Topics: Timing the Market, Market Efficiency, Public Opinion, Clout, Greed and Fear

“Hey bro, what are your thoughts on the market right now?”

“Are you buying the dip?”

“Think we’re heading towards a recession?”

“This stock is a sure thing!”

“If this stock goes to *fill in random price* then I’ll make *fill in random percentage*!”

If you haven’t discovered this yet, I’m a big finance nerd *gasp*. I know, it’s a shocking revelation. Pretty much every post I’ve made thus far has been a deep dive on topics that I love aggressively nerding out on. For this post, I want to take a step back and share some insights that are relevant for everyone: how to invest for non-finance nerds (i.e. normal people).

As disappointed as I am to learn that not everyone loves discussing the theoretical implications of applying the principle of convexity to equities (IYKYK), there are still principles of stonk science that apply to everyone; these time-tested principles can help you develop an investment strategy and portfolio that will outlast any market cycle.

For today’s blog, I’d like to give a shoutout to my parents and grandma - pretty sure y’all have read every single one of my posts and always have encouraging feedback. Thanks for being awesome! Patrick Mahomes and Aaron Judge are cool, but y’all are the real MVPs!

Let’s get into it…

IDK Where to Start

Perfect. You’re not alone. No one has all the answers (except for ChatGPT) and I don’t think we should pretend that we do.

My homie Zechariah and I discuss financial planning 101 in our first podcast episode. If you don’t like funny jokes and people with awesome personalities, I’ll summarize our IPO (initial podcast offering hehe) below:

• Set up an emergency savings fund

• Pay off high-interest debt (i.e. credit card debt)

• Open up a Roth IRA and contribute to your 401K to maximize your employer's contribution

• Invest for the long term in accordance with your financial goals

Once you’ve come to understand the principles of financial planning 101, you can begin Stonk Science 101. Welcome to class.

Stonk Science 101

Invest your portfolio in accordance with your goals, objectives, and risk tolerance. Deviating from those will result in undesirable outcomes, such as failing to finance your retirement, delaying your purchase of a home, or just underperforming the market.

During periods of market turbulence, many investors abandon their investment strategy and end up underperforming the market. Thanks to Ron Blue for the pretty charts - thanks to Dalbar for the data.

Yikers. I’ll also note, that this data is likely exaggerated because most mutual funds (specifically actively managed mutual funds) underperform their respective indexes. For passive mutual funds, this is due to expense ratios. For active mutual funds, underperformance is due to expense ratios, as well as a myriad of other behavioral biases. Read here for an explanation of active vs. passive.

*active = trading more in hopes of beating the market | passive = trading less to match the market*

Financial Goals?

“Okay Drake, but what does it look like to invest in accordance with financial goals?”

Glad you asked 😉 

Here are some sample financial goals:

Once you develop those financial goals and objectives, match them with investments that have an appropriate time horizon. For example:

• Ultra-short term: cash or high-yield savings account

• Short-term: High-yield savings account and/or treasury/investment grade corporate bonds

• Medium-term: Stonks and/or corporate bonds (high-yield and investment grade)

• Long-term: Stonks

• Ultra-Long-Term: Stonks

My Risk Tolerance?

• How often do you check your retirement?

• Are you often anxious and worried about the future?

• Do you find that you want to change your investment strategy frequently?

• Do you have an emergency savings fund?

• Do you have a significant amount of debt and/or other financial obligations?

• Do you have frequent feelings/thoughts of greed or fear?

If you answer those questions honestly, you’ll have a good gauge of your risk tolerance.

The higher your risk tolerance, the higher your ability to invest in higher-risk assets (stonks). The lower your risk tolerance, the lower your ability to invest in higher-risk assets. It’s okay if you don’t invest in triple-leveraged S&P 500 ETFs; it’s more important that you invest in accordance with your financial goals and stick with your investment strategy.

Tying It Together

At the intersection of your financial goals and risk tolerance is where your portfolio should be hanging out. By the way, if you have several financial goals, you can create different portfolios to match those goals.

For example, here are some sample portfolios that give you an idea of how you should think about investing your portfolio:

This is all based on goals-based investing. This is not something new that I came up with. For a deep dive into how goals-based investing came to be, click here. Another way to think about goals-based investing can be summarized in this chart:

If you’re thinking about my earlier comments regarding mutual funds frequently underperforming the market, then I’m glad you’re still reading. ETFs (exchange-traded funds) are portfolios with very low fees designed to match popular stonk market indices (S&P 500, Dow Jones, etc); contrary to mutual funds, ETFs are passively managed and have little tracking error.

• For stock ETFs, check here. SPY is the largest ETF in the world (~$300B).

• For corporate bond ETFs, check here. BlackRock and Vanguard are the two largest players in this space.

• For treasury bond ETFs, check here. BlackRock is the largest player in this space.

• For information on HY savings accounts, check here. Note: there is a higher return associated with these accounts primarily because withdrawals are commonly restricted to 6 times per month.

• For information on places to store cash, check here.

