Editor’s note: This article was first published in December 2015; the figures it cites for Warren Buffett’s track record, including a 24% average annual return over 32 years, are those quoted at that time.
The headline of this article may sound a little sensationalist. It is. But the search for the stock market secrets that the great millionaires supposedly know gives rise to hundreds of articles along the lines of “what they don’t want you to know“. The truth is that, when it comes to investing, I think we already know everything there is to know; in this world, however, a large share of investors can fall victim to self-deception.
So while we are not going to uncover hidden secrets available only to a select few, we can arrive at a few truths about stock market investing that are always worth remembering.
An old investor I once knew used to say that the beauty of the markets lay in the fact that anyone who did their homework could, at some point, double or triple their money, whether we are talking about a company whose shares soar or one that sinks 70%.
See also: 18 truths about investing that come as a bucket of cold water to many people
So what are these investing secrets?
1. Can you get rich in the short term by investing in the stock market?
Can you make annual returns of 200% for 10 years?
The answer to the first question is “yes”, and the answer to the second is also “yes”. You can, but you most likely won’t, bearing in mind that the average annual return of the best investors in history comes nowhere near that figure.
In fact, Warren Buffett’s average annual return has been 24% over 32 years. And that is why we consider him the best investor in the world today.
Of course, someone can get rich on the stock market in a couple of years, but to do so they would have to treat it like a casino, because people have got rich in casinos too. You can make a lot of money or you can lose everything. That is the risk you will have to be willing to take: all or nothing, with the odds stacked against you.
There is the case of the young trader who turned $1,500 into more than $1 million in 3 years, and his mentor did the same. Both traded penny stocks, a market where, in a long-term investment, you will most likely lose your shirt. Trading in that market is probably the riskiest thing an investor can do with their money. In fact, the probability of making money consistently there is no different from that of earning a living playing roulette in a casino.
See also: The truth about penny stocks
We know that long-term investing is what pays best on the stock market
However, hardly anyone sticks to that style of investing (yours truly included, on many occasions). Many people claim to be long-term investors, but what they really want is a hefty return in the shortest possible time, so they can take that money and reinvest it in another company that is more likely to go up.
And that is not bad in itself. In fact, those of us who don’t have Warren Buffett’s capital or income are probably doing something smart when we take a profit (before the share turns down) and invest it in a company that has fallen a long way and is more likely to rise.
One of the cases most often held up as an example is Jesse Livermore, an investor who got rich several times and went broke several times as well. He was one of the first to show how an ordinary person could get rich on the stock market quickly by taking enormous risks, the same risks that made him go bust.
2. Market manipulation
This is not a closely guarded secret but an open secret that we all know (or should know). Great strides have been made so that anyone can buy and sell shares from their smartphone, for which we can thank technological progress. But now the “strong hands” (those who move the market) probably know where investors have placed their stop-losses, so we will often see big drops just before big rises.
They make money by knocking out your stop-loss and triggering a chain reaction of panic, and then they make money again by buying at the bottom, so that you get back in at the top for fear of missing the train and a bull market.
As Hoyle said in his book The Game in Wall Street, the short-term market is designed so that a few people make a lot of money. And for a few to make a lot of money, many small investors have to lose a lot of money. When we talk about short-term investing or trading on the stock market, we are already talking about a zero-sum game. Knowing this, what makes you think you can beat the people who move the market if you play against them?
That is precisely why market manipulation does not affect the long-term investor.
3. Any investor can increase their gains
First of all, anyone who talks about investing in the stock market should acquire the knowledge to do so, and I would say not just the basics but something more advanced.
Then investors need to be very clear about what they want from the stock market and to conclude as soon as possible (if that is the case) that they are not in it for the long term.
If you are going to buy into a stock because you are “fairly sure” the company is going to rise in the next few days, perhaps because the market is about to enter a short-term uptrend, that is the time to use leverage.
