Contrary to many people in the financial independence/early retirement community I have always been a stock picker and have no interest in becoming an index investor. I really do believe that for an individual investor it is certainly possible to beat the index and thus achieve financial independence sooner.
This does not mean the FIRE community has it wrong. On the contrary, I think they are very right to promote low cost index investing for the majority of people. It is a sure way to financial independence.
Investing in individual stocks is only something you should do if you love it and have the personality for it.
For the love of the game
You really, really have to love it. You have to love reading books about it. Reading even more about companies you think to invest in. Read their annual reports, their balance sheets. Read about the CEO of a company. Or books about past great CEO’s so you can identify current great CEO’s! You have to love it, because in the beginning your efforts will be in no way compensated by your profits. Investing is something where you have to do the bulk of your effort in the beginning. But that is also the moment where you have the least amount of money so your reward for all that effort will be the smallest. Getting a return of 10% on a stash of 30.000 euro is great but it is only 3.000 euro. And there is a mountain of reading to do to just cover the basics. If you would calculate your hourly pay for all that reading you probably only made a dollar per hour …
Fast forward 10 years and your stash might have grown to 300.000 euro. Making 10% then is 30.000 euro. And since you have already learned most in the early years and have a few companies where you have done your extensive homework, the work you need to do is little to none.
Because of this reversed compensation structure you really need to love investing and stock picking to get you through those first couple of years.
The right personality
Not only do you need the type of personality that loves reading about all the stuff I mentioned above. You also need to be the type of person that loves numbers. There’s the balance sheet of the companies. There is the stock price, your return, the risk you run … Numbers, numbers, numbers.
And then you need to be able to see past the numbers. Recognize trends but also be able to determine which companies have a big moat, which numbers are relevant for which sector. Which company has an excellent management and which has a crap one. Does the story the company tells you in its annual report and in its balance sheet match? And does it all make sense or is it a reincarnation of Enron?
Are you disciplined enough to stick to your own rules and not be influenced by the daily noise the stock market generate every day? Can you handle the up and down swings of stocks? To give you an example of the latter: I had a 60.000 euro position reduced to around 24.000 euro in a matter of a year! I was earning 2.000 euro a month by working, and here I was losing 36.000 euro in one year! I can tell you it hurt. It physically hurt! It would talk 7 years before I could exit the position profitable. And it is in large part thanks to some fancy option work (and luck) that after 7 years I could walk away with a 41% profit. But 41% on a 7 year period is only a compound annual growth rate of 5.14%. Believe me, I paid for those 5% with pain and a tenacity I really did not know I had (if there is any interest I will dedicate a seperate post to this ‘very painful’ investment). So the question is: do you have the right personality for it? If not, well as mentioned before, index investing is a perfectly fine way to achieve financial independence.
Beating the index
In my opinion it is certainly possible for a private investor to beat the index. I also believe it is very difficult for an actively managed fund to beat the index. The reasons are very simple.
– Professionally managed funds have a very high cost basis. They have insane overhead and personnel costs, eating up a nice chunk of return. Your cost structure is close to zero.
– they have tons of government rules to follow, and then a shit load of internal rules to follow. You have absolute flexibility.
– Private investors can take advantage of the career risk of professional investors. Lyn Alden in a guest post over at amber tree leaves explains this well. She also explains option trading pretty well. I too like writing options and her post is well worth the read (personally I keep my distance from commodities and precious metals, but I agree with everything else she wrote).
-financial velociraptor just wrote a fantastic post about three different asset classes that should return above 10% at the least (selling or writing options is one of them, hmm great minds think alike). Go read this post people! it is really brilliant in my humble opinion. And after you are done with that post, read everything he ever posted about UVXY. That is a truly horrible financial product and he found a way to profit of it! Another brilliant find!
Conclusion
If you love it and you have the personality for it you should definitely become an active investor. It will turn into a livelong obsession that will probably change the way you look at the world. Figuring stuff out. Or discovering a great investment opportunity can give you an incredible rush! The money is just a nice extra!
Great write up. It takes indeed dedication, sweat, some stress and a plan to have consistent returns in whatever active investment strategy you pick.
I have picked the option path… Not the easiest one, well the one that suits me best.
Lyn Alden has indeed written a great post.
And the uvxy strategy is one I plan to try one day. Especially after burning myself on his little brother.
A big advantage of option premiums is that for the moment they are tax free. That makes a big difference compared to the current 30% tax on dividends (and something our more dividend loving fellow FIRE enthusiasts should really run the numbers on ;-).
Another advantage in my opinion is that volatility is something professional investors apparently are ok to take into consideration to determine the option premium but you as a long term private investor can pretty much ignore. It makes for better returns and also for very fun conversations with ‘professionals’.
Fingers crossed the government does not screw up to hard options… And when they do, losses should be taken into account.
If you do not take options into consideration smart investors can avoid a tax on capital gains on stocks completely. Example: if stock price is 40, you write a put at 50 and get 11 premium (which would be tax free). In reality you buy at 39 but for tax purpose you have bought at 50. If the stock appreciates, you can still sell at 50 and not have to pay any capital gain taxes and then just write a new put at 60 …
But if you do want to include options in the taxes things still are tricky. Do you tax when an option is written or bought or when he is sold or closed? And what do you tax? Realized gains minus losses or also unrealized gains minus unrealized losses? Because premium can be taxed but if assigned you can have an unrealized loss on the underlying stock. The reverse is actually also possible. If you take both realized and unrealized gains minus losses, hell I can make it look like I have zero profit for the past year by making a construction that will only let the profit emerge in the next year, and the next year off course push the profit out even further. If you only tax realized profits minus losses and not the unrealized, well then I hope for the government there is no tax credit for those losses because in that case I am going to have a realized loss of 20.000 each year and an unrealized gain of more than that which I will keep pushing to the next fiscal year for a decade to come …. Buy and sell, put and call, strike price and expiry date, you can play with those things a lot and decide where profits land and in which year they land … Good luck to whomever wants to created a fool proof tax for it …I think there is a reason why the Dutch went with a tax on a theoretical return. The Amsterdam stock exchange has a pretty active option trading activity so it appears that at least one person in government understood the possibilities and knew that if they would tax realized profits the financial industry would create products that would let them push the realization of those profits to eternity. No, the real threat is a wealth tax like the Dutch have but luckily for us, that is not where the discussion is going … I would off course rather avoid all of this but some in our government seem to be hell bent to discourage saving and investing.