In this post, you’re going to learn the 5 reasons why you shouldn’t passively invest in stocks.
People who are looking to get into the stock investing space typically ask me, “What are the top stocks to invest in”?
Is it Apple? Google? Netflix? How do I find the next Amazon?
Should I research some companies and pick stocks or should I just buy and hold? Should I actively manage my money or should I passively buy an index fund?
These are all valid questions.
There has always been debate between picking stocks, buying and holding, and buying index funds.
Regardless of the strategy, it has always been conventional advice to invest in stocks when you are young because stocks provide the highest return over the long-run. Under this advice, you would buy some stocks and hold them for 30 or 40 years until retirement in hopes of turning out with a decent sized nest egg.
However, I respond by telling them that they actually shouldn’t be investing in stocks at all.
Here are my reasons why:
Buying stocks is a 50-50 bet
Would you put money on a flip of a coin?
In this section, we'll lay out the reasons why betting on the stock market is a flip of a coin.
Buying stocks in hopes of it appreciating in price is a coin flip.
Here’s the reason why:
When you invest in stocks, you are making an assumption that the stock market will go higher in the future.
However, there is an equal chance of the stock price going higher as the chance of the stock price going lower. You can see this proven in the graph below.
This graph displays the distribution curve of the daily returns for the S&P 500 index. The horizontal axis represents the daily percentage change. The vertical axis represents the number of occurrences.
This graph shows that the average daily price change is centered around zero. Sometimes the daily stock market returns are positive, but daily stock market returns are negative at the same frequency.
The stock market does have a general bias of going higher.
In fact, the stock market goes higher around 53% of the time. This could be due to a number of reasons like innovation and growth of the economy or the risk-free rate of return.
So, when you see stocks like Amazon or Apple that has only gone higher year after year, those stocks are simply outliers.
An event or observation point that distant from other observation points.
There is a slim chance of you actually picking a stock that will do the same in the future.
This is because on average, stock returns hover around zero percent.
The stock market is a two-sided market so having to pick stock direction correctly is a tough bet.
Buying stocks has no underlying strategy
Some may lead you to believe that there is a stock picking strategy that will give you double digit returns without any risk.
However, there is no strategy like that.
Let's find out why.
You may think there is some strategy to building a stellar stock portfolio to invest in.
There are market gurus who will try to tell you that there is a secret system to picking stocks or a trading algorithm that can double your account overnight.
However, this is far from the truth.
There is no strategy to buying stocks or trying to figure out the best stocks to invest in.
This is because the markets are random. You may think that there is some magic formula to investing in stocks, however, it is not proven with data.
It is simply a educated guess at best, not a proven strategy.
In fact, randomly picking stocks from a list will produce the same, if not better returns than trying to pick which stocks to buy.
So, the “strategy” is just to buy and hold stocks and hope that it goes higher in the future. This is not much of a strategy.
A similar analogy might be coming up with a strategy for picking numbers on a game of roulette.
You may think that you are coming out ahead by strategically placing your bets and picking certain numbers, but at the end of the day, it is all random.
If it wasn’t random, the casino wouldn’t make any money.
Passive stock investing makes you complacent
In this section, we'll explain why passive stock investing makes you a complacent investor.
Why is complacency a bad thing when it comes to your investments?
Let's find out the answer.
Many investors have become complacent with a bull market that has returned a positive amount for the past 10 years.
The US economy has been in an incredible cycle of growth for the last 10 years.
This is caused the stock market to go higher and higher each year.
This makes investing in stocks a compelling argument because it would have worked for the last 10 years or so.
Why not buy and hold some stocks, it only goes higher?
However, this is the big red flag.
Investors have gotten extremely complacent with positive stock market returns.
When you are passively invested in stocks, you are simply unaware of the business cycles.
Look at foreign stock markets like Japan. The Japanese stock market has not gone higher year after year. There is a possibility that this could also occur in the US stock market.
There have also been times in US history where the stock market did not give positive returns for decades at a time.
You simply cannot be complacent and you cannot ignore the possibility that the stock market may not go higher. There has to be some awareness of the different situations that could occur and have the knowledge and skills to do something about it.
You miss out on intellectual benefits
There are other intellectual benefits to active investing.
In this section, we'll outline what you miss out by passively investing in the stock market.
Let's get started.
When you passively invest in stocks, you miss out on some key intellectual benefits.
The main benefits are just general awareness of opportunities and ability to assess risk.
There is absolutely nothing in life that will produce the results you want to see by being passive.
If you want to learn a new skill, you cannot passively learn that skill.
If you want to lose weight, you simply cannot be passive about trying to lose weight. It simply does not work that way.
Investing in the stock market is no different. You have to take an active approach when it comes to your trading. It is your money and only you will do what is best for your money. No one else.
What happens when the stock market stops going higher?
When you are passively invested, you don’t have any knowledge or skills to take any action to better your position or to act on opportunity.
The only thing that you know is buying or investing in stocks because they only go higher.
You pigeonhole yourself into a position where you are at the mercy of the stock market.
When you are actively managing your investments, you begin to see risk and opportunity in a new light.
You can identify where there is opportunity and begin to assess expectations around that opportunity.
There is so much opportunity in the stock market aside from it going higher.
There are times when the stock market goes down or stays flat.
These are all moments of opportunity that you can take advantage of if you are active in the stock market.
You learn how to construct a portfolio. You learn how correlations work in practice. You see opportunities in volatility.
You can also begin to gauge risk differently. Active investment management helps you see these risks and even assign probabilities to levels of risk or levels of opportunity.
This even extends outside of the work of finance. Having the skill of looking at risk and opportunity in a probabilistic manner is applicable in any decision making process.
Let’s take the 2008 stock market melt down as an example. If you were passively invested in stocks during this time frame, your investments got wiped out and took you almost a decade to get back to even.
However, if you were actively investing, you would have spotted an opportunity of a lifetime that in hindsight resulted in one of the longest bull markets in history. In the midst of all the chaos, there was opportunity that you would have only noticed if you were active in the markets.
Is there a better alternative?
There has to be a better way to invest in the markets.
Options trading is that answer.
Let's find out why.
Is there a better way?
In fact, we think there is a better way to invest in the markets.
Investing in the stock market does not have to be this way. There is an alternative to the traditional passive stock investing that avoids all of these negative characteristics.
That’s why we actively trade options contracts.
Options contracts are simply a tool to take advantage of opportunity using probabilities instead of directional market bets.
Options contracts are powerful tools for active investments in the market.
Let me explain.
When you invest in stocks, you fundamentally have to make a directional assumption on the future stock price, which we already established is a 50-50 bet.
Instead, with options trading you can construct strategies that have more than a 90% probability of success.
How is that possible?
It’s because instead of making a directional bet, most of the options trades we execute are non-directional in nature.
This means that we can profit if the stock price does not move at all or if the stock price stays within a predefined range.
Even when we do take directional bets, the options strategies we use allows us to make those directional bets with a high probability of success.
This higher probability of success allows us to make more consistent investment profits.
Now It's Your Turn
Do you passively invest in stocks?
Or do you actively trade options contracts?
Either way, let me know in the comments below.