The stock market’s average return is a cool 10% annually — better than you can find in a bank account or bonds. That’s what everyday investors have made with a simple, low-cost fund based on the Standard & Poor’s 500 index. So why do so many other people fail to earn that 10%?
Fear and greed.
The secret to making money in stocks is remaining in the market; your length of “time in the market” is the best predictor of your total performance. So it’s critical to understand how your emotions — especially fear and greed — can fool you into moving in and out of the market at the worst possible times and thus missing out on that annual return.
(First things first, you need a brokerage account to invest in the stock market. If you don’t have one, here’s how to open one. It takes only 15 minutes to set up, and you want to have everything in order so that you can take action.)
To make money, time in the market is critical
“Time in the market” refers to how long you’ve been invested (not to be confused with “timing the market,” which is virtually the opposite). More time equals more opportunity for your investments to go up. The best companies tend to increase their profits over time, and investors reward these greater earnings with a higher stock price. So more time allows companies the chance to grow their earnings and reward you with a higher stock price.
More time in the market also allows you to collect any cash dividend, if the company pays one. If you’re trading in and out of the market on a daily, weekly or monthly basis, you can kiss those dividends goodbye because you likely won’t own the stock at the critical points on the calendar to capture the payouts.
If that’s not convincing, consider this. Over the 15 years through 2017, the market returned 9.9% annually to those who remained fully invested, according to Putnam Investments. However:
- If you miss just the 10 best days in that period, your annual return drops to 5%.
- If you miss the 20 best days, your annual return drops to 2%.
- If you miss the 30 best days, you actually lose money (-0.4% annually).
In other words, you would have earned twice as much by staying invested (and you don’t have to monitor the market, either!) for just 10 extra critical days. No one can predict which days those are going to be, however, so investors must stay invested the whole time to capture them. The longer you’re in, the closer you’ll get to that historical return of 10%.
Fear and greed keep investors trading in and out, ruining their chances at that annual gain. Here’s how you’re likely to trick yourself out of staying invested in the market.
Three excuses that keep you from making money
The stock market is the only market where the goods go on sale and everyone becomes too afraid to buy. That may sound silly, but it’s exactly what happens when the market dips even a few percent, as it often does. Investors become scared and sell in a panic. Yet when prices rise, investors plunge in headlong. It’s a perfect recipe for “buying high and selling low.”
To avoid both of these extremes, investors have to understand the typical lies they tell themselves. Here are three of the biggest:
1. ‘I’ll wait until the market is safe to invest.’
This excuse is used by investors after stocks have declined, when they’re too afraid to buy into the market. Maybe stocks have been declining a few days in a row or perhaps they’ve been on a long-term decline. But when investors say they’re waiting for it to be safe, they mean they’re waiting for prices to climb. So waiting for (the perception of) safety is just a way to end up paying higher prices, and indeed it is often merely a perception of safety that investors are paying for.
What drives this behavior: Fear is the guiding emotion, but psychologists call this more specific behavior “myopic loss aversion.” That is, investors would rather avoid a short-term loss at any cost than achieve a longer-term gain. So when you feel pain at losing money, you’re likely to do anything to stop that hurt. So you sell stocks or don’t buy even when prices are cheap.
2. ‘I’ll buy back in next week when it’s lower.’
This excuse is used by would-be buyers as they wait for the stock to drop. But as the data from Putnam Investments show, investors never know which way stocks will move on any given day, especially in the short term. A stock or market could just as easily rise as fall next week. Smart investors buy stocks when they’re cheap and hold them over time.
What drives this behavior: It could be fear or greed. The fearful investor may worry the stock is going to fall before next week and waits, while the greedy investor expects a fall but wants to try to get a much better price than today’s.
3. ‘I’m bored of this stock, so I’m selling.’
This excuse is used by investors who need excitement from their investments, like action in a casino. But smart investing is actually boring. The best investors sit on their stocks for years and years, letting them compound gains. Investing is not a quick-hit game, usually. All the gains come while you wait, not while you’re trading in and out of the market.
What drives this behavior: an investor’s desire for excitement. That desire may be fueled by the misguided notion that successful investors are trading every day to earn big gains. While some traders do successfully do this, even they are ruthlessly and rationally focused on the outcome. For them, it’s not about excitement but rather making money, so they avoid emotional decision-making.
Index funds or individual stocks
If that 10% annual return sounds good to you, then the place to begin is with an index fund. Index funds comprise dozens or even hundreds of stocks that mirror an index such as the S&P 500, so you need little knowledge about individual companies to succeed. The main driver of success, again, is discipline.
If you’re looking to invest in an individual company, you’ll want one of the good brokers for stock trading. The upside here is that you potentially can earn much higher returns in individual stocks than in an index fund, but you’ll need to put some sweat into researching companies to earn it.