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While reading ‘The Simple Path to Wealth: Your road map to financial independence and a rich, free life’ by J L Collins, I got the answer to this critical question. And the question is “Why do most people lose money in the share market?”
I have asked several corporate professionals, who were engaged in various types of trading activities, what is their net profit till now. The first response was hardly they were having profit. Scenarios were like that they were having very high profit in one bucket of shares but at the same time high loss in another bucket of shares. Overall it was merely any profit.
Of course, there were few people, who had made a good amount of profit. But the point is they were only a few. Most of them were losing money or just hoping for a good return on their selected bucket of shares in the future.
Even when the market is going up, people do not book their profit & come out. They constantly hope for the rising of the market.
In this article, some of the research content is related to the U.S., but it hardly matters as finally, it’s share market. Its rule and psychology are the same for us. So let’s start to understand the why: (the excerpt is from the above book)
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros
We Think We Can Time the Market
While stepping out when it is high and back in when it is low sounds enormously appealing, it is almost impossible to do. The reality is that we usually buy high and sell low, panicking when times are tough and buying when the market is soaring.
This applies to all of us. It is the way humans are hard-wired. Over the past twenty-odd years an array of academic papers have appeared investigating the psychology of investors. The results aren’t pretty. Seems we are psychologically unsuited to prosper in a volatile market.
Here’s a sobering fact: The vast majority of investors in mutual funds actually manage to get worse returns from their funds than the funds themselves generate and report. Our psychology is such that we can’t help trying to “time” the market. We tend to jump in and out, almost always at the wrong times.
We Believe We Can Pick Individual Stocks
You can’t pick winning stocks. Don’t feel bad. I can’t either. Nor can the overwhelming majority of professionals in the business. The fact that this ability is so rare is the key reason why the very few who apparently can are so famous.
Oh, sure. Occasionally we can and, oh my, what a heady feeling it is when it works. It is incredibly seductive. Picking a stock that soars is an intense and addictive high. The media is filled with “winning” strategies that feed on this delusion.
In the word of J L Collins, “I am not immune from the attraction. Back in 2011, I thought I had spotted a trend and as it happened made 19% in four months on the five stocks I chose. (Sigh. I still have this addiction.) That’s almost 60% annualized, while the market was flat for the year. That’s spectacular if I do say so myself. It is also impossible to do year after year. It’s a great rush, but a very poor foundation upon which to try and build wealth.”
Even slightly beating the index year after year is incredibly difficult. Only a handful of investors have been able to modestly beat it over time. Doing so makes them superstars. That’s why Warren Buffett, Michael Price, and Peter Lynch are household names.
We Believe We Can Pick Winning Mutual Fund
Actively Managed Stock Mutual Funds (funds run by professional managers, as opposed to Index Funds) are a huge and highly profitable business. Profitable for the companies that run them. For their investors, not so much.
So profitable that there are actually more mutual funds out there than stocks. According to the U.S. News and World Report, as of 2013 there were about 4,600 equity (stock) mutual funds operating in the U.S. Recall there are only about 3,700 publicly traded stocks in the U.S. You read that correctly. Yeah, I’m amazed too.
The article goes on to say about 7% of funds fail each year. With so much money at stake, investment companies are forever launching new funds while burying the ones that flounder. The financial media is filled with stories of winning managers & funds and lavishly profitable advertising from them. Past records are analyzed. Managers are interviewed. Companies like Morningstar are built around researching and ranking funds.
The fact is, few fund managers will beat the index over time. In 2013, Vanguard posted the results of their research on this. Starting in 1998 they looked at all of the 1,540 actively managed equity funds that existed at the time. Over the next 15 years, only 55% of these funds survived and only 18% managed to both survive and outperform the index.
82% failed to outperform the unmanaged index. But 100% of them charged their clients’ high fees to try.
Every fund prospectus carries this phrase: “Past results are not a guarantee of future performance.” It is the most ignored sentence in the whole document. It is also the most accurate.
Mutual fund companies launch new funds all the time. Random chance is enough to predict a few will do well, at least for a while. Those that don’t are quietly closed and the assets folded into something doing better. The bad fund disappears and the company can continue to claim its funds are all stars. There’s lots of money to be made with actively managed funds. Just not by the investors.
We Focus on the Foam
Imagine you’ve been reading this article on a nice warm summer afternoon. Richly deserving of a reward, you crack open a bottle of your favorite brew and pour it into a nice chilled glass. If you’ve done this before you know that if you carefully pour it down the side you’ll wind up with a glass filled mostly with beer and a small foam head. Pour it fast and down the center and you can easily have a glass with a little beer filled mostly with foam.
Imagine now someone else has poured it for you, out of sight, and into a dark mug, you can’t see through. You have no way of knowing how much is beer and how much is foam. That’s the share market or stock market.
See, the share market is really two related but very different things:
It is the beer: The actual operating businesses of which we can own a part.
It is the foam: The traded pieces of paper that furiously rise and fall in price from moment to moment. This is the market of the business news channels. This is the market of the daily share market report. Yes, this is the market people are talking about when they liken Wall Street to Las Vegas. This is the market of the daily, weekly, monthly, and yearly volatility that drives the average investor out the window and onto the ledge. This is the market that, if you are smart and want to build wealth over time, you will absolutely ignore.
When you look at the daily price of a given stock, it is very hard to know how much is foam. This is why a company can plummet in value one day, and soar the next. This is why business news channel routinely features experts, each impressively credentialed, confidently predicting where the market is going next—while consistently contradicting each other. It is all those traders competing to guess how much beer and how much foam is actually in the glass at any particular moment.
While this makes for great drama and television, for our purposes it is only the beer that matters. It is the beer that is the real operating money-making underlying businesses, beneath all that foam, that over time drives the market ever higher.
Understand too, that what the media wants from these commentators is drama. Nobody is going to sit glued to their TV while some rational person talks about long-term investing. But get somebody to promise the market is going to cross XX,000 by year’s end. It’s all just so much foam, fluff, and noise. It doesn’t matter to us. We’re in it for the beer!
So be wise while investing in the share market.
