Trading is the key to wealth

Today, I'd like to share with you the true secret to creating wealth, and that is trading.  Buying stocks low and selling them high at key points, getting out before it goes down.  Buying and selling constantly is the true key to creating fast wealth.

Lol, no it isn't.

I have read thousands of articles on finance, and studied dozens, if not hundreds of finance books, and many investment styles, and one thing that stands out to me is that passive investing is a far superior strategy than gambling in the stock market for the average investor.  The more I learn, the more concrete this concept becomes.  That's not to say there aren't people who don't do very well by picking stocks.  Warren Buffett has handily beat the market by about 10% annually on average over the last half century.

But for every Buffett, there are a hundred wanna-be's, people who claim to have found the perfect strategy to beat the market.  They'll dazzle you with figures, and give you a specific timeframe in which their stock picks did very well, or show you a handful of stocks they recommended back in the day that went up by a whole bunch.  Of course, what they don't mention is that they also recommended a bunch of other stocks that didn't do so hot.  Incidentally, these people are either trying to make money off you by selling you their method, or are trying to brag.

Here are a couple of examples I want to highlight.  Both were teenagers, and in both cases, the financial media pounced on their stories, making it sound like these kids were investing geniuses.  The first was a 17-year old whose name virtually guarantees he'll get "randomly selected" every time he flies.  A Stuyvesant High School student by the name of Mohammad Islam (no, really) was rumored to have made $72 million trading stocks.

Apparently trading also adds a year or twelve to your appearance 

Here's an excerpt from the original article on Business Insider: "While having caviar and apple juice with his buddies, Islam acknowledged that his net worth was in the "high eight figures."  Later that day, he was going to meet a hedge funder who "basically wants to give us $150 million."  At only 17, Islam has already rented an apartment in New York, but his parents won't let him stay there until he turns 18.  He also bought a BMW even though he doesn't have his license yet."

I snorted when I read the bit about the caviar.  Anyway, the second one was a 16 year old with a name I can't pronounce, who has made $43,000 IN 3 YEARS! (capitalization mine) by picking stocks.  The financial media loves to highlight this kind of stuff, because, much like winning the lottery for poor people, rich(er) people want to believe they can successfully gamble in the stock market and beat out everyone else.

But when you look closely, the truth comes to light.  Turns out that tubby sack of sad with the most jihad name I've ever heard (and I spied on the Taliban for several years, so I've heard a few) had made it all up.  He hadn't made a dime in the stock market, and the apartment and the BMW were all imaginary.  He was just a teenager who liked the fame as long as no one asked very hard questions.

As for the second one, yes, he did make $43k, which amazed CNN, but when you look closer, it's less  than impressive.  This kid's rich parents let him play with a quarter mil of their retirement money (that's $250,000 for you squares).  He invested in popular stocks, got lucky, and STILL underperformed a total market index fund (his annualized return was about 5.4%).  Indeed, near the bottom of the article, it says that "like other investors, Sridharan has struggled this year, admitting he got caught up in a few bad trades."  So basically he got lucky for a couple of years, but his luck ran out.

That's why you have to be wary of anyone claiming to have a special system, or who claims they can beat the market year after year.  Statistically, they're full of shit.  Trading is a zero-sum game, meaning that for one person to win, another has to lose.  So anyone can do well one year, or maybe for a couple, but over time, traders tend to revert to the mean, which means their losses neutralize their gains, giving them an average of zero.  Actually, even less than zero.  A lot of traders end up in the negative, because of all the fees they have to pay every time they trade.

So take every trading success story with a huge grain of salt.  As an average investor - and let's face it, you're extremely average - your best bet to make money is also decidedly boring.  Regular, passive investing in index funds will probably make you more money than swinging for the fences and trying to play with stocks, or with derivatives like options.  And for the love of God, don't ever borrow money to invest.  That's called leverage, and it's one of the main reasons for the 2007 housing crash.  The one exception would be if the return is guaranteed and the interest rate is lower than your guaranteed return.  That's called arbitrage, a guaranteed profit.

