Chapter 2
Don't Play a Game That's Rigged

So, if attempting to mimic the behavior of institutional investors by analyzing and reacting to the day-to-day gyrations of financial markets is unlikely to produce the outcomes you desire, what should you do?

The answer is fairly simple and one that you've undoubtedly heard before. You should start with a financial plan that clarifies and specifies your financial goals. Then, you should find an investment approach that works for you and stick with it for the long haul. And of course you should do all of this in a tax-efficient manner, since a dollar saved is a dollar earned.

Of course, that's “boring” financial advice and also easier to say than to do. Therefore, the remainder of this chapter will attempt to provide you with a better understanding of why financial advisors often give this advice. This chapter will also demonstrate the downside of deviating from your long-term approach.

The Upward Path of Markets

The Grand Canyon is one of the world's most iconic sights. I've known many people who have visited, and none have ever come back disappointed. The sheer immensity of the crevice gouged from the earth boggles the mind. Standing on the cliffs and looking at the floor of the canyon 6,000 feet below, you see the Colorado River. At that height the river looks small, which makes it even more amazing when you stop to consider that it's that river that created the canyon.

The river is heavy with sediment and over the course of some five or six million years, it has gradually ground away at the surrounding rocks. The result is an ever-deepening ravine. The present view, the one that draws millions of visitors from around the world to stare in awestruck wonder, is the result of that river.

Of course, six million years is a long time. If we were able to step into a time machine and flashback to the point at which the Colorado River first began its work, the resultant view might not be very impressive. Sometimes, great doings take a while.

Such is the case with compound interest. Just as the silt in the river eventually carves a magnificent canyon, so, too, does compound interest turn small sums into large fortunes. Unfortunately, though, the urge to shift in and out of markets often prevents people from enjoying the true benefit of this magnificent power.

Figure 2.1 S&P 500 (1927–2019)

SOURCE: Data courtesy of MacroTrends Data Download.

Let's take a look at what compound interest can do across long periods of time. We have data going back to the 1920s, and we can use this information to measure progress and performance. Of course the world was very different back in the 1920s, but it's helpful to take a look at a long data series because it incorporates many different political, economic, and financial environments.

The message that data gives us is quite clear: over very long periods of time, investors who resist both the urge to speculate and the urge to panic do very well, indeed (see Figure 2.1).

What's really interesting about the chart is that it doesn't look like anything happens until about 1980. This is an illusion, given the scaling of the chart, but the visual also demonstrates a deeper lesson. Just as the Colorado River did its work for countless millennia before creating one of the most impressive sights on earth, compound interest does much of its work in the background. For years, its effect might not be apparent. But when its impact does burst forth, the effect can be magnificent.

The chart also shows that there have been bad times over the past nine decades. Undoubtedly, there have been many periods during which it was tempting to abandon the market until it was “safer.” With the power of perfect foresight and the ability to consistently time your way in and out of the market, this might've been a good approach. But as will be discussed in greater detail later in this book, that perfect foresight is a very rare commodity.

So, if we work off the assumption that you don't have the ability to see with perfect clarity what the future holds, it becomes clear that, despite the many fluctuations the market has encountered, the long-term trend has been higher. What that means is that if you want to achieve success, you must participate in the financial markets even though doing so will undoubtedly subject you to a great deal of volatility and perhaps even some sleepless nights.

Remember, having a portfolio that fluctuates in value has almost never prevented someone from meeting their financial goals. However, not benefiting from the power of compound interest and the long-term upward trend of financial markets has prevented many people from living the life they deserve.

Asset Class Returns

One of the main goals of much of the financial industry is to provide you with guidance about what security, sector, or asset class will serve you best in the coming months and years. This has always been the case and it makes sense. Undoubtedly, in the years to come, some sectors of the stock market will do better than others. Perhaps technology stocks will lead the way. Or maybe energy stocks will produce the strongest returns. Or it could be consumer discretionary companies or consumer nondiscretionary companies. Although we don't know which of the sectors will perform the best, we do know that some will do better than others.

It's the same with asset classes. Perhaps small-company stocks will do better than large-company stocks over the next decade. Maybe commodities will outperform real estate.

Figure 2.2 shows the performance of several asset classes and portfolio mixes over a 20-year timeframe (1999–2018). As you can see, some investments have done better than others. The cumulative affect has been that investors in say, real estate investment trusts (REITs) have grown their wealth significantly beyond that of investors who purchased bonds (at least during the 20-year time frame measured in Figure 2.2).

Figure 2.2 Asset Class and Portfolio Performance (1999–2018)

SOURCE: Analysis by Brian Perry. Data from JP Morgan Asset Management & Dalbar Inc.

Consider that a $50,000 investment in REITs during that 20-year time frame would have grown to $330,311 while the same $50,000 invested in bonds would have turned into $120,585.

