The New York Stock Exchange was created on May 17, 1792 when 24 stock brokers signed an agreement under a buttonwood tree at 68 Wall Street. Countless fortunes have been made and lost since that time while shareholders fueled an industrial age that’s now spawned a landscape of too-big-to-fail corporations. Insiders and executives have profited handsomely during this mega-boom, but how have smaller shareholders fared, buffeted by the twin engines of greed and fear?

Discount brokers, advisors and other financial professionals can pull up statistics showing stocks have generated outstanding returns for decades. However, holding the wrong stocks can just as easily destroy fortunes and deny shareholders more lucrative profit-making opportunities. In addition, those bullet points won’t stop the pain in your gut during the next bear market, when the Dow Industrial Average could drop more than 50%, as it did between October 2007 and March 2009. 

Retirement accounts like 401(k)s and others suffered massive losses during that period, with account holders ages 56 to 65 taking the greatest hit because those approaching retirement typically maintain the highest equity exposure. The Employee Benefit Research Institute (EBRI) studied the crash in 2009, estimating it would take up to 10 years for 401(k) accounts to recover those losses at an average 5% annual return. That’s little solace when years of accumulated wealth and home equity are lost just before retirement, exposing shareholders at the worst possible time in their lives. 

That troubling period highlights the impact of temperament and demographics on stock performance, with greed inducing market participants to buy equities at unsustainably high prices while fear tricks them into selling at huge discounts. This emotional pendulum also fosters profit-robbing mismatches between temperament and ownership style, exemplified by a greedy uninformed crowd playing the trading game because it looks like the easiest path to fabulous returns.

Making Money In Stocks Through The Buy and Hold Strategy

The buy and hold investment strategy became popular in the 1990s, underpinned by Nasdaq’s four tech horsemen, a.k.a. big tech stocks that financial advisors recommended to clients as candidates to buy and hold for life. Unfortunately, many folks followed their advice late in the bull market cycle, buying Cisco Systems Inc., Intel Corp, and other inflated assets that still haven’t returned to the lofty price levels of the dotcom/internet bubble era. Despite those setbacks, the strategy has prospered with less volatile blue chips, rewarding investors with impressive annual returns.

In 2011, Raymond James and Associates published a study of long-term buy and hold performance, examining the 84-year period between 1926 and 2010. This era featured no less than three market crashes, generating more realistic metrics than the majority of cherry-picked industry data. Small stocks booked an average 12.1% annual return over this period while large stocks lagged modestly with a 9.9% return. Both asset classes outperformed government bonds, treasury bills and inflation, offering highly advantageous investments for a lifetime of wealth building.

Equities continued their strong performance between 1980 and 2010, posting 11.4% annual returns. The REIT equity sub-class beat the broader category, posting 12.3% returns, with the baby boomer real estate boom contributing to that group’s impressive performance. This temporal leadership highlights the need for careful stock picking within a buy and hold matrix, either through well-honed skills or a trusted third party advisor.

Large stocks underperformed between 2001 and 2010, posting a meager 1.4% return while small stocks retained their lead with a 9.6% return. The results reinforce the urgency of internal asset class diversification, requiring a mix of capitalization and sector exposure. Government bonds also surged during this period, but the massive flight to safety during the 2008 economic collapse likely skewed those numbers.

The James study identifies other common errors with equity portfolio diversification, noting that risk rises geometrically when one fails to spread exposure across capitalization levels, growth vs. value polarity and major benchmarks, including the Standard & Poor’s 500 Index. In addition, results achieve optimal balance through cross-asset diversification that features a mix between stocks and bonds. That advantage intensifies during equity bear markets, easing downside risk.

The Importance of Risk and Returns

Making money in the stock market is easier than keeping it, with predatory algorithms and other inside forces generating volatility and reversals that capitalize on the crowd’s herd-like behavior. This polarity highlights the critical issue of annual return because it makes no sense to buy stocks if they generate smaller profits than real estate or a money market account. While history tells us that equities can post stronger returns than other securities, long-term profitability requires risk management and rigid discipline to avoid pitfalls and periodic outliers.

Modern portfolio theory provides a critical template for risk perception and wealth management, whether you’re just starting out as an investor or have accumulated substantial capital. Diversification provides the foundation for this classic market approach, warning long-term players that owning and relying on a single asset class carries much higher risk than a basket stuffed with stocks, bonds, commodities, real estate and other security types.

Also recognize that risk comes in two distinct flavors, systematic and unsystematic. Systematic risk from wars, recessions and black swan events generate high correlation between diverse asset types, undermining diversification’s positive impact. Unsystematic risk addresses the inherent danger when individual companies fail to meet Wall Street expectations or get caught up in a paradigm-shifting event, like the food poisoning outbreak that dropped Chipotle Mexican Grill Inc. more than 500 points between 2015 and 2017.

