(This is the fourth post in a series on the risks of investing in stocks. The series starts here)
So far we have covered the risk posed by volatility and the risk posed by poor stock picking. Volatility is the risk posed by the large potential changes in price for common stocks. Poor stock picking poses a risk both because of actual money lost and because of time lost while holding bad investments. Another risk that those venturing into individual stock investing face is that they will start to over trade, and that over trading will reduce their returns.
People trading individual stocks also tend to get enamored with the price movements of the stocks and begin to believe that they can nimbly move into and out of stocks. Similar to the rush some people get from gambling, those trading stocks get excited by seeing money made quickly. Individual stocks can (and do) increase or decrease in price by 50% or more during a year. It is not unusual at all for a stock to double within a year.
People will have a stock that does well, resulting in a good profit within a relatively short period of time, and begin to think that they can jump in and out of stocks and beat the market. Perhaps they buy 100 shares of a stock at $20 per share and sell it a couple of months later for $25 – a $500, or 25% gain. They start to extrapolate and imagine a lifestyle where they trade during the mornings and then play golf in the afternoons. Some even think that they can become day traders, making money on 1/8 point movements up or down.
The reality is, the price movements over short periods of time are just random fluctuations. At any given time, everything that is known about a company will be factored into the price of the stock. This means that everything else is just noise. If you are trying to jump into and out of a stock to take advantage of price movements, you are doing no better than betting on red and black in a casino. While you may have a lucky streak now and again, the odds will catch up with you (and the odds are that you will have a 0% return since the chances fo you being right or wrong about the direction of the stock are about 50-50). Combine this with trading expenses, and you will slowly lose money over time. At best, you will eek out a small return but lag the overall market.
The bigger risk is that you will make your 25% return, and then miss a several thousand percent return over the next several years because you’ve sold out before a really big price move.
People who make money in the markets – real money – do so by putting the odds in their favor. This means buying companies that show a good potential to grow and then holding them for long periods of time. You make money because the company grows more profitable and you own a piece of the company. This type of growth is predictable. The random fluctuations that the price of a company will make over a few weeks, months, or even a year are not.
When you invest in this manner, you also make serious money. You see $10,000 investments turn into $100,000 positions over a period of several years. Not $2,000 investments turn into $2,500 investments. You make more money than your broker or the tax man. It is not exciting and it is not going to win you any great stories for the golf course. It is boring. But it is how you make money in investing.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Picture Credits: Thomas Picard, downloaded from stock.xchng