That, in one simple example, is why investors place so much focus on asset allocation, economic research, market forecasts, and the like. Picking the correct asset class, or mix of asset classes, can hold the key to financial success.

No wonder Wall Street churns out a constant parade of asset class forecasts!

No wonder the media talks breathlessly about the best or worst performing sectors!

Make no mistake: Buying the right sectors or asset classes can make an enormous difference in your investment returns and ultimately determine whether you achieve financial freedom.

A Twist in the Plot

Everything I wrote earlier is absolutely true. Some asset classes or sectors greatly outperform others. And choosing the winners will produce better results. But here's the interesting thing. Let's look again at that chart with the returns of the different asset classes and portfolio mixes.

This time, though, I'm going to add one bar to the chart. That bar, which you can see in Figure 2.3, represents the performance of the average individual investor across the past 20 years.

It turns out that it almost didn't matter what you bought over the past 20 years! Almost anything would have produced better results than what most people actually achieved!

Sure, buying real estate investment trusts (REITs) was better than buying bonds, and the S&P 500 did better than international stocks. But at the end of the day, buying and holding any of those would have outperformed the average investor's portfolio.

Figure 2.3 The Performance of the Average Investor (1999–2018)

SOURCE: Analysis by Brian Perry. Data from JP Morgan Asset Management & Dalbar, Inc.

The same holds true for asset allocations. Yes, different investors might want to have different investment mixes. And the asset allocation mix is one of the most critical decisions you need to make. But ultimately, nearly any reasonable asset mix would have done better than the actual experience of the average individual over the past two decades.

So, first I talked about the importance of asset allocation and selecting the best sectors or asset classes. But now I'm telling you it didn't matter what you bought, because almost anything would have done better than the average investor. So, what gives?

Time in the Market versus Timing the Market

The difference between asset class performance and investor performance comes about as a result of timing issues – namely, many people are getting in and out of sectors and markets at the wrong time, and all too often buying high and selling low. Moving in and out of the market and spending too much time on the sidelines prevents an investor from leveraging the most powerful tool at their disposal.

But what exactly is compound interest? Well, let's say you invest $10,000. One year later you've earned 10% on your investment, or $1,000. Now assume that in year two you also earn 10% on your investment. Have you earned another $1,000? No. You have in fact earned $1,100, because you earned 10% not only on your original $10,000 investment, but also on the $1,000 worth of gains you'd achieved in the prior year. (Please note that 10% annual returns year after year would be exceptional. I've selected that number simply for ease of math.)

This pattern would continue indefinitely; if in year three you again earned 10%, your dollar gain would come out to $1,210. Over longer periods of time, this compounding factor can produce truly immense gains.

In 10 years, $10,000 grows to $25,937

In 15 years, $10,000 grows to $41,772

In 20 years, $10,000 grows to $67,274

In 30 years, $10,000 grows to $174,494

In 50 years, $10,000 grows to $1,173,908

Figure 2.4 Growth of $10,000 with 10% Annual Returns

SOURCE: Analysis by Brian Perry.

For instance, using the initial $10,000 investment from the preceding example and assuming 10% annual returns, Figure 2.4 shows what your growth would look like.

As you can see, while the percentage returns remain consistent, wealth accumulates exponentially. That ability to convert small initial investments into vast sums reflects the power of compound interest.

That power in turn leads to a couple of important truths when it comes to organizing your finances.

First of all, time is your friend. The sooner you begin investing, the more likely you are to build wealth. In the earlier example, someone who had invested $10,000 shortly after graduating college would have accumulated more than $1,000,000 by their early 70s.

The second important takeaway is that compounding works in both directions. That same power that can build your wealth can also destroy it, if you allow yourself to become saddled with too much debt. The compounding effect of credit card, student loan, and other consumer debt can make it virtually impossible for some people to dig their way out.

The final takeaway is that, given that financial markets tend to go up more often than they decline, staying invested is vitally important. In other words, an investor needs to remain invested in order for compound interest to work its magic.

As we'll discuss in the remainder of this chapter, staying invested is something many individuals struggle to do. But for those who succeed, the rewards can be vast.

Why Are Las Vegas Casinos So Nice?

I need to be careful here in this section, because for many people, the idea that financial markets are similar to casino gambling strikes too close to home. So just to be clear in advance, I am not suggesting in any way, shape, or form that investing is akin to gambling. Speculating, short-term trading, and wading into markets you're unfamiliar with may very well represent a form of gambling. But long-term investing, when armed with knowledge and the intestinal fortitude to stay the course, represents a systematic endeavor with a high likelihood of success, which by definition is the exact opposite of gambling.

So, no, long-term investing isn't gambling. However, there is an important similarity between investing and gambling – namely, the importance of understanding probabilities.