Many individuals and advisors address unsystematic risk by owning exchange traded funds (ETFs) or mutual funds instead of individual stocks. Index investing offers a popular variation on this theme, limiting exposure to S&P 500, Russell 2000, Nasdaq 100 and other major benchmarks. Both approaches lower but don’t eliminate unsystematic risk because seemingly unrelated catalysts can demonstrate high correlation to market capitalization or sector, triggering shock waves that impact thousands of equities simultaneously. Cross market and asset class arbitrage through lightning-fast algorithms can amplify and distort this correlation, generating all sorts of illogical price behavior.

Common Investor Mistakes

The 2011 Raymond James study noted that individual investors underperformed the S&P 500 badly between 1988 and 2008, with the index booking an 8.4% annual return compared to a limp 1.9% return for individuals. The most detrimental investor mistakes were segmented as follows:

Top results highlight the need for a well-constructed portfolio or skilled investment advisor who spreads risk across diverse asset types and equity sub-classes. A superior stock or fund picker can overcome the natural advantages of asset allocation but sustained performance requires considerable time and effort for research, signal generation and aggressive position management. Even skilled market players find it difficult to retain that intensity level over the course of years or decades, making allocation a wiser choice in most cases.

However, allocation makes less sense in small trading and retirement accounts that need to build considerable equity before engaging in true wealth management. Small and strategic equity exposure may generate superior returns in those circumstances while account building through paycheck deductions and employer matching contributes the bulk of capital. Even this approach poses considerable risks because individuals may get impatient and overplay their hands by making the second most detrimental mistake, i.e. trying to time the market.

Professional market timers spend decades perfecting their craft, watching the ticker tape for thousands of hours, identifying repeating patterns of behavior that translate into profitable entry and exit strategies. Timers understand the contrary nature of market cyclicity and how to capitalize on the crowd’s greed or fear-driven behavior. Conversely, the average investor fails to comprehend the cyclical nature of market movement, often buying too high or selling too low. As a result, their market timing decisions undermine long-term returns while draining their confidence, adding a psychological barrier that can be hard to overcome.

Investors want to believe in the companies they own but the love affair can be detrimental because it encourages excess exposure in a few stocks, adding greatly to unsystematic risk while blinding them to negative catalysts that alter the playing field. We get hypnotized by tall tales about buying and holding Apple or Amazon and look forward to the big killing we can brag about during the next family reunion.

Unfortunately, paradigm-shifting story stocks are few and far between, demanding a journeyman’s approach to stock ownership rather than a gunslinger strategy that chases the next big thing. This is tough to accomplish in our social media–dominated environment, in which equities attract near religious adoration while shills quietly fill comment sections with misinformation.

Know the Difference: Trading vs. Investing

For many individuals, employer 401(k) programs offer their first opportunity to play the stock market. These accounts encourage buy and hold strategies, with yearly allocations that may be difficult or impossible to change mid-year. Stock ownership opportunities expand geometrically after years of wealth building generate the capital required to open a self-directed brokerage account or to place funds in the hands of a trusted advisor. Job changes add to these choices, with access to self-directed rollover IRA accounts.

Trading and short-term speculation become viable alternatives in these fortunate circumstances, taking part or all of the freed-up capital and seeking to profit from technical price movement, news flow or shifts in sentiment. Endless anecdotes about windfall profits and thousands of websites lure billions of dollars into these strategies, which sound more exciting then splitting a retirement account between stocks and bonds and walking away for a decade. However, the vast majority of traders are destined to fail, often losing their entire stakes in the blink of an eye.

As with market timing, profitable trading requires a full-time commitment that’s nearly impossible when one is employed outside the financial services industry. Those within the industry view their craft with as much reverence as a surgeon views surgery, keeping track of every dollar and how it’s reacting to market forces. They understand the enormous risk after surviving massive drawdowns and have endured long enough to escape the gauntlet of profit-robbing games unleashed by predatory algorithms and market insiders.

In 2000, the Journal of Finance, published a University of California, Davis, study that addresses common myths ascribed to the trading game. The authors surveyed over 66,000 households, noting that trades produced an 11.4% annual return between 1991 and 1996 compared to 17.9% for broad benchmarks. They also note that net returns fell in direct proportion to turnover, i.e. the number of times stocks were bought and sold. Those results challenge the myth that frequent trade execution produces higher profits because the strategy captures the most dynamic intervals in strongly trending securities.

The authors identified over-confidence and a preference for small high-beta stocks as precursors to high volume trading and poor performance. This partially addresses the issue of perception when it comes to trading and investment. Adding to a prior analogy, the gunslinger feels that the ticker tape can be bent to his or her will, paying off on short-term bets. Conversely, the journeyman accepts the often chaotic nature of stock movement, seeking a symbiotic relationship that capitalizes on the underlying trends.

Authors Xiaohui Gao and Tse-Chun Lin offered interesting evidence in a 2011 study that individual investors view trading and gambling as similar pastimes, noting how volume on the Taiwan Stock Exchange inversely correlated with the size of that nation’s lottery jackpot. Their findings suggest that investors chose to forego trading positions when viewing the lottery jackpot as offering a greater profit opportunity.

