Why Most People Lose Money In The Stock Market
It’s a fact. Most individual investors who invest in the stock market lose money. That’s why in this post we are going to dive into 5 reasons why so many people lose money in the market, and most importantly, how you can avoid it.
1 - We Try To Pick Winning Stocks
The first reason why most people lose money in the market is that we try so hard to pick winning stocks. Let me be upfront. The harsh truth is that we can’t pick winning stocks. And that includes both you and I. And we shouldn’t feel bad about this because the overwhelming majority of professionals in the business can’t either.
There are thousands of professionals who’s full time job is to study companies and predict their future performance. Yet studies have shown that even these super smart individuals struggle selecting winning stocks. Every year, S&P Dow Jones Index does a study on active versus passive management. Their studies show that in a 10 year period, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent underperformed the index.
The reason why is actually pretty obvious if you ever worked in a major corporation. From the surface a company’s forecasting process may seem like a rational mathematical exercise. How much revenue does the company expect to make in the upcoming quarter? What is its expected net profit? The forecasting team just needs to add up all the numbers to produce a detailed forecast, right?
Well what we are all forgetting is that numbers are actually being provided by people, and as we all know we the people are not very logical beings. Sales people have incentive to provide revenue projections that will make them look good. Operations departments have the incentives to show how they plan on finding efficiencies by next quarter. The company CEO has incentive to instill confidence in Wall Street investors.
The bottom line is that the forecasts that many analysts use to make their buy and sell decisions are actually further from the reality than most people would like to believe. Now if professional analysts whose full time is to pick winning stocks are struggling, what makes us think we can beat them? And beat the market at that? Reading a few investing books and reddit forums unfortunately will not give us the edge to pick winning stocks. Most people can’t beat the market and neither can you.
2 - We Try Pick Winning Mutual Funds
Alright, you might be saying. I get it. I can’t pick winning stocks. But how about winning mutual funds? Well I’m again sorry to be the bearer of bad news, but trying to pick winning mutual funds is just as futile. This is the second reason why most people lose money in the stock market. We try to pick winning mutual funds.
Actively Managed Stock Mutual Funds are funds run by professional managers, as opposed to Index Funds which are passively managed essentially by a computer. They are one of the most profitable investment products in the market. And when I say profitable, I mean for the companies that run them. Not for individual investors like you and I.
What’s so fascinating about the mutual fund market is that there are actually more mutual funds out there than stocks. According to the U.S. News and World Report there are about 4,600 equity mutual funds operating in the US. Do you know how many total publicly traded companies there are in the US? Slightly over 4,000.
Yes. There is more packaging of the goods rather than the goods themselves. Pretty interesting if you think about it. But the sad fact is the very few of these actively managed funds beat the index over time. In 2013, Vanguard studied over 1,500 actively managed equity funds over a 15 year period and found that 82% of the funds failed to outperform the simple index.
But actively managed mutual funds will never advertise that they have a horrible track record. They instead just bury the underperforming ones and launch new funds to entice new investors. When there is a lot of money to be made, especially for the investment firms, don’t be surprised by how far they will go to keep their highly profitable investment products selling.
3 - We Ignore Fees
This leads to our third reason why most people lose money in the market. The number three reason why most people lose money in the stock market is that we ignore fees. We are conditioned to believe that we get what we pay for. But this is not true when it comes to investing. Let’s take a look at three most common mutual fund fees.
Expense Ratio
An expense ratio represents the percentage of your investments that the mutual fund company will take as a fee. For example, an expense ratio of 1% will cost you one percent of your portfolio every year. If you invest $10,000, it will cost you $100 annually.
Transaction Cost
Second common mutual fund cost is the transaction cost. If we were buying and selling individual stocks and bonds, we would have to pay a brokerage fee for each transaction. Mutual funds are not exempt from this. They need to do the same.
What is sneaky about these transaction costs in mutual funds is that they are a separate fee from the expense ratio. They are costs that are subtracted from our investments and worse than expense ratios, we oftentimes don’t know ahead of time what those fees will be. Why? Because most often the mutual funds don’t even know themselves what their transaction costs will be until they actually decide to buy or sell something.