Why are the casinos in Las Vegas and other large gambling centers so nice? Why do they have dancing fountains, rollercoasters, elaborate Egyptian or Parisian themes, or painted ceilings reminiscent of the Sistine Chapel?

The answer of course is that the reason casinos are so nice is that they can afford to splurge on decorations because they make a heck of a lot of money. Plus, the nicer or more elaborate the casino, the more likely people are to visit. And casinos, above and beyond all else, want to generate foot traffic to their location.

And why is that?

Well, it's because visitors might gamble, and gamblers, in the long run, always lose money. And when the gamblers lose money, the casino wins.

Yes, I realize that your Aunt Milly may have won $500 on a penny slot machine last week, and you may have had a good run at the blackjack tables last visit and gone home with an extra five grand in your pocket. Heck, sometimes casinos even get taken to the proverbial cleaners. Not that long ago, a group of high-stakes players went on a roll, and Wynn Casino in Macau lost $10 million! The loss was so large that Wynn was forced to disclose it publicly, because it had a material impact on their quarterly earnings.

But you know what? Despite the loss, Wynn opened its doors the very next day (or to be more accurate, the doors probably never closed in the first place). And Wynn would have been more than happy to invite those very same gamblers back at any point and give them another shot at winning big.

Why? Because while the probabilities don't mean that the casino is going to win every game, or every day, or even every month or year, they do mean that, in the long run, the casino is absolutely, 100%, guaranteed to win. There simply cannot be any other outcome.

After all, gamblers have the following odds on casino games:

• Roulette: 45%
• Slot machines: 35% (depending on the casino and game)
• Blackjack: 48%

Of course, that means that the house has the following odds on casino games:

• Roulette: 55%
• Slot machines: 65%
• Blackjack: 52%

So, if you're the casino, you stay open 24 hours a day, 365 days a year, come rain or snow or sun. Because the more you're open, the more people play, and the more you win.

The True Cost of Sitting on the Sidelines

The same principal applies in the stock market. Historically, stocks have risen on approximately 53% of trading days. The stock market has declined on approximately 47% of trading days. Of course, no one knows in advance which days stocks will rise, and nearly half the time they fall in value. Yet despite that fact, it still makes sense to stay invested, because over time, the odds are in your favor.

In a perfect world, an investor would participate in the market's upside while avoiding the downside. In this state of nirvana, the investor would perfectly time their moves in and out of the markets, thereby capturing the long-term upside while avoiding ulcer-inducing declines. The blissful investor would thereby meet their financial goals in a stress- and worry-free manner.

And that is precisely the goal of market timing, whose fundamental precept is to invest when markets are rising and then move to the sidelines prior to sharp declines.

Unfortunately, successfully timing the markets is an exceptionally difficult thing to do. After all, when markets are falling, how do you know if the decline will continue for six more months or if the rebound will start tomorrow? Similarly, although selling when markets seem overvalued might make sense on the surface, overvalued markets often continue higher for months or even years on end. And when the market does eventually decline, there is no guarantee that prices will fall below the level at which you sold in the first place.

And of course, a successful approach must be repeatable. And so, the challenge facing the market timer is not simply to move into or out of the market once or twice, but rather to do so again and again over the course of years and decades. And that ability to correctly anticipate when to buy and sell across different market environments, political regimes, and economic cycles, is very rare indeed.

If there were no cost to mistiming moves in and out, then perhaps the endeavor would make more sense. After all, a high-reward, low-risk strategy would be appealing. The problem, however, is that if your movements are anything less than perfect, market timing is one of the riskiest tactics you can employ.

That statement may sound odd. After all, isn't it risky to stay invested in an overpriced market that may eventually decline in value? Wouldn't prudently sitting on the sidelines make sense?

Well, for starters let's discuss two different types of investment risk. The first, and more commonly cited, is volatility. This is the figure you might see quoted in mutual fund reports or stock analysis websites. Commonly measured as standard deviation, volatility simply describes how bumpy an investment's path has been over time. And of course, the bumpier the ride, the more uncomfortable it is to hold on. This volatility is what many market timers attempt to mitigate by moving in or out of the market.

However, there is a second type of risk that I would argue is more dangerous than volatility. I'm referring to shortfall risk, which is simply the risk that your realized investment returns fall short of the returns you require to meet your financial goals.

This risk, in my opinion, is the far more important one. Think about it this way: if you go to Disney World, the route you take to get there and any delays you face along the way may very well impact the quality of your vacation. But wouldn't a far greater measure of how good or bad the vacation is simply be this: Did you ever actually get to Disney World?

Similarly, although you certainly want to minimize the bumps you face on your journey toward financial freedom, the far more important measure of success is whether you actually achieve that freedom. And that is why moving in and out of the market, with anything less than perfect timing, is so dangerous.

