Winning the stock market game is a matter of knowing which game you’re playing.
It’s no secret that investors are notorious for under-performing the stock market, realizing returns far below the general market. Data for the ten years through 2013 shows that the average investor earned an annual return of just 2.6% compared to a return of 7.4% for stocks and 4.6% for bonds.
In hindsight, we know why we lose. Investors chase high-flying stocks they hear about on TV only to realize they must have been the last to jump on the bandwagon as the price comes crashing down. Panic sets in and the investor sells out of the stock just before it levels off or stages a rebound.
So why is it so hard to win the stock market game? Why can’t investors conquer their bad habits and earn a better return on their investments?
The answer is because most investors are playing the wrong game!
Two professionals playing the game will need to do everything they can to score points. They each know that the other will make few mistakes so the key to victory will be in taking risky shots for the ace.
By comparison, when my wife and I play tennis, the strategy is very different. I can try for the risky shots and get lucky on a few but, more often than not, the ball is going to go soaring over the fence and I’ll be running after it. Since it’s more fun to return the ball back as hard as possible, practicing my best guttural grunt as if I were John McEnroe, I make a lot of these errors and my wife usually wins.
She knows the key to winning this amateurs’ game is to just concentrate on getting the ball back over the net…and making the fewest mistakes.
It turns out, winning the stock market game is a lot like winning in tennis.
The Professionals’ Stock Market Game
Professional money managers are measured against the rest of the managers in their investing style. Around the beginning of the year, you’ll see rankings come out placing managers among the ‘median’ return for their group.
Since everyone is constantly trying to score a few extra percentage points to put them above the median, the professionals’ stock market game is about taking risks to beat your comparison index.
It turns out that even the professionals have a tough time playing their own stock market game. Data from 2012 mutual fund performance shows that just 39% of professional fund managers beat their index while the average fund return actually trailed the stock market (S&P 500) by a percent after fees.
If the average fund return was 15% and nearly 40% of managers beat their index, there’s a good chance that a lot of ‘professionals’ lagged the rest of the market by a wide margin.
Why? Because they are making big bets and losing big when those bets don’t pay off. They’re trying to serve an ace but hitting the ball into the bleachers!
The Amateurs’ Stock Market Game
By comparison, most of us won’t face losing our job if our investment returns fall short of the ‘average’ investor. We only need to avoid making the big mistakes and meet our long-term financial goals.
Just as my wife doesn’t have to play like Steffi Graf to beat me at tennis, you don’t have to invest like a pro to win the stock market game.
Use these four strategies to win the amateurs’ game in the stock market.
1) Winning the Stock Market Game with Diversification
The most important amateur’s trick to winning the stock market game is diversification. This means having a mix of investments that react differently to the economy and the stock market. Bonds and stocks rise and fall differently because bonds are a contract for fixed payments while stocks are only an ownership stake in potential profits.
Even within stocks, different companies react differently to the business cycle. Stocks of utility companies do better when the economy isn’t doing well and interest rates are falling. Stocks of retailers do better when the economy is humming along and people are buying lots of stuff.
The idea behind diversification is that, no matter what the economy does, your investments will make a smooth path higher. Some individual investments will fall as others rise but your overall wealth will increase and you won’t suffer the big losses that lead to panic-selling. I put together an easy table of four major asset classes and 12 different groups of investments in another post to make sure you get the diversification you need. Click here to check out Why Real Investors Don’t Worry about a Stock Market Crash.
2) Keep your Investing Fees Low
Mutual funds charge an average 1.4% a year to pay their managers and overhead cost. Add in a fee for buying or selling the fund and you could need a decent annual return just to break even. You won’t pay annual fees for holding individual stocks but the commissions for buying and selling will add up.
The solution…don’t sell your stocks! Invest in companies with products that people love and that will be around forever, and then hold the investment until you need the money in retirement. You’ll save on fees and will avoid a lot of the bad investing habits that lose money.
A new online broker, Motif Investing, offers an innovative way to diversify your investments and cut fees at the same time. For a one-time fee, you can buy a group of 30 stocks around a common theme and hold the shares without paying an annual management fee. It’s the low-cost solution to higher fees in mutual funds. I detailed how to invest on Motif Investing in a recent review.
Get up to $150 when you start trading at Motif Investing.
3) Amateurs in the Stock Market Game don’t use Margin
If you don’t know what investing margin is, you’re already on your way to winning the stock market game. Margin is basically a loan your broker gives you to buy more stocks than you can afford. You’ll pay interest on the borrowed money but can increase your return as long as your investments pay off.
Unfortunately, you’ll set yourself up for big losses if stocks fall. Lose 10% on your $5,000 portfolio and you are only down $500. Lose 10% on that same portfolio margined to $10,000 and you’ll lose more than $1,000 with interest.
4) Getting the Easy Points in the Stock Market Game
The easiest money you’ll ever make in the stock market game is the free money you get from your company’s 401(k) match and from tax savings on retirement accounts. I know it sucks to have your money locked away in an account until you’re 59 ½ but so many people turn down free money by not maxing out their 401(k) or IRA contributions.
If your company matches $0.50 for every dollar you invest in your 401(k), you’ve instantly got a 50% return! If you pay 25% on income taxes, you could invest $1,000 in a retirement account or pay the taxes and only have $750 left to invest in a regular account.
If a lot of the tips for playing the amateur strategy in the stock market game sound like my recent Top 10 Investing Basics for New Investors, there’s good reason for it. It’s only when investors try to boost their returns with complex strategies that they make the big mistakes that ultimately lose money.
The beauty of the stock market game is that you can pick your match. You’re free to play the professionals’ game, analyzing stocks daily for the slimmest of chances at a few extra percentage points. You’re also free to play the amateurs’ game, investing for the long-term win on making fewer mistakes.
It’s your decision, just make sure you know which game you’re playing.
Looking for what NOT to do when investing in stocks? Check out the Top 10 Investing Myths and How to Avoid Them.