My investing philosophy is pretty simple.  Dollar cost average into index funds, maxing out your tax-advantaged retirement accounts first.  For the layman, that means putting the same amount of money every month into funds that mimic stock indexes like the S&P 500, which contain the 500-ish strongest and largest companies in the U.S., maxing out your 401(k) and IRA before you invest in other accounts.

Of course, I have some positions in single stocks such as Tesla - which I think will do very well over the next couple of decades - but they only represent a portion of my overall net worth.  The majority of my money is in index funds.

Don't day trade

About a week ago, I finished buying 50 shares of Tesla Motors, a plan I’ve had for some time.  I believe in Elon Musk’s vision, and I think the company will do very well.  My goal was to get them for $200 each, for a total of $10,000.  There’s no science to this choice.  I’ve often read “If you had invested $10,000 in stock Y in year X, it would be worth this many millions today,” so I went with $10,000 as the amount, and wanted a round number, so I went with 50.  Tesla has been very volatile over the past couple of years, mostly because it’s hard to value the company, as they haven’t had any earnings.

Less than a week after I bought the shares, the stock was up to 216, which made me a profit of over $800, and when I told someone at work about this, they congratulated me and said I should take the profits and treat myself.  This goes against everything I stand for, for the following reasons:

1)      You haven’t made or lost any money until you sell the stock, so right now it’s all on paper

2)      I have a long time horizon.  I bought those shares to hold for the next 15 years, and I will hang on to them even if they drop below my original purchase price.

3)      The stock is at 226 right now, so I would have missed out on $500 extra of profit if I had sold when they told me to, and

4)      Most importantly, I do not day trade

Day trading is when you buy and sell shares of a stock in the same day to make a quick profit.  For most people, it’s a terrible way to make money.  It’s difficult, if not impossible, to time the market, and constantly buying and selling is a recipe for disaster, due to fees.  Trading is a zero-sum game.  For someone to win, another person has to lose, and chances are, the person on the other side of your trade knows more about it than you do, and is buying or selling for a good reason.

I know several people who used to day trade.  They all tell me it was a bad idea, and if they had held on to the stocks they traded, they would be a lot richer than they are now.

"Screw you" money

Have you ever heard the term "screw you" money, or some variation thereof?  Probably not, since it's not generally used in polite company.  But you probably understand the concept, and it's something you definitely need.  "Screw you money" is having enough money to be able to tell almost anyone to fuck off.  Most people would call it financial independence.

Is your boss a jerk?  Do you hate your job?  Legal troubles?  Medical issues?  Creditors?  There are very few situations in life where having enough money wouldn't remedy your problems and make you not have to kiss anyone's ass.

You need this, because the most important thing money can buy is freedom.  Freedom from a toxic work environment, a crappy neighborhood, crushing debt.  Freedom to do what you want (within reason) and pursue your passions.

Those who live paycheck to paycheck are slaves.  Those who carry debt are slaves.  You need to get out of debt, and work on having enough money to not have to work if you find yourself unwilling or unable to.

What would happen if you lost your job and couldn't find another one?  What if for some reason you didn't qualify for welfare, unemployment, or any other kind of assistance?  I've been in both situations and it's terrifying.  Too many people spend their entire paycheck on frivolous bullshit because they think they'll always have one, or if they lose their job, they'll be able to find another one.

The concept of "screw you" money is very appealing, but most people think they'll never be able to have it, unless they win the lottery or something.  I'm here to tell you that's not true.  As I've mentioned before, all you really need to do is save up enough money so that when properly invested, it's producing enough income to last you for the rest of your life, a self-sustaining "fuck you" fusion reactor, if you will.

Like this, but like, throwing off money instead of heat and radiation

You may also think you need an amount greater than you'll ever be able to save, but that's also not true.  All you really need to last you forever is 25 times your annual desired expenses.  So say you wanted to retire today with an $80,000 annual salary for the rest of your life (which would increase with inflation, so you can buy the same amount of stuff today as in 50 years), you'd multiply that $80k by 25, and it gives you $2 million.  All you'd need is $2 million dollars.

