Stocks — Part III: Most people lose money in the market.

So, here we have this wonderful wealth building tool that relentlessly marches upward but – and this is a major but  – boy howdy it’s a wild and unsettling ride.

In Part I & Part II I presented to you a very rosy view of the stock market and its wealth building potential.  Every thing I wrote is true.  But, this too is true:

Most people lose money in the stock market.

Here’s why:

1.  We panic when times are tough and buy when the market is soaring.

We buy high and sell low.  This applies to all of us.  It is the way humans are hard-wired.  We are psychologically unsuited to prosper in a volatile market.  It takes an act of will and effort to understand, accept and then change this destructive behavior.

Here’s a sobering fact: The vast majority of investors in mutual funds actually manage to get worse returns from their funds than the funds themselves generate and report.  Let that little nugget sink in a moment.  How can this be?  We can’t help trying to “time” the market and so jump in and out; almost always at the wrong times.

Listen here for a moment to what Warren Buffett has to say about this.  My favorite line:

“The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did because they tried to dance in and out.”

2.  We believe we can pick individual stocks.  

You can’t pick winning stocks.  Don’t feel bad.  I can’t either.  Nor can 80%+ of most pros.

Oh, sure.  Occasionally we can, and Oh My what a heady feeling it is when it works.  It is incredibly seductive.  Picking a stock that soars is an intense and addictive high.  The media and internet are filled with “winning” strategies that feed on this delusion.

Last year I spotted a trend and made 19% in four months on the five stocks I choose.  (Sigh.  I still have this addiction.)  That’s almost 60% annualized.  This while the market was flat for the year.  That’s spectacular, if I do say so myself.  It is also impossible to do year after year.

Even slightly beating the Index year after year is vanishingly difficult.  Only a handful of investors have been able to modestly outpace it over time.  Doing so made them superstars.  That’s why Warren Buffet, Michael Price and Peter Lynch are household names.  That’s why I don’t let my occasional win go to my head.  That’s why I let Index Funds do the heavy lifting in my portfolio.

For more on this, here’s the 2nd post ever I wrote for this blog:

http://jlcollinsnh.wordpress.com/2011/06/02/why-i-can’t-pick-winning-stocks-and-you-can’t-either/

And here’s my take on a currently popular strategy:

http://jlcollinsnh.wordpress.com/2011/12/27/dividend-growth-investing/

3.  We believe we can pick winning mutual fund managers. 

Actively Managed Stock Mutual Funds (funds run by professional managers as opposed to Index Funds) are a huge and highly profitable business.  Profitable for the companies that run them.* For the investors, not so much.

So profitable are they, there are actually more mutual funds out there than there are stocks.  You read that correctly.  Yeah, I’m amazed too.

There is so much money at stake, investment companies are forever launching new funds while burying the ones that fail.  The financial media is filled with stories of winning managers and funds, and advertising from them.   Past records are analyzed.  Managers are interviewed.  Companies like Morningstar are built around researching and ranking funds.

The fact is only 20% of fund managers will beat the Index over time.  80% will fail.  100% of them will charge you high fees to try. There is no predicting which will be in that rarefied 20%.

Every fund prospectus carries this phrase:  “Past results are not a guarantee of future performance.”  It is the most ignored sentence in the whole document.  It is also the most accurate.

Here’s little “trick” the mutual fund companies employ.  When one of their funds under-performs they’ll simply quietly close it and fold the assets into something doing better.  The bad fund disappears and the company can continue to claim its fund are all stars.  Cute.

There’s lots of money to be made with actively managed funds.  Just not by the investors. Want to hear me rant more about this?  Here you go:

http://jlcollinsnh.wordpress.com/2012/01/06/index-funds/

4.  We play in the wrong end of the pool.

Mmmm.  Beer.

Imagine you’ve just spent a few hours reading all pithy posts here on jlcollinsnh.  (As well you should!)  Richly deserving of a reward you crack open a bottle of your favorite brew and pour it into a nice chilled glass.

If you’ve done this before you know that if you carefully pour it down the side you’ll wind up with a glass filled mostly with beer and a small foam head.  Pour it fast and down the center and you can easily have a glass with a little beer and filled mostly with foam.

Imagine now someone else has poured it for you, out of sight, and into a solid mug you can’t see thru.  You have no way of knowing how much is beer and how much is foam.  That’s the stock market.

See, the stock market is really two very different things:

1.  It is the beer:  The actual operating businesses we can own a part of.

2.  It is the foam:  The traded pieces of paper that furiously rise and fall in price moment-to-moment.  This is the market of CNBC.  This is the market of the daily stock market report.  This is the market people are talking about when they liken Wall Street to Las Vegas.  This is the market of the daily, weekly, monthly, yearly volatility that drives the average investor out the window and on to the ledge.

This is the market that, if you are smart and want to build wealth over time, you will absolutely ignore.

When you look at the daily price of a stock it is impossible to know how much is foam.  This is why a company can plummet in value one day and soar the next.  This is why CNBC routinely features experts, each impressively credentialed, confidently predicting where the market is going next – while contradicting each other.  It is all those traders competing to guess how much beer is actually in the glass, and how much is foam.

Over time, it is the beer that matters.  It is the beer that is the real, operating, money making underlying businesses beneath all that foam and froth that relentlessly drives the market ever higher.

Understand, too, that what the media wants from these commentators is drama.  Nobody is going to sit glued to their TV while some rational person talks about long-term investing.  But get somebody to promise the Dow is going to 20,000 by year’s end or, better yet, is on the verge of careening into the abyss, and brother you’ve got ratings!

But it’s all just so much noise and it doesn’t matter to us.  We’re in it for the beer!

Next time we’ll talk about that big, ugly event.

Disclaimer:  Like everything on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

Addendum I:

Wander on over to Mrs. EconoWiser’s fine site and you can listen to what Warren Buffet says about stocks: You can’t dance in and out of them. My favorite line:

“The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did because they tried to dance in and out.”

Addendum II:

*In addition to underperforming Index Funds, actively managed funds cost more, and those costs have a very serious and negative impact on your results. My pal Shilpan has a great post on this:  That Mutual Fund is Robbing Your Retirement

 

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