Tom Williams puts it this way: “I wonder if the answer to the question you posed to Greg is that because the mutual fund managers have lots of money invested in a lot of different stocks, they are more subject to the law of averages than the little guy who can target fewer stocks. No doubt the average single investor doesn’t beat the market, but it’s probably true that a few do much better than the market while others do much worse. Which is what everyone has known all along: if you are willing to take more risk, you MIGHT make more money. And Greg might to. He just needs to understand that there is also a good chance that he won’t.”
Yes. And this actually breaks into two questions.
The first is purely about risk. For example, in the short run, stocks are riskier than savings accounts. But if you take more short-run risk, you are very likely — even if you’re just an average Jane or Joe — to do better over the long run than if you had played it safer. (Warning: Not everyone . . . indeed relatively few . . . can afford the long run. If you have a car loan and credit card balances, etc., you should not be in the market. It’s only with money you won’t need to touch for many years even if the roof needs to be replaced that you can invest for the long term.) So, yes: prudent risk — risk thoughtfully and soberly assessed and accepted — yields rewards. (Taking risk-for-risk’s sake, by contrast, can pay off — people do win the lottery — but is generally dumb. You are paying for a thrill, not investing.)
And it’s not magic. One way to look at it is that the market pays you to take risk. Another is that, with stocks, you are investing in actively managed wealth-producing enterprises that, taken as a whole, over the long run, will likely grow and prosper. So it just makes sense that owning a piece of them would do better for you than keeping your money in a savings account. (Or look at it this way. The money you put in the bank or a bond you are, in effect, lending to company that’s pretty sure it can earn a higher return on it — or else why would it be paying you this interest to borrow this money in the first place? So you can lend it at a low rate, or buy a piece of the business, or the bank, that thinks it can earn a higher rate, a little sliver of which, in theory at least, as a tiny co-owner of the business, will be yours.)
One more warning here: With the Dow at nearly 14,000 (yes! I’ll explain tomorrow), there may be more risk in the market and less potential reward, than usual. Risk really does have its ugly side. Look at the investors in Russian stocks in 1916. Or Japanese stocks in 1989. Or Trump Hotels, symbol DJT, the Donald’s initials, at 35 (it’s 4 today).
But the second question is, for any given amount of risk, can you consistently do better than others taking the same level of risk? I.e., if you and someone else both choose the stock market . . . and if, what’s more, you both choose a handful of fairly risky stocks . . . one of you may do much better than the other this year. But is it because one of you was smarter? Or is it, rather, because one of you was luckier? Surely at the roulette table or the slot machines, we credit success mostly or entirely to luck. We don’t assume that the fellow who left the roulette table a winner last night will likely leave it a winner tonight. Yet we do tend to assume that last year’s outstanding stock-market performers will be among next years as well. A little of that assumption is sometimes justified. But not nearly as much as we instinctively think.
Tomorrow: Dow 14,000.
Quote of the Day
Very few American investors buy any stock for the sake of something which is going to happen more than six months hence, even though its probability is exceedingly high; and it is out of taking advantage of this psychological peculiarity of theirs that most money is made.~John Maynard Keynes
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