If someone walks up and offers a way to make easy money without effort, it would seem too good to be true, why would anyone want to give me money? That is basically how the stock market works. On average in the long run, the stock market is a reliable source of personal income, basically without any effort required. In any other circumstance, like playing roulette, we all know that the average outcome is losing money since casinos make profits. It is the other way around with the stock market; sometimes you have bad luck, but the average result is a win. How come that is not too good to be true?

There are two reasons why owning stocks provides effortless passive income. Money is a form of capital, and just like a machine in a factory, using money actively can provide a positive return. For instance, imagine that I have a friend living in a high-traffic area in the center of Barcelona without any money. I could then give him funds to buy and manage a vending machine, and we could agree to share the returns of it. I don’t have to do anything,  but since the money can be used to generate profits from the vending machine, my friend is willing to practically borrow money from me at a performance-based interest rate. That is the basic relationship between employees and shareholders in any company.

The complementary reason the stock market generates positive returns is that people are risk averse. It is an established fact in economics that people deviate from ‘rational’ decision-making and have a tendency to avoid risks. There are exceptions such as gambling, but in most cases, people require a premium for making decisions with great variation in outcomes. This applies to financial investments because in general, securities with greater risk have greater returns over time. The order of return on money is consistently ascending from bank account savings to bonds to stocks, and the relationship exists within each category as well. To put it simply: The more risk, the less demand, the lower market price, and the greater return on investment. The relationship between risk and return is fundamental to understanding the stock market.

There is of course great variation in many variables between different securities on the stock market, but all else equal, there will always be a clear tradeoff between risk and return. This phenomenon can be derived from our evolution through natural selection since survival rates are greater when avoiding risks in nature. Investing in risky securities on the stock market is exploiting the bias of risk aversion, and generates on average greater income in the long run. The problem is that we ourselves, as investors, also are humans wanting to minimize risk. Many people are rightfully afraid of the prospect of losing their life savings. However, many articles in the economic literature have shown that there is a way to take advantage of the risk dynamics, called diversification. 

The way to reduce the variation in outcomes and still invest in securities with high expected returns is diversifying, i.e. putting one egg in each basket. Perhaps the dumbest thing one could do is to play on every number simultaneously when gambling in roulette, because you know you will lose money. Perhaps the smartest thing one could do is to buy a little of each stock in the stock market, because you know you will win money. Hence, by risk-reducing through diversification, one could hold relatively more risky securities with the same total variation of income, and thus exploit the human bias of risk aversion to generate greater returns on the stock market. 

Currently, many people alternate the degree of risk in their portfolio by choosing funds with different degrees of diversification. In my opinion, this is strictly suboptimal since diversification increases the average return at all levels of risks in the portfolio, ceteris paribus. I think the approach to maximize returns while altering risk levels is by always being fully diversified, but using leverage as the risk variable. In principle, all funds should be index funds with different leverage ratios for different risk profiles. One hypothesis why those do not yet dominate the stock market is that financial institutions have a high degree of monopoly. The entrance barriers in the financial industry induce market power and greater profits. The fees fund managers can charge depends on how actively the fund is managed. Pure index funds with different ratios of leverage would be so competitive that managers would be unable to keep their current markups. Hence, the current monopolies in the financial sector may be a hindrance to optimal investing. 

Always being diversified implies passive management of the portfolio. One reason to be passive when investing in the stock market is the principle of ‘Wisdom of the crowd’. The idea is that many uneducated guesses to a question together give a more accurate estimation than what a few experts could come up with. Although many individuals in the crowd may lack knowledge on the matter, an unbiased distribution would make it so the overestimations cancel out the underestimations, and their average answer is accurate. This applies to the stock market as well. Although there may be some biases in the crowd’s evaluation of different stocks, the true values of stocks are unpredictable, because future prices will be based on the same biased estimation of the crowd again. There are good statistical reasons to believe that the average estimate of thousands or millions of people will outperform even the most expert minds on stock market evaluation in the world.

But why do active undiversified funds beat the stock market index all the time? Imagine there are 100 people. 50 of them decide to play roulette for their life savings. The richest person at the end will probably be one of the people playing roulette who happened to win. Does that mean that it was a good strategy to play roulette? No, because the expected outcome was to lose money. The stock market is less risky and has better odds, but we only notice and admire the well-performing stocks and forget about the poorly performing funds with the same strategy. Another term for this is hindsight bias. In hindsight, we think we understand the development of stocks and funds, despite reality surprising us over and again.

Unless someone possesses insider information or can influence the outcome of the company, the evaluation of all of the people trading the security, providing a market price, will most often be a better estimation than anyone else’s.

In summary, I strongly believe in utilizing the fact that the stock market on average generates around 8% return on investment, and capturing that each year by diversifying as much as possible between regions, sectors, currencies, growth & value, and the timing of the purchase.