If a company has started to rise after some news, we expect it to rise a lot, and we know we are not going to hold it for years but want to make money and cash it in, it might be smarter to use leverage through options, futures, or even CFDs or warrants, as well as buying on margin.
However, the moment we use leverage, we are already increasing the risk of loss if our view turns out to be wrong, and these kinds of trades must be closed without hesitation at the slightest sign that our reasoning was mistaken.
If the trade goes as we expected and our chosen stock rises 10%, then depending on the vehicle or investment product we have chosen, we could be talking about a return of 40, 50 or 70 per cent. That is what leverage is for.
In other words, Banco Santander rising 3% in a week may not seem like much if we only have 5,000 euros (a 150-euro gain), but with leverage we could make close to 1,000 euros.
In short, we can multiply our stock market gains if we also multiply the risk, although there are times when the potential reward is more likely to pay off.
4. Nothing is ever certain on the stock market
The only certain thing on the stock market is that nothing is ever certain. It doesn’t matter which company, which market or which commodity we are talking about. At any moment something unexpected can come up and turn your investment upside down, even if only temporarily.
And when something like that happens temporarily, all you can do is pray it hasn’t caught you leveraged.
Even so, it is always a matter of probability. If you have chosen solid companies, the probability of this happening will always be lower than if you are invested in penny-stock gambles, chasing technical rebounds in a company that could disappear tomorrow.
There are times when all the analysts agree that “the stock market will rise 15% this year”, and so some savers, having been advised accordingly, put their money into equities. That will most likely be the case, but you can never foresee a war, a change in monetary policy in the region or any other unexpected event.
If, on top of that, these investors have put in money they will probably need within a year, they will most likely end up selling at a loss and leaving the stock market “disgusted”.
See also: Warren Buffett’s 16 best pieces of advice
5. Most fund managers fail to beat the market
If we start from the premise that those who pay millions to Harvard-educated analysts and hold widely diversified portfolios are unable to beat the market’s return, why would we, who are, after all, nobodies, manage to do it?
The truth is that the market already does well on its own. Indices tend to rise. In fact, many people lose money on the stock market, but people rarely lose money over a 10-year investment horizon if their portfolio is diversified. That said, before diversifying excessively (over-diversification is a bad deal), the best diversification is to buy the whole index through a low-cost index fund.
6. Stock market speculation is more emotional than rational
We sell shares that are showing a profit and hold on to shares that are showing a loss, even though that is the opposite of what we should do. Why? Because of loss aversion.
If a share has gradually lost 20% over 3 months and an investor says they finally sold it, they most likely sold it having taken the full loss. They didn’t sell when it was down 2%, or when it was down 10%, hoping it would recover some of its value. But when they saw their capital shrink by 20%, they couldn’t take it any more and decided to sell.
To avoid falling victim to their emotions, a rational investor needs to know the possible scenarios and decide in advance how they will act when the time comes. That way you avoid becoming a victim of your own emotions. In the case above, this investor should have been clear from the start: “sell if I’m down 2%”, or, if I keep this share, “if it falls 15% or 20%, I’ll average down, because I like this company for the long term”.
But in a speculative trade, not selling at a 2% loss and then selling at a 20% loss is one of those moments when we tell ourselves we are idiots. And the truth is that we are, for not planning our decisions in advance.
The consolation is that I think almost all of us who invest in the stock market have been through this. For some of us the lesson was expensive, but we learned it. Others still haven’t.
To what extent is investing more emotional than rational?
More than 90% of traders consistently lose money. But more than 40% of traders make gains on a simulated investment platform. The only difference between those two figures is called “panic”. When you are not playing with real money, your decisions tend to be more rational, but once real money comes into play, rationality goes out the window and we let our emotions guide us.
If we look at trading competitions (with play money), some people get rich, because they take risks they would never take with real trades. And that answers the question we started with: to get rich from short-term stock market speculation, you will have to take the very actions that can lead you to bankruptcy.
See also: 11 tips for investing in the stock market
Featured image: Edvard Munch, Public domain, via Wikimedia Commons.