The results dovetail with anecdotal evidence that traders seek the adrenaline rush generated by short-term stock speculation as well as financial returns. Unfortunately, that rush comes whether the trade produces a profit or a loss, generating self-destructive reinforcement that helps to explain why so many traders blow out their accounts with catastrophic and often life-altering losses. It also makes sense that overconfidence adds destructive power to this feedback loop and explains why it can encourage traders to double and triple down on losers.

Finances, Lifestyle and Psychology

Profitable stock ownership requires narrow alignment with an individual’s personal finances. A recent college graduate may be limited to 401(k) allocations for many years before acquiring the capital required to expand investment options. At the other end of the spectrum, older families may have accumulated substantial wealth but have little time to grow returns, making a trusted advisor the only viable option. Many folks fall in between, building tidy nest eggs they want to grow at a faster pace through self-direction.

Mismatches may generate inferior returns or no returns at all. Younger folks just starting out may grow impatient with wealth building and sample too many investment styles, losing money in the process. The dangers of trading should be clear at this point, limited to disposable capital until a long-term track record supports greater risk. Meanwhile, older individuals with limited skill sets can make catastrophic errors self-directing stock portfolios when a professional, presumably unburdened by the greed-fear polarity, makes wiser choices based on extensive market experience.

It’s imperative that personal health and discipline issues be fully addressed before engaging in a proactive investment style because markets tend to mimic real life. Drug and nicotine abuse as well as sedentary lifestyles can have adverse impacts on returns if they generate low self-esteem, which may unconsciously seek reinforcement through financial losses. This is especially true when engaging in short-term speculation, in which the cards are already stacked in favor of the house.

A 2005 study describes the Ostrich Effect, which found that investors engage in selective attention when it comes to their stock and market exposure, viewing portfolios more frequently in rising markets and less frequently or “putting their heads in the sand” in falling markets. It also notes how these reviews or non-reviews generate pain and pleasure events, generating secondary reinforcement that may impact financial returns.

The author further notes how this phenomenon impacts trading volume and market liquidity. Volumes tend to increase in rising markets and decrease in falling markets, adding to the observed tendency for participants to chase uptrends while turning a blind eye to downtrends. Over-coincidence could offer the driving force once again, with the participant adding new exposure because the rising market confirms a pre-existing positive bias.

The loss of market liquidity during downturns is consistent with the study’s observations, indicating that “investors temporarily ignore the market in downturns—so as to avoid coming to terms mentally with painful losses.” This self-defeating behavior is also prevalent in routine risk management undertakings, explaining why investors often sell their winners too early while letting their losers run—the exact opposite archetype for long-term profitability.

Black Swans and Outliers

Wall Street loves statistics that show the long-term benefits of stock ownership, which is easy to see when pulling up a 100-year Dow Industrial Average chart, especially on a logarithmic scale that dampens the visual impact of four major downturns. Ominously, three of those brutal bear markets have occurred in the past 31 years, well within the investment horizon of today’s baby boomers. In-between those stomach-wrenching collapses, stock markets have gyrated through dozen of mini-crashes, downdrafts, meltdowns and other so-called outliers that have tested the willpower of stock owners.

It’s easy to downplay those furious declines, which seem to confirm the wisdom of buy and hold investing, but psychological shortcomings outlined above invariably come into play when markets turn lower. Legions of otherwise rational shareholders dump long-term positions like hot potatoes when these selloffs pick up speed, seeking to end the daily pain of watching their life savings go down the toilet. Ironically, the downside ends magically when enough of these folks sell, offering bottom fishing opportunities for those incurring the smallest losses or winners who placed short sale bets to take advantage of lower prices.

Nassim Taleb popularized the black swan event in his 2010 book “The Black Swan: The Impact of the Highly Improbable.” He describes three attributes for this colorful market analogy.

  1. First, it’s an outlier or outside normal expectations.
  2. Second, it has an extreme and often destructive impact.
  3. Third, human nature encourages rationalization after the event, “making it explainable and predictable.” Given the third attitude, it’s easy to understand why Wall Street never discusses the black swan’s negative effect on stock portfolios.

Shareholders need to plan for black swan events in normal market conditions, rehearsing the steps they’ll take when the real thing comes along. The process is similar to a fire drill, paying close attention to the location of exit doors and other means of escape if required. They also need to rationally gauge their pain tolerance because it makes no sense to develop an action plan if it’s abandoned the next time the market enters a nosedive. Of course, Wall Street wants investors to sit on their hands during these troubling periods, but no one but the shareholder can make that life-impacting decision.

The Bottom Line

Yes, you can earn money from stocks and be awarded a lifetime of prosperity, but potential investors walk a gauntlet of economic, structural and psychological obstacles. The most reliable path to long-term profitability will start small by picking the right stock broker and beginning with a narrow focus on wealth building, expanding into new opportunities as capital grows. Buy and hold investing offers the most durable path for the majority of market participants while the minority who master special skills can build superior returns through diverse strategies that include short-term speculation and short selling.

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