They say investing in the stock market is risky. And yes, some people have lost money while others have made a lot. But here is the question: how can investing in the stock market be risky when it has been rising for 220 years?
The reality is that the stock market, although it does not rise in a straight line and is not immune to severe corrections, has kept going up to this day. Put like that, it sounds illogical for investors to lose money. But it does happen, and sometimes it is because of misunderstood concepts that even the most advanced investors keep falling for.
(Read: Why the stock market always ends up falling, and how often)
This is an unusual article, a companion to the earlier “Only 4 things you need to know about investing“. I hope it helps you draw some conclusions, or at least understand what we are going to say before you jump into the stock market.
1. Learn and educate yourself before investing
It doesn’t matter whether you are going to invest directly or put your money in the hands of an outside manager. You need to understand how the stock market works and its essential concepts. That takes time, just as choosing the companies we are going to invest in takes time.
In any case, I am in favour of everyone investing their own money.
(Read: 8 books Warren Buffett thinks everyone should read)
2. Forget about investing in the hope of getting rich on the stock market
Only a snake-oil salesman would tell you that, the kind who wants to sell you some sort of method called “get rich on the stock market with no experience needed”. It sounds so easy that any fool could make money, when the truth is that even very intelligent people can lose money.
The stock market is not there to make you rich (in quotation marks) but to preserve your wealth and earn an extra return on your savings.
You will not get rich investing in the stock market unless you have done a lot of other things right in life, such as having a high income or a business that brings in a lot of capital, and investing large sums in the market. Of course, you can always get lucky with a high-risk investment and become a millionaire overnight. But if that is what you are after, statistically your chances are the same as in a casino.
As Warren Buffett said: “No matter how great the talent or efforts, some things just take time.” And building wealth in the stock market is one of them. The more money you invest, the more likely you are to make more money. The longer your money stays invested, the more you will earn thanks to share price appreciation and reinvested dividends (compound interest).
(Read: The myth of getting rich on the stock market and retiring young and wealthy)
3. Even when you invest in stocks, you are usually not investing in the stock market
And no, I haven’t lost my mind by saying this. As I said at the beginning, the stock market has been rising for 220 years. So how is it that some investors have lost money? Very simple: most investors don’t invest in the stock market, but in individual stocks.
This is a distinction you need to make. If you buy shares in Telefónica and Microsoft, you have not invested in the stock market; you have obviously invested in Telefónica and Microsoft.
If you want to invest in the stock market, buy the stock market. In other words, buy an index fund or an ETF directly, and that way you will be investing in the group of companies as a whole.
To date, the average annual return of the S&P 500 (the 500 leading companies) has been almost 10%.
Of course, even when buying an index fund we need to be clear about when we get in, because there have been cases of people whose retirement day coincided with a brutal correction in the index, and their retirement savings were cut almost in half at that moment.
But in the end we buy individual stocks because they promise higher returns than an index fund. And clearly, the higher the return, the higher the risk. That is why the only way to limit that risk is to have some knowledge of the subject.
4. Use your own investment judgement. Don’t invest based only on someone else’s
Some stocks perform well when you buy them and then turn around. Before that moment comes, you need to be very clear about why you do or don’t want them in your portfolio.
For example, right now my inbox is full of questions about Ezentis and Navidea: “What should we do: sell, hold or average down?”
At the risk of being wrong, these are two stocks I want to hold for the long term. And I have my reasons. Could I be wrong? Of course. But the mistake would be mine. The question is “why do you have them in your portfolio?”, and if the only answer is that someone recommended them, that’s a bad sign.
You can hear arguments for and against any stock, but we should always do our own analysis.
5. You can lose money quickly
Whether you invest in an index or in individual stocks, the price can fall quickly, without warning and without anyone having seen it coming. And truly, no one can predict it. Nobody knows what the market will do in the short term.
If, when that moment comes, you forget that you are in the stock market for the long term, you can lose money fast by buying at the top and selling in the middle of a severe fall, when sometimes an investment can drop before continuing its upward path.
6. You have to choose: are you an investor or a speculator?
Most people who say they are starting to invest in the stock market don’t really come in with an investor’s mindset; they try to speculate. More money is made in speculation than in investing, but going into speculation with limited knowledge will give you an overly active approach to investing that will end up losing you money.
Speculators trade in both directions of the market, so they make money on the way up, on the way down, in wars and in natural disasters, using all kinds of instruments such as CFDs, warrants, options, futures…
(Read: How to make money in a bear market: tips to keep in mind)
Meanwhile, the investor who behaves like a speculator thinks his business is buying at 3 and selling at 6, and often finds himself buying at 6 and selling at 3, just before the stock shoots up to 9.
Investing is not wanting to sell a stock tomorrow because it has gone up, and then keeping it for the long term because today it has started to fall. That is more like a disastrous attempt at speculation.
(Read: The risk of executing the right strategy in the wrong context)
7. But the stock market is the most profitable investment
Once we understand the concepts and the risks, the truth is that over the long term the stock market has proved more profitable than fixed-term deposits or keeping our money under the mattress, because inflation is an investment with a negative return.
If you don’t do anything too crazy, it isn’t hard to make money on the stock market. What is hard is trying to get rich in three days, which as a rule produces the opposite effect.
But to make investing a profitable business, we must never forget that it is about the long term and that sometimes the simplest thing is the most effective. The problem comes when people focus on quick gains by investing in high-risk companies, or by getting into the market at the wrong time and getting out at the worst moment.
The stock market has different levels of risk, and there are companies for both conservative and high-risk profiles. We can aim for 100% returns, or we can settle for 8% a year plus dividends. The latter is easier to achieve by buying into solid companies, but always with a long-term mindset. As we gain more experience, we can take on more risk.
Further reading
- The mother of all stock market investing mistakes
- Jim Rogers: 10 stock market investing lessons
- 19 secrets of stock market investing
- 18 truths about investing
Featured image: Founding and Subsequent Fathers, Public domain, via Wikimedia Commons.
