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Why Retail Investors Systematically Lose Money in the Stock Market

While you wouldn’t consider being the general contractor on the construction of your home—although you could if you dedicated the time and effort—many individuals (retail investors) seem to be comfortable in building their own investment portfolios without the knowledge or training to do so. Yet, the end result in either case is the same: disaster.

Successful Investing: Success in the stock market is really about profitably predicting the future. Essentially, that involves discounting future information with regards to the manifold factors impacting the markets, i.e., political, economic, financial, etc., and incorporating these factors into a stock’s or market sector’s valuation and to do so prior to everyone else.   

Late to the Party: Retail investors who are not dedicated to study of the factors influencing investment valuation are typically way behind the information curve and become the exit strategy for many professional investors.

Light-Hearted Assessment: Below is a light hearted look at a typical stock price cycle and how many arm-chair investors get “burned” by being late to the party.

The George Constanza School of Investing: In the middle of a stock (or sector) price advance (see “A” in chart above) investors begin hearing about the advances in the stock price, e.g., gold is a good example. Then they go to a cocktail party and hear their neighbors talk about how much money they’re making by buying that stock (“B”). Next they see the stock touted in the financial press; it makes the cover of “Time” magazine (“C”).

They can’t stand it any longer. The whole world is making money and they're not. So, they buy the stock (“D”).

Masters of the Universe: For a while the stock continues to rise and they feel like they’re one of the “masters of the universe”. However, since they’re late on the information curve, the stock was bought near the top.

Here Comes the Pain. As the stock starts to “top” and move off its high, they think this is just temporary—it will go back up (“F”). However, the stock keeps moving down to below their cost basis—can’t sell now! (“G”). Now, it’s fallen way past their cost and they’re trying to make deals with the deities to get the stock back up over their cost basis (“H”). Finally, they’ve lost anywhere from 50% to 70% on their investment and have decided in disgust to sell the stock at a loss (“I”).

Of course the time you should have bought the stock is when it was ebbing in price (“J”). However, to do that you’d have to have some superior knowledge regarding the stock.

Great Minds: This exercise calls to mind two great investors’ perspectives on investing and beating the information cycle.

The famed Peter Lynch reminded investors that they can make more money by making investments in sectors (stocks) they have superior knowledge. If you’re a doctor, is there some product or device that you think is a breakthrough? Here you have the advantage over the legions on Wall Street. You’re now “hanging five” on the information wave.

The other great investor is Warren Buffett who pointed out that you should be “fearful when others are greedy and greedy when others are fearful”.

Parting Observations: If you’re an individual investor who infrequently buys and sells individual securities, here are four disciplines you should consider:

1.     Don’t buy stocks that are in the news or considered “hot”. The old saw on Wall Street “buy on rumor sell on news” still applies.

2.     Find a financial advisor you can trust and who can make you money. Remember, 70% to 80% of the money managers can’t beat their benchmark. (Check their numbers.)

3.     Consider buying a diversified portfolio of ETFs and you’ll do as well as the market and better than 70% to 80% of the people you’d hire to manage your money.

4.     If you’re going to dapple in the stock market, allocate 5% to 10% for that purpose. View it as more like going to Las Vegas—more for entertainment than for profit.

Joe Eqcome
Disclosure: None

Disclosure: none