Can You Earn Money in Stocks?
If we look at the graphs showing historical stock value, we will be able to see outstanding results. However, this does not mean that owning stocks is a completely foolproof way of obtaining income. Entire families have been destroyed by a poor choice of stocks. Global meltdown showed us just how careful we must be with our investments.
One of the problems is the pendulum of emotions that can swing in the direction of selling and buying for a massive number of investors. This is why we need to know what strategy to choose in order to protect our investments and maximize our profits.
Making Money In Stocks Through The Buy and Hold Strategy
This strategy became popular in the 1990s due to the rise of tech companies. Financial advisors have recognized the potential these companies have in the long run and advised their clients to buy stocks and hold on to them for life.
It is important to note that from 1926 to 2010 small stocks managed to have an annual return of 12.1%, while the large stocks had a modest return of 9.9%. This is why it is of great importance to have a good choice of stocks on a buy and hold strategy. Consequently, this means that we can either hone our finance skills or hire a professional advisor.
According to James and associates (2011), there are “some common errors when it comes to equity portfolio diversification when investors fail to spread exposure across capitalization levels, growth vs value polarity and major benchmarks”. In short, this means that we can make a cross-asset diversification, combining stocks and bonds.
The Importance of Risk and Returns
We can secure long-term profitability by applying constant risk management. This means that the rate of return that comes with an investment needs to compensate for the risk rate that accompanies it.
There are two types of risks — systematic and unsystematic. If an individual or a company can do nothing to affect the risk, we call that risk systematic. This can be any risk that exists on a national or international level and affects everyone. Inflation rate, tax rates, interest rates, exchange rates, political instability, purchasing power, wars and so on are all considered systematic risks. We cannot remove this type of risk by diversifying our investments.
On the other hand, unsystematic risk is a part of the danger that comes with investing a certain stock or company. Worker strikes, food poisoning scandals (remember what happened to Chipotle?), marketing failures, product failures and so on are all prime examples of unsystematic risks.
Common Investor Mistakes
A 2005 Survey of financial advisors on asset allocation breaks down the most common mistakes investors make:
- They don’t pay enough attention to allocating their assets (33%).
- They are trying to time the market (31%).
- They put too much money into one investment (16%).
- They hold on to their investments for too long (11%).
- They buy overvalued investments (8%).
- Other mistakes (1%).
The first two most common mistakes show us the need for hiring investment advisors in order for us to have the best portfolio we can. Moreover, it takes a lot of time and effort spent researching in order to have continuous results. Even some experienced players can lose their continuity and start to think that allocation is a wiser choice. However, allocating is not very logical for small accounts such as the ones for trading or retirement.
If the account is small, it may be wiser to concentrate on small and strategic equity exposure. It will create superior returns. Nevertheless, this strategy can also pose considerable risks, since individuals can get impatient. Consequently, the second most common mistake is born.
Professional market timers spend decades honing their craft. They understand the cyclic nature of the market and they know how to capitalize on the psychology of the masses. In contrast, an average investor does not understand this nature. In turn, that makes them buy at too high of a price while selling at too low of a price. Also, your average investor puts way too much trust in companies, leading to excess exposure in few stocks. This makes the unsystematic risk even higher.
Know the Difference: Trading vs Investing
The first opportunity to invest for many of us is the 401k program. In 401k, it is impossible to change allocations mid-year and opportunities to own more stocks increase as the years go by. This is why 401k programs encourage buy and hold strategies. Long-term asset ownership generates capital that is required for opening a brokerage account. However, we can also choose to place our funds into the hands of a financial advisor.
In order to be profitable in trading, we need to be absolutely dedicated and a have a full-time commitment to it. It is not possible to be successful in the long run if financial activities are not our primary job.
In a nutshell, trading is based on buy to sell strategy and investing is based on buy to hold strategy. This is the fundamental difference.
It is interesting to note that a number of studies indicate that traders are often motivated by the adrenaline rush that happens after a successful sale.
Finances, Lifestyle, and Psychology
Not all of us have the same goals and expectations when it comes to finance and the biggest factor for these differences is age. When it comes to allocation, younger people will be limited to their 401k programs for years. On the other hand, people who are about to retire have a wide spectrum of choices, but not much time to grow returns. When it comes to older people, a solid advisor is the best choice of action.
Mismatching assets with individual needs may create no returns at all. Young people tend to fall into the trap of being impatient, losing their money. At the same time, older people tend to fall into another kind of trap — that of arrogance. Thinking they know how to handle their finances can lead them into a world of problems, especially if they are run by green and/or fear.
Black Swans and Outliners
In his, now famous, book “The Black Swan”, Nassim Taleb defines the black swan as an unexpected event with a long series of systemic consequences. He describes three attributes this phenomenon has:
- It lies outside of normal expectations.
- It has an extreme and destructive impact.
- Humans tend to rationalize this event, thinking of it as predictable and explainable.
Given all this, it is easy to understand why Wall Street isn’t too keen on discussing the black swans’ negative effects on our portfolios.
The Bottom Line
We can earn money in stocks. But it takes dedication, choosing the right broker, and a correct strategy.