Alright, so maybe that's a lot. But say you lower your expenses a bit, to $30k a year (which is very doable, depending on where you live).  You would only need $750,000 invested in the stock market to throw off $30k in today's dollars for the rest of your life.  You could walk out of your office proudly baring the one finger salute, and never have to work again, as long as you maintain your standard of living.

Here's John Goodman explaining the concept.  In case this gets removed from Youtube or something, it's from "The Gambler."  The position of fuck you:

To place yourself in the position of "fuck you" it's important to start early, save as much as possible, and invest it.  There are many people who have retired super early.  You do not have to work until you're 65.  I'm currently working on my "screw you" money, and as long as things go according to plan, I'll be financially independent by 45 or so.  Maybe earlier, though I doubt I'll stop working.  It'll just be nice to be able to finally relax and free myself of the worry that comes with poverty,  I've encountered some setbacks in life that have left me cynical but realistic, and have shown me how truly necessary financial independence is.

I hope you get it too.

Life insurance example

I've previously talked about the different kinds of life insurance and how term is best for most people.  I say most because I'm sure there are people out there who could benefit from the other kinds.  Getting to the point of this post, here's an illustration of a real insurance policy one of my friends was kind enough to share with me.  Obviously, the name and information of the person and the company have been redacted for privacy, and so the company doesn't sue me or whatever, but I've circled the points I'd like to draw your attention to.

This particular policy is a variable life insurance policy, which is a permanent life insurance policy with an investment component.  The policy has a cash value account, which is invested in a number of accounts similar to mutual funds.

Now that you've all snoozed off, allow me to put that in plain English.  Not only do your dependents get paid a bunch of money if you die (like a regular life insurance policy), but the insurance company helpfully invests your premiums for you, and you don't even have to croak to get paid!  How fucking cool is that?

"Of course, it costs a little more, but it's worth it."  
"What was that?"

"Oh, I was just mumbling that it costs a little bit more that term, but let me redirect your attention to something else."

"Wait, how much extra?"

"Ah, don't you worry yourself about that.  It's worth it.  Let me just dazzle you with a bunch of figures."

That's the gist of the spiel most insurance salesmen (or women, whatever, I'm equal opportunity) will run by you, and to the uninformed schmuck, it sounds awesome.  And it IS all fine and dandy, except for one crucial point they tend not to cover - these policies charge fees; a lot of them.

This particular policy you can see above was purchased at the beginning of November 2007, when the insured was 19 years old, for a death benefit of $400,000.  The monthly premiums are $116.50, and the current cash out value is just over $5,200.  To put that into perspective, a term policy for the same amount costs maybe $25 a month.  To date (11/2007 - 09/2015), this person has paid out $11,067.50 in premiums.

Did you notice the difference between the cash value and what was paid?  It's less than half.  That's not even taking into account the stock market returns.  Let's pretend this same person had purchased that $400,000 term life insurance policy for $25 a month, and invested the remaining $91.50 in an S&P 500 index fund.  The cash value today would be just over $12,000.

In summary, you're probably throwing your money away if you purchase anything other than a term life insurance policy.  If someone is trying really hard to sell you something (other than advice), they're not doing it to help you out.  They're doing it because it's lucrative.  And more fees for them equals more costs for you.

And they'll probably say something like this as well

Now for the obligatory disclaimer: I'm not a licensed financial anything (yet) so I can't legally give you advice for money.  This is all my opinion, and if you take my advice, that's on you.  However, licensed advisors like Dave Ramsey and Suze Orman (and pretty much anyone not trying to sell you a product) tend to agree with me.

Keep your nose to the grindstone

In March 2010, I became debt-free.  I had already been making small contributions to my retirement accounts for the previous 4 years, so I wasn't starting at zero.  Best I can tell, I had about $5,000 in my Thrift Savings Plan when I paid off the last of my credit cards and my car loan.

So little work actually goes into successful investing, people who aren't in the right mindset will think you're lying.  The key is to set aside as much money as possible from your paycheck BEFORE you receive it and have a chance to spend it.  People call this "paying yourself first."  If you're in debt, that money should go towards ensuring your freedom from bad debt, and if you're out of debt, that money should go towards your future financial freedom.

