When I became interested in the financial markets many years ago, I spent many hours and days trying to devise ways to make money in the stock market.
There are many ways that investors try to make money in the stock market, including:
- Trying to find the next hot stock.
- Finding a new trading strategy, based on charts or other strategies.
- Picking the next hot fund manager.
- Looking for an option trading strategy that can outperform the market.
Don’t get me wrong; it’s thrilling to make money when trading in the stock market. When you get a stock pick right, or atrade goes really well, it’s exciting. When you make money on a trade, you get a satisfaction that you actively made decisions that lead to a higher portfolio balance. You may even gloat about it to your friends on the internet or in real life.
CNBC and Bloomberg TV fill their days with an endless parade of talking heads with stock picks and trading strategies. Viewers eat it up, as they search for that magical stock pick or trading strategy that can deliver them superior returns at less risk.
Of course, trying to beat the stock market, whether through stock picking, trading strategies, or selecting a fund manager, is a futile exercise. While many investors feel that they need to do something (i.e., trade, pick the right stock) to improve their stock returns, success in the investing game is more about consistently avoiding the traps that erode investment returns.
A tennis analogy
In sports, you can play to win or play not to lose.
In tennis, points are won in one of two ways. You can either hit a winner with a great shot that your opponent can’t return. Or you can avoid unforced errors, just consistently hitting the ball back and forth to your opponent, waiting for them to make a mistake.
Everyone loves to hit winners. We love to whack the ball really hard into the corners of the court. Most of us play tennis for the thrill of these winners.
But I’ve found that the players who win matches, especially at the high school level or lower, don’t hit the most winners, but have the least unforced errors. If you can just get the ball back enough times to your opponent, eventually your opponent will miss. For recreational players, the vast majority of points in tennis end in an unforced error rather than a winner.
Avoiding unforced errors in investing
As in sports, winning the investing game is not about trying to hit winners, but minimizing unforced errors. Here are the big types of unforced errors investors commonly make:
Trading too much
Investors are notoriously unsuccessful at trading. When they try to time the market, they inevitably buy high and sell low instead of buying low and selling high. They get eaten up by commissions and bid-ask spreads. If they trade in a taxable account, they have to pay short-term capital gains taxes on any profits. One study found that the most active traders had the worst investment returns.
Paying too much money in fees
When investors trade too much and are unsuccessful in trading themselves, they often then believe they can hire someone who can beat the market. They might look for a manager with a superlative training / education background or who has a track record of beating the stock market. Unfortunately, these managers also on average fail to beat the market. Over time, a significant percentage of an investor’s portfolio gets transferred to the fund manager’s pocket in the form of fees.
Not minimizing taxes on profits
You can’t keep all of your investment gains, and you want to make every effort to keep as much of your investment gains by minimizing taxes. Some of the steps to minimize taxes include maximizing money in tax-advantaged accounts, minimizing short-term trading in taxable accounts, and placing tax-inefficient asset classes into tax-deferred accounts.
Taking too much risk
When investors take too much risk, it can be difficult to stay the course when the stock market falls. The paper losses can cause them to lose sleep at night and possibly make rash, emotional decisions to sell at the worst possible time.
Taking too little risk
For some investors, taking too little risk can be just as bad an unforced error as taking too much risk. There are some investors, whether they are fearful of the stock market or for other reasons, choose to hold all of their money in CDs or other “safe” investments. However, taking too little risk can make it less likely, not more likely, to reach your investment goals, as Warren Buffett explained in his 2018 annual letter to shareholders.
While it is more enjoyable to try to find ways to increase investment returns, to win the investing game, you should instead focus on avoiding investing mistakes. If you are able to keep as much of the total stock market return as possible, you will win the investing game and beat the vast majority of your fellow investors.
What do you think? Is most of your investing success based on strategies that increase investment returns? Or is most of your success based on your ability to keep as much of what the market will give you?
“Wall Street Physician,” a former Wall Street derivatives trader , is a physician who blogs at his self-titled site, the Wall Street Physician.
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