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[Alex] The world of investment advice is a crowded and noisy place.
The good news is, you can turn down the shouting.
And you also don't have to follow stock quotes
minute-by-minute in order to be a smart investor.
In the next few videos, we're going to lay out some rules
for smart investing.
No, we're not going to tell you how to get rich quick,
but we will give you some good advice
for getting richer slowly and steadily.
Now let's start with Investment Rule #1,
"Ignore the expert stock pickers." What if I told you that a blindfolded monkey throwing darts
at the financial pages could select a basket of stocks that would do just as
well as one chosen by the experts? That was the controversial claim made
in 1973 by economist Burton Malkiel, in his book, A Random Walk Down Wall Street.
Years later, one of his undergraduate students turned out to be
journalist John Stossel. And Stossel, he set out to test this claim. Now,
blindfolded, dart-throwing monkeys, they're not easy to come by and the lawyer's a
little bit worried, so Stossel threw the darts himself.
- [John] My darts landed on 30 companies. How would they do compared to the stocks
recommended by managed mutual funds? Oops! Better!
- [Alex] Sure, Stossel got lucky on his throws and he reaped high returns. But the lesson
here turns out to be correct. Random picking does just as well as the
professionals. Let's take a closer look. Most people
invest in the stock market by buying a mutual fund, a portfolio of assets like
stocks and bonds managed by professionals. There's thousands of mutual funds. Some of
them are actively managed. They have experts picking stocks and charging fees.
The other type of mutual fund is called a passive mutual fund. Passive funds don't
try to pick winners or avoid losers. They simply invest in a big basket of stocks
such as the S&P 500. Now this chart shows the percent of mutual
funds that were outperformed by the S&P 500. You can see that in most years, the
S&P 500 beat a majority of the actively managed mutual funds. Okay, so perhaps
you're thinking, "I got it. Most mutual funds don't beat the market, but what if I
invest in the ones that do beat the market?”
The problem with this strategy is that the funds that beat the market are different
every year. In other words, past performance does not predict future
performance. The funds that beat the market this year - they probably got lucky.
And they're unlikely to beat the market next year. In fact, one study looked at
the 25% best-performing funds. How many of these funds were still top performers just
two years later? Less than 4%. And after five years, only 1%
of the initial top performers remained in the top quarter. So funds which are great
this year - they're probably not going to be so great in the future. They probably
just got lucky. Okay, what about those very, very few funds that do beat the
market over many years? Hasn't Warren Buffet, for example, the world's most
successful investor. Hasn't he shown that you can beat the market? Maybe.
There's no denying - Buffet's a very smart guy; he's made some very good choices. But
it's actually harder to distinguish luck from skill than you might imagine. Let me
explain. Imagine that we started with a thousand so-called experts, except all the
experts do is flip a coin. Those who flip heads say the market is going to go up
this year. Those who flip tails, say the market is going to go down this year.
At the end of the year, 500 are going to be right, purely by chance. Now suppose
that those 500 then flip the coin again, and they make a new predication. At the end of
the second year, 250 of these so-called experts, they'll have been right two years
in a row. Again, purely by chance. Now keep going with this logic. At the end of 5
years, just 32 of the original 1000, they will have been right about the market 5
years in a row. Now these 32 - they'll probably be labeled
market geniuses. They'll show up on television. Their services will be in high
demand. Perhaps some of them will write books about - how to predict the stock
market and get rich quick. But the laws of probability tell us, however, is that
out of the initial 1000 experts, about 32 were going to predict the market correctly
no matter what the market did. So are some market geniuses truly
skillful? Sure. But it also helps to be lucky. And it's sometimes not obvious which
is more important. In recent years, in fact, Buffet's investments haven't done
all that well. So lesson number one is ignore the people who shout stock tips at you.
- [Man] Dividends funded by debt and not excess free cash flow are just too risky
to own from now on!
- [Alex] And definitely don't pay big bucks for professional money managers. But what if
you have some information about what looks like a great investment? Can you beat the
market? Well we're going to cover that and the Efficient Market Hypothesis
in the next video.
- [Narrator] Check out our practice questions to test your money skills. Next
up, Tyler will show you how a tragic space shuttle explosion can teach us about
investing. Click to learn more.
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