The World’s Most Expensive Hobby (Part 1)
- Hobbies can provide lasting benefit by allowing individuals to refocus their efforts away from their careers towards alternative forms of enjoyment.
- Nevertheless, active investing as a hobby might not be the best use of one’s free time.
- Not only are the chances of adding value from this endeavor very slim, but also, the costs associated with investing unwisely can profoundly impact one’s long-term goals and aspirations.
- As an example, most investors often overlook opportunity cost when making investment decisions even though this particular expense can be significant.
When it comes to deciding what to do with one’s free time, it’s imperative to choose wisely, because time (rather than money) is your most valuable commodity. But using your free time to make more money may not be the best for your long-term health and wealth. Let’s explore.
Hobbies Are Great!
Having a hobby is important for long-term health and well-being. The ability to get away from one’s career and focus on an alternative activity that can provide fun, enjoyment and intellectual stimulation can be invigorating and wholesome.
A hobby is a regular activity that is done for enjoyment, typically during one’s leisure time. Hobbies can include collecting themed items and objects, engaging in creative and artistic pursuits, playing sports, or pursuing other amusements. –Wikipedia
There are many hobbies that you may choose to pursue over your lifetime, but if you’re on the lookout for something new and interesting, this list from Wikipedia has hundreds to choose from. However, I find it completely surprising that one popular hobby did not make the list. You guessed it. Investing. But more specifically, I’m talking about active investing.
Hobbies Are Great?
As I’ve discussed in the past, the goal of active investing is to outperform one’s benchmark through the active selection and timing of investments that one thinks will ultimately, in aggregate provide greater value than a passive investing strategy, such as simply investing in an index fund that is tied to one’s benchmark.
Granted, hobbies are not meant to be for making money. But what I’ll soon argue, neither is active investing. Essentially, in the world of investing, “making money” can have two meanings; the first is turning a profit, the second is beating one’s benchmark. The former is easily accomplished with a simple passive investing strategy. Indeed, this can even be done with minimal risk by investing in U.S. Treasuries. The latter is next to impossible according to the Efficient Market Hypothesis, as we’ve discussed in my series, Why invest in one thing over another? And for added evidence to back up this assertion, in my previous series, Passive is the New Aggressive, I provide analysis that suggests that actively managed mutual funds don’t even outperform their benchmarks on average.
Accordingly, if you plan to take on managing your own investment portfolio, consider this:
Whenever you decide to make any investment decisions, the impact that you can potentially make to your future well-being is tremendous. So BIG that if you invest poorly, you could be left with far less wealth than you should have otherwise, which could potentially add years to your working career before you have enough saved for retirement.
Nevertheless, almost all of us at some point have experienced or have heard of someone that has experienced the excitement of making that one great stock pick that paid off handsomely. Therefore, given the many pitfalls, but also potential excitement associated with managing one’s investments, I consider active investing, in particular, to be “the world’s most expensive hobby”, and over the course of this series, we’ll explore why I think this way.
So to kick off this topic, let’s discuss one big cost associated with investing in general that is all too often forgotten; i.e., opportunity cost. Most people do not consider “opportunity cost” to be an expense because this type of cost is not exactly visible on a brokerage statement nor is it paid directly to anyone. Nevertheless, ultimately this “expense” can be the most impactful component to your future returns so it definitely should be taken into consideration with any investment decision that you plan to make. Let me explain.
Opportunity cost represents the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them. –Investopedia
Let’s say your benchmark is the S&P 500® Index and you have $10,000 to invest for your retirement that is many (many) years away. However, it’s the beginning of 2017 and the S&P 500® Index is near its all-time high so you are reluctant to put your money to work in the stock market.
Note: we’ll discuss this particular concern in detail when we dig into the joys of market timing.
So instead you opt to wait for the market to dip into correction territory before investing in stocks, which would suggest waiting for a fall in the S&P 500® Index of about 10% from its peak. In the meantime, you temporarily place the $10k in a money market account that provides an annual yield of 1%.
Hypothetically Speaking, Of Course
Unfortunately, the “dip” that you were looking for never transpires over the entire year, as depicted in Figure 1. Given this, your initial capital of $10,000 has “grown” to an unimpressive sum of $10,100 by the end of 2017. However, inflation for the year was upwards of 2% for the year, so the buying power at the end of the year of your $10,100 is closer to $9,891. And don’t forget, you still have to pay ordinary income taxes (which can be close to 40%, depending on your personal tax situation) on the $100 you “earned” in interest. Therefore, ultimately the buying power of your initial $10,000 actually fell over the year once you factor in all this.