Load Fees
The third most common mutual fund cost is load fees. These are fees you pay when you either buy shares of the fund or sell shares of the fund. Front end load fees apply when you buy shares of mutual funds. Back end load fees apply when you sell shares of a mutual fund.
Thankfully this isn’t with all mutual funds, but nonetheless, the load fee gets baked into the expense ratio making funds with them much more expensive to invest with. It’s easy to think that these small fees shouldn’t add up to much. Especially if our investments are outperforming the market.
However, they do. And they have a significant impact on our overall wealth when we fail to consider fees in our investments. 1% additional expense ratio can not only cost us thousands in the short run, but tens and even hundreds of thousands of dollars in the long run.
Don’t lose money in the market by ignoring fees. Personally, I think any fund that has an expense ratio of more than 0.25% is too high. To keep your fees low, stick to low cost index funds. Most have super low expense ratios. Minimal transaction costs and no load fees. Fees are critical if you want to grow your wealth. Be aware of them and keep them as low as possible so that your money is working for you, not for the mutual fund company.
4 - We Try To Time The Market
Alright, you might be thinking at this point. I get it. I won’t try to pick stocks or mutual funds and I’ll be wary about high fees. So I should be immune to losing money in the market right? Well close. But there is a fourth reason that even the most cautious of us fall into. And that is we try to time the market.
The concept of buy low, sell high seems simplistic enough. Many of us, whether we like to admit it or not, look at the market and have an opinion about where the market is. The market is too high. Or we are at a dip.
And there is alot of appeal to the notion of stepping out when the market is high and back in when the market is low. But the reality is that it is almost impossible to do. Many of us who try to time the market are oftentimes buying high and selling low. Panicking when times are tough and buying when the market is soaring.
Regardless of how unique we think we are, most people follow the herd mentality. When the news is filled with doom and gloom, people can’t help themselves but sell because they are afraid that what they own is going to fall further. When the news is filled with glitz and hope for the future, people buy and artificially drive up the market even more.
Trying to time the market is a hopeless goal. Our human psychology is instinctively wired to follow the herd mentality - if a group of people started running in one direction in hysteria, how many of us would have the rational mind to stop and try to think why they are running? We’d run first and ask questions later. It takes awareness and intentional effort to counter this natural human tendency. Don’t try to time the market. Instead, consistently buy and hold forever. Time will do the heavy lifting for you and if you give it enough time, you will see your net worth grow and multiply.
5 - We Think We Understand The Market
The fifth and really the biggest reason why most people lose money in the market is the fact that we think we understand the market. We have friends that are constantly talking about the stock market. Or how their investment is performing because of what is happening in the stock market. They use fancy terms like Alpha, Spread and Volatility. And when we are insecure about our knowledge of the market, it's easy to be intimidated.
But the sad fact is that most people who throw around terms like this don’t completely understand the market themselves. JL Collins, the author of the Simple Path to Wealth, uses a fantastic analogy of foam vs. the beer in his book to explain this concept. In his book, he refers to the stock market as being made up of two things - the actual beer and the foam.
The Beer
The Foam
The Beer represents the actual underlying business that the stock represents. The product that this company sells. The people that develop great ideas and bring them to the market. It's what makes the beer, a beer.
The Foam represents the late night, short-term stock crazed news. The rumors of who the new CEO is going to be. What new products Apple might be launching. This type of news drives the daily and weekly volatility of a stock. It’s interesting, but this is not tied to the core fundamentals of the business.
If you want to really build wealth, you must ignore the foam. Networks make money by getting people to watch more of their content. And the way they do this is by talking more and more about the foam; the short-term ups and downs. Who would want to sit glued to their television when the host is talking about the benefits of long-term index investing?
The market isn’t what we see on the news. It’s made up of thousands of businesses that are creating value for its customers, that will in the long run drive the market up. And the truth is that even the smartest economists in the world don’t completely understand what’s happening in the market. One guy is saying the market will crash. Another one is saying it is fine. Who do you listen to? Neither one. Ignore the noise and focus on the long term fundamentals.
