The requirement of certainty would mean that one couldn’t take a stand on anything in the stock market. The problem with modern portfolio theory is that, according to it, one cannot know anything about companies and their development that isn’t already reflected in prices. A proponent of the theory therefore considers a company whose stock price has fallen for any reason to be bad, and a company whose price is in a bubble to be good.
Don’t prices rise simply because the increasing popularity of index investing and the lack of alternative investment options have increased demand in the stock markets? Company results are boosted by borrowed money. Then, when the money taps are turned off and households finally have to pay down their excessive debts, consumption will fall. That’s when a wave of stock selling will begin, and everyone will advise against owning stocks at all due to their high risk and dismal future prospects.
It’s been a long time since my school days, so it might be a bit dangerous to state strong truths here.
However, I confess I’m skeptical that endless diversification is an investor’s only free lunch. Well, perhaps the only free one, but a free lunch is rarely the best one.
As I understand it, portfolio theory requires perfect markets, meaning, among other things, that everyone has the same information and expertise. But having invested for about 15 years, I’m quite convinced that there are enormous pricing errors in the market that can persist for years. How else can one explain, for example, the constant large fluctuations in stock prices, index collapses, and absolutely incredible index bubbles? New data on individual companies doesn’t continuously flow into the market. And if the market had all the information and the markets were wise, surely there wouldn’t be stock market crashes either? Last week, I was amazed by a guy on Shareville who had made a steady profit of over 5000% in 5 years! In my opinion, it smells of market pricing errors, it certainly wasn’t luck.
If one believes that there are pricing errors, how can one find them and how should one exploit them? There are probably as many answers to these questions as there are stock pickers. Some succeed, some don’t.
I’ve never heard of anyone who became a millionaire by saving 200 euros a month into all possible index funds. But indeed, according to calculations, it probably is possible. At least if you don’t happen to have bad timing, don’t need to realize savings for a car or apartment change, etc.
Instead, I know that many have become millionaires by playing the lottery and by stock picking. Although many who got rich through stock picking were probably insiders.
MAVRICK from Shareville is my favorite example when someone claims that the markets are always and all the time efficient. MAVRICK is even more efficient than the markets, or maybe they’ve just been incredibly lucky.
“Hand up as a sign of error”
I am both a timer and a concentrator of investments.
I am a concentrator for the simple reason that I need to have sufficient certainty of a “bomb-proof” return from an investment during the investment period. Such targets just aren’t found in enough quantity to diversify.
Currently, 95% of my investment capital is in Nokia, acquired almost exactly a year ago, and PYN Elite, acquired in 2016.
Neither has been subjected to temporal diversification; instead, there has been a deliberate attempt to time them.
So I have made both mistakes, and I cannot recommend the same to others.
Regards, concentrator-timer.
I will start diversifying more broadly if I don’t identify sufficiently clear targets for concentration.
Around the middle of the next decade, it remains to be seen whether my concentration strategy has led me to ruin or not. The intention is not to prematurely divest from either investment.
You’re simplifying things a bit and putting words in my mouth. I didn’t say that I consider markets to be perfectly efficient. I just said that even investors like Buffett practice diversification. So almost everyone diversifies at least to some extent. The exception being people like @Pika-Sissi, who apparently also sometimes have diversification in play?
The point of my previous message was that the theory you brought up is irrelevant in this thread, as everyone invests with a relatively similar philosophy, practicing some kind of diversification and avoiding perfect timing.
Some diversify by investing in 10 different indices, and some by investing in three different stocks. Still, no one here disputes the existence of momentum or bubbles, etc., in the markets.
To @Pika-Sissi, I’d also like to comment that I was referring to the idea that because the Bank of Finland says this and Shiller’s PE says that, the equity allocation should be 0% or 100%. Everyone there also tries to avoid timing by choosing a percentage other than 0% or 100%.
The whole point was that this thread is useless because we’re all the same, just with different emphases
MAVRICK is even more efficient than the markets, or maybe they’ve just been incredibly lucky. 
