Lately there seems to be so many reasons to stay away from the stock market. And yet, statistics show that over time, even including the tough times like we’re having now, the stock market has consistently outperformed inflation and other mainstream investment vehicles.
Given that statistical validation, it can be easy to just dive in. But the new investor especially should beware, because there are inherent risks in the stock market, just as there are in other forms on investing. Especially in downward-trending markets.
One of the biggest mistakes investors make is trying to time the market.
There is a huge difference between short-term and long-term investing, and understanding it can be key to your success. Long-term investors who try to time the market – pull out at the high points, then buy back in at the low points – are risking not only short-term catastrophe, but a significant compromise to their return over time.
Statistics have proven this to be true. Why? Because nobody can consistently outguess – in other words, time – the stock market. And when you add in transaction fees, downside risks, opportunity costs transactions fees, the downside almost always overwhelms the potential gains of trying to time the market.
It’s like gambling. You can’t always guess right when it comes to red or black.
Better to buy wisely and then stay the course.
Another risk is to act on second-hand or unreliable information, often positioned as insider tips, rather than solid research. While stock prices are affected by the general economy, current events and even rumor, the fundamental variable over time in the performance of a security is the underlying company’s financial strength and profitability, all in context to their future outlook.
These are the things you need to understand, because you’ll never completely understand – or time – those other non-performance-based variables. Those factors are the tools of short-term investors, who try to play market swings for quick gains, which are often not directly related to profitability and outlook.
Putting All Your Money on One Horse
A key concept for safe investing is diversification. This means you spread your risk over several securities instead of putting all your money behind one company. While this may limit your upside – not all of them will experience explosive growth and success, though one or two might – it does limit your downside exposure for the same reasons.
One way to diversify is to invest in mutual funds comprised of a certain profile of stocks according to your wishes. Mutual funds exists for virtually any type of goal, and the common attribute is the spreading of risk through diversification.
These funds are managed by professionals who research and monitor the market and the companies who play in them far more closely and with much greater sophistication than any individual investor could possibly achieve. The smart money listens to them and selects the fund that aligns with their goals, rather than going it alone.
As always, the golden rule of investing holds true – there is a tradeoff between risk and reward, and you don’t get the best of both worlds. Only you know your tolerance for risk, and that is the thing that determines not only what you invest in, but how.
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Great articles, Larry.
I especially agree with not timing the market and buying based on thinking independently.
One thing about diversification …. it’s important to know how many stocks constitute sufficient diversification.
In my experience, if you pick strong companies with wide economic moats at attractive prices, you can get by with 6 or 7 such companies. Your risk is mitigated due to the strong fundamental criteria your companies pass before selection and the large margin of safety in the price.