Money you can afford to lose

If you go to any online community related to money you will find people talking about their desire to learn about investing by researching and selecting individual stocks. They understand that this is risky, they will say, but they will only try it out with money that they can afford to lose.

This statement implies a lot more than people realize when they write it. What puts you in a position to have money that you can afford to lose? At the very least, you need be financially independent. That is, have enough financial capital that you do not need to rely on your human capital to meet your desired lifestyle.

Let me give you some context to understand that: to spend $5,000 per month, adjusted for inflation, for 30 years, you would need to have about $1.7M in an investment portfolio. Most people, especially people wanting to get their feet wet with stocks for the first time, are not in this position. Until you have attained financial independence you cannot afford to lose any money.

Not only are most people not financially independent, but they are probably not saving enough to eventually become financially independent with the lifestyle that they want. They are also likely to have debt, a lack of emergency savings, and a lack of life insurance coverage. Where is this money that you can afford to lose coming from?

It’s not just losing money that you have to worry about either. You might pick a stock that drops a little bit and then sputters along for a while before you sell it. Great learning experience, right? Even if you do not sell it at a loss, you may have missed an opportunity if the market has gained over the holding period. This opportunity cost is as good as a loss in terms of achieving your financial goals.

It would be one thing if you had a reasonable chance at picking winning stocks, but you most certainly do not. For example, if you had picked one of the S&P 500 constituents at random in January 2017, you had a 53% chance of underperforming the index as a whole by the end of December. For anyone keeping score, that is worse than flipping a coin.

I know that the premise of this conversation is based on the idea that you are able to learn about investing by picking stocks, and maybe you can even get better at picking them as you learn. Unfortunately this is not how the stock market works. You may be able to learn a little bit about how to open a brokerage account, how stocks trade, and even how to analyze companies. Those things might be empowering to know, but there is no reason to believe that they will make you better at investing.

The stock market is a pricing machine. For the most part, it instantly prices stocks based on the aggregate information of market participants. No matter how much you may know about a company’s earnings, growth prospects, or business model, you have to know more than everyone else in order to have a performance edge. Put another way, it is not your absolute information and skill that matters in picking stocks, it is your relative information and skill.

If you do not have better information and more skill than other market participants, then they may be taking advantage of you when you trade. When you buy a stock, you are buying it from somebody. When you sell, you are selling it to somebody. Who are these people on the other side of trades? They are mostly large institutions whose core business is buying and selling stocks. I think it is a bit of a stretch for any individual person, especially a person trying to learn how stocks work, to believe that they have an edge in terms of information or skill.

The odds are massively stacked against you. But don’t worry, it’s not just you that the odds are stacked against. Even those institutions have trouble beating the index. For the 10-year period ending December 2017, only 1.67% of mutual funds in Canada that invest in US stocks were able to beat the S&P 500 index.

If you get to a point in your life where you are financially independent and you still want to trade stocks, the next question that I would be asking is what causes are important to you? Is it more fulfilling to make risky bets with a negative expected outcome by picking stocks, or to donate all of that extra money that you can afford to lose to support something that is important to you?

Stock picking is well documented as a losing game. It is, by all accounts, akin to gambling. Experience trading stocks does not make you a better investor. I do not see how the average Canadian has any money to lose in an effort to learn about something that will not benefit them in any way.

I’ll leave you with a quote from the 1967 classic book The Money Game: “If you don’t know who you are, [the stock market] is an expensive place to find out.”