UPS hired me last December, and I started out making $10 an hour.  I quickly did what I could to learn a skill (sorting by zip codes), which got me another dollar an hour.  For the first seven months I was there, I was making roughly $800 a month after taxes.  Since my rent is $500 a month, and food is included, you'll probably guess living on $800 a month is possible, but not very pleasant.  You'd be right.  I did manage to survive on that money without having to dip into my savings, but only because I did absolutely nothing.  I went nowhere, and only bought the absolute necessities, taking the bus to save on gas sometimes.  Every additional penny spent was scrutinized for practicality and necessity.

Many people in my position would have gone ahead and used their savings to maintain their "quality of life," but I was determined not to cheat my future self.  I also knew that this low level of pay was merely temporary until I could land a better position.  That position ended up being part-time supervisor, which effectively doubled my salary.  As you can see from a quick calculation, it's still not very much, but I now had enough money to buy myself small luxuries such as fast food and hour-long leisure drives to visit friends without having to really worry about spending more than I earned.

I also now had extra money with which I could fund my retirement, so I opened a Roth 401(k) and set aside 10% of my income to go towards that.  This is money that would get pulled out before I got my paycheck, so I wouldn't have an opportunity to miss it.  To many people, 10% may seem like a lot, but keep in mind my paycheck was still 80% higher than just a few months prior.  If I could survive on $800 a month, $1,440 would still be a fantastic raise.

Now we come to the main point of this post.  After I realized that I was still doing fine on a 10% contribution rate, I increased it to 15%, then 20%.  Every time, I would wait a month or two and see if my living expenses were covered.  What you want to do is drive up your savings rate until it hurts, then ease back just a little.

At work, I encourage many of my co-workers to start saving, especially the younger ones.  They don't really listen, because at 21, all you really care about is having fun, not thinking about the future.  Putting money in a retirement account means less money you can spend on awesome stuff today.  And even if they don't spend very much, there's always an excuse as to why they can't start right now.  They're content just coasting.  I am not.

I make no excuses.  I just do it.  My 401(k) currently sits at $1,460 or so, including the 3% matching contribution that UPS gives us.  That's $1,460 more than my co-workers have saved.  We both started at zero, but I bought one less restaurant meal, or went on one less trip, and instead put that money to work for me.

You can too.  Start saving today.  You'll be amazed at how little you can live on when your priorities are straight.

Successful investing

Recently, the stock market took a pretty big dive. Plenty of people thought this was The End. The start of another Recession. You should have bought gold when Glenn Beck yelled at you. The market hit a peak in May, then dropped over 10%, and bottomed out on August 25. Since then, it's been steadily going up. How many of you panicked and sold?  In the grand scheme of things, this is an insignificant blip you won't remember. The stock market tumbled in October of 2011; how many of you remember that?

Let's pretend you regularly check your portfolio. Let's also assume you decided you wanted to take a vacation from it all and go camping or out to sea for 7 months or so, leaving the day before the market started tanking. During your time away, you had no internet access and couldn't check your portfolio. When you come back in December or January, you open up your account and notice it's slightly higher than when you left. Not by very much, but still in line with the gradual upward trend of the market over time. Nothing to see here. You shrug, close your computer, and go about your day as usual. And unless someone said something, you would have had no idea there was a small crisis in your absence.

That beard has got to go before you go back to work

The best investors keep their cool. They have a solid, SIMPLE plan, and know that stocks aren't something to buy and sell, but rather portions of ownership of real businesses. Businesses that produce things, that earn money, that keep the economy going. Good investors view stocks like most people would view investment real estate. Would you buy an apartment building just so you can sell it a year later and collect the profit? Probably not. Most people would buy it so they could collect rent and eventually have it as a source of passive income so they don't have to work any more.

In the same way, good investors buy business ownership for the long run. There are some people that try to make money by buying and selling stocks or real estate.  Most people that try to time the market end up broke.  A handful, either through luck or skill, do extraordinarily well, which fuel the dreams and ambitions of those trying to emulate them with little hope.  During the real estate bubble, millions of people bought properties with the goal of capitalizing on the market increases. Those who sold before the bubble burst were either lucky or smart.  Some people get lucky with risk. Statistically, you're probably not one of them.