But let’s not also forget: your benchmark was the S&P 500® Index, which was up almost 21.8% (including dividends and distributions) for 2017. You could have earned very close to this return by investing in an index fund whose benchmark is the S&P 500® Index; essentially 21.8% minus an expense ratio of 0.08%, or 21.7%. In dollar terms, your $10,000 would have grown to $12,173 after fees. Adjusting for inflation, your investment would still be worth around $11,922 so you’re still talking about a nice profit at this point.
Of course, there are still taxes to pay in this scenario as well, so let’s touch on that. When it comes to taxes on an S&P 500® Index fund investment, there are three components to consider. The first is dividends from the 500 companies that make up the index.
The second is distributions (a.k.a. realized capital gains). This can occur if, for example, a company leaves the list of 500 companies as another one enters. When the company leaves, the fund must sell the company’s stock in the fund, which may create a taxable event, known as realized capital gains. As such, at the end of the tax year, if there are gains from any sales the investors will be subject to paying taxes on these gains that are not offset from any losses from other sales. Fortunately, the constituents of the S&P 500® Index are fairly stable, and thus, the impact of distributions on this particular index is not major.
The third, and most important, is the rising price of the S&P 500® Index, which for 2017 was indeed major. However, because you don’t plan on selling for a long time, you might not need to pay taxes on this component of the gain for quite some time. The dividends and distributions (which yielded around 2% in 2017) will be taxed in 2017, but the gains resulting from the S&P 500® rising in price, known as unrealized capital gains (which yielded around 20% in 2017) will only be taxed when you sell your position. This is because there is a big (and important!) difference between how interest, dividends, and distributions are taxed versus how unrealized capital gains are taxed. Interest, dividends, and distributions are taxed in the year that they occur, while unrealized capital gains are only taxed when you sell (i.e., when those gains become realized), which can be many (many) years into the future.
Note: the ability to defer taxes into the future can be your greatest weapon for wealth creation, but we’ll need to get into this particular topic at a later date.
Summary of Findings
So what was your opportunity cost for 2017 in this scenario? In the first case, investing in a money market account, you would be left with $9,891 (inflation-adjusted and before taxes) at the end of the year; in the second case (had you followed your benchmark), you would be left with $11,922 (inflation-adjusted and before taxes). So going with the money market account left you with an over $2,000 opportunity cost, which is an over 20% difference on your original $10,000 investment. That’s one hefty expense!
Now, I know what you’re thinking. The S&P 500® Index could have easily gone the other way. The market could have tanked and your reluctance to invest in the S&P 500® Index could have saved you from considerable loss. But for this line of reasoning to make sense, you would have to correctly time the market such that the returns from this active strategy are greater than your benchmark’s return over an entire lifetime of investing. This is indeed a daunting task.
The concern with this line of reasoning is that by deviating from your benchmark you are making an active decision that says two things: first, the benchmark risk-adjusted return is not sufficient enough for you, meaning you think the benchmark has too much risk for the amount of return that it provides; second, that you think the markets are sufficiently irrational to the point you can tell when this irrationally exists and when it will go away. As we’ve noted in our series on Efficient Markets, this task might as well be impossible. Further, as we’ve noted in Part 4 of this series, even professionals can’t seem to pull off this feat most of the time.
Clearly, the impact of an opportunity cost can make an incredible difference, and therefore it behooves an investor to take its impact into consideration whenever deciding how to put money to work. But for more color on this, in Part 6 of my series, Passive is the New Aggressive, we’ll apply this same opportunity cost concept to selecting an active fund over a passive one and we’ll further study the potential impact of this decision over long periods.
So, check out Part 2 of this series for more insight into the long-term performance of non-professional active management as suggested by academic research.
If you’re ever in need of guidance, these blog posts may be of help. But be sure to contact a financial, tax, or legal professional for guidance and information specific to your individual situation. And as always you can reach out to me directly here with questions or concerns about your personal situation.
Finally, if you want to see how your portfolio stacks up, check out my risk assessment here.