March 18, 2019
Despite my best attempts, majority of people around me still dabble in stock picking. I’m not here to convince you that passive index investing is superior. It is probably self evident to anyone reading a blog called Effai.me. You must have heard all the evidence and you know stock pickers, on average, under-perform — including the pros.
I do want to share a fun story though. It comes with a lesson that happened to cost very little to learn but had the potential to cost hundreds of thousands of dollars.
It all started around 2009. This was the year I made my first investment. It was right around the bottom of the recession. Before you start calling me an investing genius, let me stop and explain. I have picked 2009 as the year to start investing because it was the first time I ever had any money to invest — Nothing more, nothing less. I did not call the bottom. I did not have any insights. I just had cash.
My strategy was very clever though. In fact, my entire retirement plan was brilliant. I was going to invest solely in “Dividend Aristocrats”. Dividend Aristocrats is an exclusive list of companies that have been increasing their dividends for 25 years in a row. You heard that right. Increasing — not just paying out.
The nice thing about companies belonging to the dividend aristocrats was the semi-regular dividends that would come in. At the time, it was paying roughly 4.5%. My plan was to accumulate enough wealth that I could live exclusively on the dividends. I would never have to touch the principal.
I picked only the companies that had a price to earnings ratio that was below 17, a consistently decreasing number of outstanding shares and a couple of other indicators I chose.
Considering the stability of these companies for the last 25 years, the regularity of the dividend, never having to touch my principal and the favorable indicators, I thought I was bulletproof. What could be better?
Easy! What if… I took the historical price data of the 20 or so stocks that ended up in my portfolio, and back tested my strategy. In other words, what would happen if instead of buying these companies in 2009, I bought them in 1995. I certainly haven’t figured out how to turn back time. But it would be very reassuring if my new portfolio performed well in a back test.
And boy it did! In my back test between 1995 and 2009, my 20 dividend aristocrats with all the dividends reinvested would triple the performance of the U.S. market.
To say that I was ecstatic would be an understatement. I was overcome by euphoria and joy. I imagined retiring in my 30’s with millions in the bank, jet setting all around the world. I would have a wonderful life. The only thing I couldn’t figure out was how come no one else figured it out.
I remember the day I realized my mistake. I call it black Wednesday. I was walking to work, still elated by my discovery. I was passing by the Scotia bank building in Toronto on my way to the office. The building had a convenient stock ticker display. I remember looking at it when it hit me.
What I did there with my portfolio was a classic cognitive error. I back tested stocks I selected in the present based on data from the past. Then I pretended to buy them in the past to see how they would do until the present.
In other words, I got to pick stocks with the best histories while ignoring all the dividend aristocrats from 1995 that never made it to 2009. I just experienced what is referred to as survivorship bias.
If we were to compile a list of dividend aristocrats in 1995, the stocks I would have picked would have looked very different from the 20 stocks I picked on that day in 2009. In fact, many of those companies didn’t even belong in the dividend aristocrats list in 1995. At the same time, many of the companies in the list in 1995 were out of the list by 2009. Some may even have been bankrupt. If I was to apply the same strategy in 1995, my portfolio had to look different. There was no other way.
Maybe I won’t triple the market over the next 2 decades, I thought to myself. I could settle for a 50% out performance instead. Most pros would die for that.
It took me another couple of months of stock picking before I realized that diversifying over 20 stocks is not the same as diversifying over 2000. Having 10 out of my 20 stocks perform badly isn’t out of realm of possibilities. Yet it would represent half my portfolio. I needed a little bit more security.
I decided to buy the entire Dividend Aristocrats index. The ticker for it is SDY. It included over 100 different companies (and still does). That seemed a little safer.
The straw that broke my portfolio’s back was the moment I added up all my expectations. If I wanted to outperform the market by 50% over a period of 15 years, my portfolio needed to return an additional 2% a year on top of the average. That may not sound like a big number but it turns out to be exceptionally unlikely. If I was to achieve this feat, I could probably join the upper echelon of portfolio managers on wall street.
Tack on the fact that Dividend Aristocrats index charges an additional 0.3% in management fees and I quickly realized my dreams of being an investment guru were crumbling.
Eventually I settled on a simple index fund tracking the entire world. No stock picking necessary (I own everything). No rebalancing necessary (I own everyone). I finally accepted my fate. I was at peace.
This was a personal anecdote. On the surface, everything looked correct. The math was right. The companies were great. The history was solid. The reality was different though. It’s important not to be fooled by these numbers. Unfortunately, you’re the easiest person to fool.
I started investing that year. Once I realized my mistake, I had to readjust my entire portfolio. But it wasn’t a big deal. My portfolio wasn’t a big deal. The problem is that many people spend years (or decades) fooling themselves. That could be costing them tens or hundreds of thousands in fees and missed opportunities (not to mention the disappointment).
Now days, I advocate keeping your portfolio as simple and stupid as possible. It’s so much harder to go wrong with that advice.
Written by Leon Tager who lives and works in Seattle writing about a better life. You should follow him on Twitter