The New Year is upon us, and there are at least two things I can guarantee for 2016: For starters, during the first few weeks in January, the gym will be more jam-packed than the ladies’ room at a Taylor Swift concert. And second: Guys like me, who write about money, will all be urging you to boost your “financial fitness.”
However, recently I’ve seen the fitness metaphor taken too far, with the suggestion that you should pump up your portfolio by investing in actual fitness-related companies. Oprah Winfrey recently sunk $43.2 million into Weight Watchers, and Under Armour is three times as expensive as Nike on the stock exchange when the stock price is compared with the company’s earnings.
But here’s the thing you need to understand: A great product that you should definitely buy is simply not the same as a great company that you should definitely invest in. And as appealing as the Hey, you’re an athletic guy, harness those gym smarts and get rich in the stock market! story is, I’d urge you to practice caution. And by learning exactly why that circumspection is necessary, you’ll learn a lot about Wall Street, building wealth, and avoiding stupid mistakes.
For perspective, be aware that the whole idea of “investing in what you know” was first popularized by Peter Lynch, one of the most successful investors in history. In his 13 years managing the Fidelity Magellan fund (1977–’90), Lynch racked up annual returns that averaged 29%—such an absurdly high number that investment calculators won’t even let you plug it in. A $10,000 investment made in Magellan when Lynch first started the company grew to $280,000 during his tenure.
Lynch advocated the “sticking close to home” school of investing: looking for innovation at the mall, the office, or a restaurant. He invested in beaten-down Chrysler shares, for instance, after seeing a prototype of a new kind of vehicle called a minivan, and tripled his money. After his wife told him that Hanes was selling panty hose in little egg-shaped containers at the grocery store—a stroke of marketing genius—he bought the stock and rode the shares up sixfold.
It sounds so easy! And that’s what’s dangerous about it. (Lynch was so great at investing in what you know because, truth be told, there was a lot more to his approach.) So just because your protein powder has added two inches to your biceps doesn’t mean you should necessarily own stock in the company.
Don’t Go Pro
To understand why, consider GoPro. I love my GoPro Hero4 camera. I’ve taken it to the top of the mountain when skiing and down into the Caribbean to snorkel with sea turtles and rays. I’ve strapped it on while mountain biking in Arizona and Colorado. I’ve taken it out fishing in nasty weather and never had to worry that it would get wet. (Expert tip, fellas: Stick the lens really close to the fish’s face to make your catch look bigger.) The videos of my exploits have impressed my wife and kids and scared the hell out of my mom. It’s a great little machine with a rabid fan base. So the stock must be a winner, right?
Well, not exactly. A good company is only a good investment if you can buy it at a fair price. But excited investors snapped up GoPro shares as soon as they went public in 2014 at $24 and quickly sent the price up to $98. One way to value stocks is to compare their price to the company’s earnings—what’s known as the price/earnings ratio. The average stock at the time sold for about 18 times the company’s profits, which is a little on the high side, based on history. GoPro shares were selling for 240 times the company’s earnings, an insane valuation that suggests a fad, not an investment.
Investors started worrying whether the company would do well enough to justify that kind of price. Could Apple add features to an iPhone that would render the GoPro obsolete? Was Sony—which makes the camera’s sensor but also sells its own action cam—a threat? Would GoPro prove to be a one-hit wonder? At press time, the shares had skied all the way back down to $24. A round trip to nowhere.
Recognize your advantages
If you are tempted to throw money at a company that makes a hot product, follow the process of investor Barry Ritholtz. After decamping from New York City to the burbs with his wife in 2001, Ritholtz headed to Home Depot to furnish his new house. As any city kid knows, Home Depot is to the neighborhood hardware store what Notre Dame is to Pop Warner football. Ritholtz, now chairman and CEO of Ritholtz Wealth Management, was in awe of the retail palace. But instead of buying the stock, he went to his Bloomberg machine and dug deeper. He saw that the shares had gained 3,500% over the previous decade. “It was clear that other people had known about this for many, many years,” he says. “I was late to that party.” Good call, Barry.
The stock was cut in half over the next 10 years, despite selling home goods into the greatest housing bubble in history. Rather than playing a game that’s stacked against you, Ritholtz suggests you recognize the advantages that you have over Wall Street. For starters, as long as you are investing with long-term funds that you won’t need for decades, you have time to amass wealth without betting on any single stock.
“You don’t have to worry about shorter-term nonsense that typically turns out to be noise,” he says. “I’m looking out 30 years, what do I care about this quarter’s earnings?” This is a huge advantage. When the market plummets—as it periodically will, count on it—professional money managers have to sell in order to return money to panicked investors. That selling sends prices lower, forcing yet more selling. Scary, yes. But every two weeks when you make that 401(k) contribution, you are buying more stock for the same amount of money. Second, by not jumping in and out of stocks, you won’t pay commissions and trading costs or get nickel-and-dimed by “flash trading” and other Wall Street practices that can disadvantage the little guy. “If you are not in the pool, you don’t have to worry about getting bitten by the sharks,” he says.
So what’s the smart way to make money in the stock market? Ritholtz recommends simple index funds, which own nearly every stock in the market, are the cheapest way to invest, and are what he uses for the wealthy clients in his hedge fund. Warren Buffett, incidentally, recommended in his will that 90% of his wife’s inheritance be invested in an index fund.
Ritholtz joked that CNBC’s energetic commentator Jim Cramer would serve viewers better if he took a different approach to his nightly show. “I think Jim should walk out and say: ‘Hold a widely diversified, broadly international portfolio of index funds and rebalance once a year. Good night.’ But then what would they do with the other 59 minutes of the show?”
Wall Street, of course, prefers that you follow a much more complicated investment scheme that will generate higher fees. “There is a tremendous noise machine that is very active trying to capture people’s eyeballs and clicks and wallets,” Ritholtz says.
Numbers are not available for this year yet, but in 2014, 81% of mutual fund managers who pick stocks did worse than the index funds they are trying to beat. If you think you can do better than four out of five professionals, go for it. Otherwise, instead of buying fitness stocks, just put your money in index funds and head to the gym.
Jack Otter is the author of Worth It...Not Worth It? Simple & Profitable Answers to Life’s Tough Financial Questions.