*Note: many bond ETFs have duration targets - this is the effective time to maturity of the bonds in the underlying portfolio. Matching an ETF with a target duration that is comparable to your financial goal(s) is often warranted.*

Okay, these are the basics of stonk science 101. If you’d like to go deeper and learn more about the theory and psychology behind these principles, read on. If not, “lIkE aNd SuBsCrIbE”!!! Lolol

Behavioral Finance 101: Efficient Markets and “Mr. Market”

Vanguard (John Bogle) brought about the emergence of index investing as a result of many taking to heart the doctrines of the Efficient-Market Hypothesis and the inability of investors to generate alpha. Though the first ETF was traded in 1993 by State Street Advisors (SPDR), Vanguard is one of the largest ETF providers (slightly behind BlackRock). What makes ETFs great is that they are not actively traded and are designed to match the returns of common market indices; this reduces fees and (often) removes behavioral heuristics of fund managers from the equation. Investing in ETFs removes the risk that you underperform the market, but also guarantees that you won’t outperform it either (unless you deviate from your predefined investment strategy); some daring individuals still actively manage their portfolios, but the widespread acceptance of market efficiency has led many investors to simply invest in the index; index funds now account for more than 40% of the money invested in ETFs and mutual funds. John Bogle would be proud.

Then why do people still day trade and actively invest?

Because the Efficient Market Hypothesis is incorrect.

*Gasp*

You heard me.

The Efficient Market Hypothesis is… *clears throat*… wrong.

If the Efficient Market Hypothesis is wrong, then there is a possibility that investors can outperform the market. The fact that most people don’t adhere to index investing should give us a good indication of how most people feel about market efficiency :)

I’d propose that the Adaptive Markets Hypothesis is the most reasonable alternative.

Its premise is that market efficiency is not an “all-or-nothing condition, but a continuum”. Market efficiency ebbs and flows based on widespread investor rationality. Here are some examples: the 2000s tech bubble, the 2008 housing bubble, the 2020 Bitcoin bubble, and so on. Though I don’t agree with everything included in Lo’s hypothesis, I do believe it is the most reasonable alternative that explains market efficiency.

In a speech at USC’s Business School in 1994, Charlie Munger, Warren Buffet’s right-hand man, shared several insights that I found very relevant to our discussion of market efficiency.

Ben Graham, the father of value investing and the OG intelligent investor, referred to the stonk market as Mr. Market, and, as Mr. Munger says, Ben Graham “treated (Mr. Market) as a manic-depressive who comes by every day. And some days he says, ‘I’ll sell you some of my interest for way less than you think it’s worth.’ And other days, ‘Mr. Market’ comes by and says, ‘I’ll buy your interest at a price that’s way higher than you think it’s worth.’ And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all.” And, as Mr. Graham himself said, “in the short run, the market is a voting machine but in the long run is a weighing machine.” Protecting one’s thoughts, beliefs, and convictions from the emotional volatility of the market (madness of the mob, if you will) is critical to creating an investment portfolio; this is the reason I don’t have Twitter, Instagram, etc. I believe that this psychology is why many investors end up underperforming the market; this transcript of Mr. Munger is phenomenal in further describing the psychology of markets.

But How Do I Beat The Market?

Mr. Munger said it well: “I think it’s hard to provide a lot of value added to the investment management client, but it’s not impossible.” I’d agree with that. Schwab performed a study that measured market timing vs dollar-cost averaging vs immediately investing vs not investing at all. Here’s what the backtest shows. I think the conclusion from this backtest is pretty straightforward: unless you are an absolute market whizz it’s best to immediately invest savings, though inaction will have the worst result.

A former colleague told me that the best time to buy stocks is when you want to throw up in a trash can; despite never having done it himself, he’s right. It’s my belief that fear and greed are the primary drivers of investor irrationality, which create the best opportunities to capitalize on deviations from intrinsic value. Thankfully, CNN conveniently reports investor greed and fear using an index. You can also use the VIX as a proxy for the market’s perception of risk.

If this were a perfect science, it’s likely they wouldn’t share it with us because then everyone would be making fat stacks of cash. Luckily for us, we have stonk science to inform our investment decisions. I believe it’s possible to use factor tilting, stock selection, macro strategies, and other investment vehicles to outperform the market, but I’m going to stop here for the sake of brevity (and so you’ll keep reading my future posts hehe) :)

In Summary:

• Do financial planning 101 and pay off high-interest debt (credit cards) and set up an emergency savings fund that is kept in liquid assets (cash or cash equivalent).

• Write out your financial goals and risk tolerance.

• Use your financial goals and risk tolerance to inform your investment decisions.

• Though there are ways to outperform the market, it’s typically more prudent and less stressful to index invest for the long term in accordance with your investment strategy.

• Markets are frequently efficient, though periods of inefficiency (and hence opportunity) arise during periods of widespread market irrationality.

If you have any recommendations for future research topics, don’t hesitate to reach out 😄 Thanks for reading!

Disclaimer: None of this is investment or financial planning advice. Do your own research and due diligence. If you need to, consult a financial advisor; contact me if you don’t know of any and I can get you connected to some (disclaimer: no, I am not compensated by connecting you to a financial advisor). Disclaimer: I’m not compensated by helping you fix your financial life - I just take great satisfaction when people have financial peace. Disclaimer: I am not compensated for referring anyone any resources for any reason ever, forever, whenever, whyever, however.