Consider two investors whom we'll call Jane and Tarzan. Both Jane and Tarzan started with $100,000. Both of them invested for 20 years. And most importantly, they both held exactly the same portfolio, allocated entirely to the S&P 500.

Jane put her $100,000 to work on day one and stayed invested through thick and thin for the entirety of her two-decade time horizon.

Tarzan did exactly the same thing, but with one important distinction. Tarzan sat out of the market for two months during that two-decade time frame.

Unfortunately for Tarzan, his timing was awful and those 60 days he missed out on turned out to be the best 60 days of the whole period. What kind of an impact do you think Tarzan's poor timing would have on his total investment returns, relative to Jane's total returns?

Jane stayed the course for the entire two decades and saw her $100,000 initial investment grow fourfold. On the other hand, Figure 2.5 shows that Tarzan missed the 60 best days during that period and saw his $100,000 drop by more than 70%! Keeping in mind that there were approximately 5,000 trading days during those 20 years, the difference between participating on 100% of those trading days versus participating in 99% of those trading days was $370,000!

Figure 2.5 Growth of $100,000 Invested in S&P 500 for 20 Years

SOURCE: Analysis by Brian Perry. Returns provided by JP Morgan Asset Management with data from Bloomberg; time frame 1998–2017.

What do you think? Would an extra $370,000 one way or the other have an impact on the quality of your retirement? Again, keep in mind that Jane and Tarzan had the same time horizon and invested in exactly the same thing. The only difference was that Jane stayed the course and Tarzan did not.

Does Crisis Equal Opportunity?

Let me ask you a question: When do you think the best trading days have occurred? Have they been during robust bull markets as stocks powered ahead? Did those magic days come following great economic news or reports of strong corporate profits?

No, they did not. In fact, most of the best days have followed sharp declines. Take a look at Figure 2.6.

That list shows the 11 best trading days in the history of the S&P 500, as measured by percentage gain. Six of those days came during the Great Depression. Two of them happened during the global financial crisis. Two more happened during the depths of the COVID-19 pandemic. And the only date that fell outside of some of the worst economic periods of the past century came immediately following Black Monday. As a reminder, Black Monday represented the most cataclysmic drop financial markets have experienced, with major market averages down more than 20%. The important takeaway is that every single one of the 11 best trading days occurred precisely when the average market timer was perhaps most likely to be sitting on the sidelines.

Ranking	Date	% Gain
1	3/15/1933	16.61%
2	10/30/1929	12.53%
3	10/6/1931	12.36%
4	9/21/1932	11.81%
5	10/13/2008	11.58%
6	10/28/2008	10.79%
7	9/5/1939	9.63%
8	4/20/1933	9.52%
9	3/24/2020	9.38%
10	3/13/2020	9.29%
11	10/21/1987	9.10%

Figure 2.6 S&P 500 Largest Single-Day Percentage Gains

SOURCE: Analysis by Brian Perry. Data courtesy of S&P Dow Jones Indices LLC.

And that brings me to another point. I've heard many people (presumably non-Chinese speakers) say that the Chinese use the same written character for both crisis and opportunity and that, therefore, “crisis equals opportunity.” In fact, I used this slogan in dozens of presentations over the years before discovering that it is in fact not true. Nevertheless, there's merit to the concept so I'm sticking with it, because as investors, crisis can equal opportunity, and bad news can be your best friend.

When you are in the accumulation phase of your financial life, a crisis and the falling prices it presents allow you to accumulate additional shares while they are “on sale.” In effect, falling markets help you to dollar-cost-average your portfolio, as your (hopefully) systematic contributions to retirement and other investment accounts purchase stocks at reduced prices.

The concept remains valid once you've retired and entered the distribution phase of your financial life. That is because you should be systematically rebalancing your portfolio during market declines, which means that you'll be selling assets that haven't fallen too much in value and using those proceeds to purchase additional amounts of the most beaten down assets. This is another form of dollar cost averaging, and although adhering to this discipline requires a level of mental fortitude, the results can be worth it, because the more stocks you can buy “on sale,” the better off you'll ultimately be. And keep in mind that, even in retirement, many of your assets are ultimately earmarked not for next month or next year but rather for a decade or more into the future.

So, the next time there's blood in the streets and markets are in free-fall, try to take a deep breath, relax, and systematically rebalance your portfolio. Because individuals who do that, while staying the course with their stock exposure, ultimately have far better odds of meeting their financial goals than people who move in and out of the markets based upon recent price action.

Sadly, many people lack the discipline to set and follow an appropriate strategy, so let me repeat myself one more time: don't swim against the tide. Be disciplined. Let the long-term upward trend of markets propel you to your financial goals.

Or, instead, you could try to successfully trade based upon forecasts of what the future holds. So now let's shift our attention and take a closer look at how well that strategy has historically paid off.