Don't try to time the market. Buy businesses that your research shows will do well over the next few decades, invest regularly and hold on to them. If you don't know how to research a business, buy an index.  History shows us that the market returns a decent 8% return in an average year. Sure, there will always be someone making more money than you, but THEY AREN'T YOU. And chances are, if they're making lot more money than the market, they're taking on foolish risks that will eventually bite them in the ass. Steer clear of get rich quick schemes and keep it simple.

The wisdom (and foolishness) of crowds

In 1906, a British smart guy named Francis Galton attended a fair and there was a contest where people would try to guess the weight of an ox. Being a statistician (and therefore presumably single), he wondered how the crowd as a whole would do, and he figured that since most of them were not experts in cow-related matters (no, their wives don't count), they'd probably come up with something laughably wrong.

The ox ended up weighing 1,198 lbs.  The average of the answers the crowd came up with was 1,197 lbs, which means that the collective guess of those amateurs was only a pound off.

NPR recently replicated the experiment and uploaded a photo to the internet, asking people to guess the weight of a cow named Penelope.  Over 17,000 people submitted guesses.  The actual cow weighed 1,355 lbs, and the average guess was 1,287 lbs.  Not as close as the original, but still less than 5% off.  Of the respondents, 3,000 were "experts," people who knew a little something about cows, and their average was 1,272.  That's right, the self-proclaimed experts actually did worse than people who knew nothing about cows.  Not by much, but still.

While at the fair, they asked a group of kids how much they thought the cow weighed, and after the first one said 200 pounds (because kids are stupid), the others followed suit and gave answers that were pretty close.  Now, I'm tempted to attribute that to the stupidity of children as well, but adults do that too.  It's what's called "information cascade," and it happens because people instinctively look to leaders.  They assume since someone already blurted out an answer with some confidence, they must know what they're talking about.

There were a handful of people who guessed the exact weight, and the guys at NPR called up one of them at random, who turned out to be a 20 year old college student, who came up with the answer via the very scientific method of "googling that shit."  His extensive 90-second research told him that the average weight of a cow was 1500 lbs, and by comparing the provided picture of Your Mom with the picture of Penelope, he correctly guessed she weighed 1355.

The two points I'm making here are that the crowd tends to do better than the experts at predicting things, as long as they aren't swayed by the decisions of those around them (like the kids were, by that first little dummy), and that just because someone gets the right answer once, it doesn't mean they will be able to do it again.

In the same vein, if left to its own devices, the stock market tends to be a very good indicator of the actual value of a stock.  Investors are irrational, but collectively, they tend to arrive at a price that's pretty close to what it's actually worth, as long as they aren't swayed by "experts" or TV personalities who talk about this or that stock or investment.

That's also why it's so hard to beat the stock market.  The wisdom of the crowd is pretty good, and the people who beat it are often just lucky.  Remember the cow experts who did worse than the average non-expert at guessing the weight?  Financial experts like money managers tend to do the same with investments.  More often than not, they actually underperform.  Four out of five do worse than the market over a 20-year time period.

Now, the principle of crowd wisdom doesn't really hold when a certain investment is highly visible and when investors are influenced by others.  When people see everyone is piling into a certain stock, they think that it must be a good investment, so they do as well.  Then bubbles and panics happen:

Remember bitcoin?  The real estate market? Fuckin' Beanie Babies?

Chances are, once you hear about something hot, it's probably too late.  That was the case with bitcoin, the real estate market, you name it.  By the time the media reports on it, the smart people have made their money and will soon be pulling it out.  Of course, there is that 20% of experts and money managers who actually do better than the market, and those genius investors like Warren Buffett and Peter Lynch, who have 9- or 10-figure net worths, but good luck with that.  Your best bet as a novice investor (as I would assume most of the people reading this to be) is to ignore the chatter and not try to go for whatever the hot investment is at the moment.  Instead, you'll be better off by investing regularly in a low-fee index fund.  To read more about cows, crowds and averages, check out this article.