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Buy the Whole Haystack: Why Index Investing Beats Stock Picking

The importance of diversification in the stock market.


Looking for the needle in the haystack


Many people wrongly believe that the stock market is akin to the lotto with one winning ticket, the needle in the haystack. Sure, a few get minor prizes but most people are losers.


Investing in the stock market and buying a lottery ticket do share some similarities, particularly when it comes to risk and the potential for financial gain. However, they are fundamentally different in their nature, purpose, and expected outcomes. Let's explore the similarities and differences between the two:


Similarities:

  1. Risk and Uncertainty: Both investing in the stock market and buying a lottery ticket involve an element of risk and uncertainty. In the stock market, the value of investments can fluctuate based on various factors such as economic conditions, company performance, and market sentiment. Similarly, buying a lottery ticket involves the risk of losing the ticket price and the uncertainty of winning a prize.

  2. Potential for Financial Gain: Both activities offer the potential for financial gain, though to different degrees. In the stock market, certain investments can experience significant price appreciation over time, leading to profits for investors. Similarly, winning a lottery can result in a substantial financial windfall.

  3. Entertainment Value: Some individuals may view both activities as a form of entertainment or a chance to dream about what they would do with a large sum of money. For some people, buying a lottery ticket or investing in speculative stocks may be more about the excitement and possibility of winning big than a calculated financial strategy.


Differences:

  1. Basis of Returns: One of the most significant differences between the two is the basis of returns. Investing in the stock market involves owning a part of a real company. When you buy shares of a company's stock, you become a partial owner and may benefit from its profitability and growth over time. In contrast, the lottery is purely a game of chance, and the winnings come from a pool of money collected from ticket sales. A lottery ticket in itself holds no value.

  2. Long-Term Growth Potential: Investing in the stock market, especially in a diversified and balanced portfolio, can provide the potential for long-term growth and compounding returns. Historically, the overall stock market has shown a tendency to grow over the long term. On the other hand, the lottery is not an investment and does not offer a path to sustainable long-term growth.

  3. Risk Management: In the stock market, investors can employ various risk management strategies, such as diversification and asset allocation, to mitigate risk and achieve their financial goals. Such risk management is not possible with lottery tickets, as it is entirely based on chance.

  4. Purpose: The primary purpose of investing in the stock market is to build wealth, save for retirement, or achieve specific financial goals. It involves a more thoughtful and calculated approach to achieve long-term financial objectives. Buying a lottery ticket, on the other hand, is more akin to gambling and is primarily driven by the desire to win a large prize, often with little consideration for long-term financial planning.


As we can see, both investing in the stock market and buying a lottery ticket involve risk and the potential for financial gain. However, they are fundamentally different activities. Investing in the stock market can be a strategic and long-term approach to building wealth and achieving financial goals, while buying a lottery ticket is a game of chance, offering the possibility of a sudden windfall but with extremely low odds of winning.


Finding the winning ticket


If we are to build long term wealth and achieve our financial goals, how do we find the “winning” ticket in the stock market? Do we randomly buy stocks and hope or is there a better strategy than guarantees us long term success?


Hendrik Bessembinder (2018) documents the surprising fact that the majority of U.S. common stocks have returned less than the returns to one-month Treasuries.


“The two key findings that surprised me, along with a number of others, are:

  1. most stocks do not outperform Treasury Bills in the long run, and

  2. net long-term creation of shareholder wealth in the stock markets is concentrated in very few stocks.


The overall stock market generates large excess returns (the “equity premium puzzle”) due to the positive skewness in the distribution of individual stock returns. In other words, large returns in a minority of stocks offset small or even negative returns in the majority of stocks.


[Q]: So how do we identify the “winning” stocks?

[A]: “Buy the haystack” – John Bogle


Attempting to pick the "winners" in the stock market is essentially like the lotto.


However, we have another option. The phrase "Buy the haystack" is often attributed to Jack Bogle, the founder of The Vanguard Group, and a pioneer in the field of index investing. This idea involves investors focusing on buying the entire market (the "haystack") using broad market index tracking funds (often exchange-traded funds/ETFs) rather than trying to pick individual stocks (the "needles").


This strategy is winning due to:

  1. Diversification: Index funds represent a broad market index, such as the S&P 500, which includes a large number of stocks across different industries. By investing in an index fund, you effectively own a small portion of each of these companies, spreading your investment across a wide range of businesses. Diversification helps reduce the impact of any single company's poor performance on your overall portfolio.

  2. Risk Reduction: Investing in individual stocks carries a higher level of risk compared to a diversified portfolio of index funds. When you invest in one or a few individual stocks, you are exposed to the specific risks associated with those companies. If any of them perform poorly or face financial trouble, your entire investment can be significantly affected. In contrast, index funds spread the risk across hundreds or thousands of companies, leading to a more stable overall performance.

  3. Lower Transaction Costs: Buying and selling individual stocks can come with transaction fees and commissions, which can eat into your returns over time. Index funds typically have lower expense ratios and transaction costs, making them a cost-effective way to invest.

  4. Time and Expertise: Successfully picking individual stocks requires significant time, effort, and expertise in analyzing companies, understanding market trends, and monitoring financial news. Many professional fund managers struggle to consistently beat the market over the long term. For individual investors, it can be challenging to outperform the market consistently.

  5. Behavioral Biases: Investing in individual stocks can be influenced by emotions and cognitive biases, leading to potentially irrational decisions. Investors may be tempted to chase hot stocks or panic-sell during market downturns. Index investing takes the emotions out of the equation, encouraging a more disciplined, long-term approach.

  6. Market Efficiency: Financial markets are generally efficient, meaning that stock prices quickly reflect all available information. This efficiency makes it difficult for individual investors to consistently outperform the market by selecting specific stocks. Index funds, on the other hand, aim to replicate the performance of the entire market, which is typically challenging to beat.


If you want to be a successful investor in the long run, your portfolio needs to contain all the winning stocks in it. The easiest way to achieve this is buying the entire broad market as cheaply as possible.


Buying the “haystack” ensures that you always get the winning ticket!



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