It's behavior that determines your success or failure as an investor -- not knowledge, skill or luck.
On that day, the Dow Jones Industrial Average($INDU -0.89%) closed at a gut-wrenching low of 6,547. Stock prices had been cut in half in just 15 months.General Electric (GE -0.59%, news) had plunged from $38 to $7, Cisco Systems (CSCO -0.84%, news) from $29 to $14, and Bank of America (BAC -2.17%, news) from $43 to $4.
Making money in the stock market is hard not because finding great companies is difficult but because the best and easiest-to-understand strategy for winning is so difficult to adhere to. That strategy can be described in three words: buy and hold.
Five years from that 2009 bottom, the Dow was up roughly 10,000 points to a new record. No, the stock market doesn't always bounce back so dramatically, but it always bounces back.
No matter what the chart followers say, the market does not rise and fall in repeating patterns. If it's down sharply in a three-year stretch, for example, it won't necessarily rise just as sharply over the next three years. The market works on its own timetable, but there are some eternal verities:
- Stocks of large U.S. companies have reliably returned about 10 percent annualized over the past two centuries. They should do just as well for the next two.
- In the short term, the market can be risky -- if we define risk as volatility, or the severity of the ups and downs. In the long term, the market is much, much less risky.
- Individual companies can vaporize (Enron and Lehman Brothers, to name a couple), but a diversified portfolio protects you from the risk that an individual company will implode and provides a smoother ride.
- Compounding is enormously powerful. Over long periods, small price gains and dividend payouts mount up (but note that the expenses charged by mutual funds, brokers and other advisers add up, too).
And that's it! That is all you need to know about succeeding in the stock market. Buy a solid, low-cost, diversified mutual fund (or assemble your own diversified portfolio), forget about it for a long time, and you should do well.
As an example, consider Dodge & Cox Stock (DODGX -2.08%, news), with an expense ratio of 0.52 percent. Over the past 15 years, a $10,000 investment in Dodge & Cox, a member of the Kiplinger 25, grew to about $40,000. At that rate, in another 15 years it will become $160,000, and in another 15 years it will be $640,000. And that spectacular growth comes from an annualized return of 9.5 percent, roughly the historical norm. Any 30-year-old who can put away $30,000 -- not every year but just once -- has an excellent chance of becoming a millionaire by age 70.
Psychological hurdles
It is behavior that determines investment success or failure -- not knowledge or skill or luck. Benjamin Graham, the Columbia University professor and financier who was Warren Buffett's mentor, wrote: "The investor's chief problem -- and even his worst enemy -- is likely to be himself." What he meant was that people let their emotions get in the way of smart investment moves. They tend to buy when stocks soar and sell when stocks sink.
- Video: The deadly sins of investing
The selling part is especially dangerous because people want to avoid losing. Richard Thaler and Cass Sunstein write in their book "Nudge" that academic research has found that "losing something makes you twice as miserable as gaining the same thing makes you happy."
They point out that in 1992, participants in retirement plans administered by Vanguard were allocating 58 percent of their assets to stocks. But by 2000, as stocks had quadrupled in value, the proportion rose to 74 percent. Then, as stocks fell sharply over the next two years, the allocation fell to 54 percent. "Their market timing," they write, "was backward." We saw the same phenomenon during the recent cycle, with investors bailing out of stock funds as prices sank and returning only recently, as indexes hit new highs.
The values that help you succeed in the market are the values that Aristotle extolled: moderation, persistence and humility. The question is how to adopt behaviors that fit those values when the minute-by-minute noise of the market is so dramatic. Here's some advice:
Avoid the noise. One way to make yourself get out of bed in the morning without hitting the snooze button is simply to move the alarm clock away from your bed. The investment equivalent is moving stock-price information as far away as you can. Twenty years ago, I told the editor of the Washington Post's business section to quit running pages and pages of stock prices. Stop encouraging readers to check how their shares were doing each morning. The Post did drop the tables, but mainly because readers can now get prices by the second on their computers and smart phones. Don't fall into that habit. Check your holdings once a month or once a quarter.
For many investors, sitting still is not an option. They have to do something. If you're in that category, I suggest you set up a "fun and games" account, a separate portfolio that represents, say, 5 to 10 percent of your assets and in which you can trade to your heart's content. Compare its results with that of your buy-and-hold portfolio over five or ten years. Chances are high that your emotions and the costs of trading have taken a toll.
Make purchases in the same amount every month or quarter. This technique, known as dollar-cost averaging, forces you to buy more shares when prices drop. Instead of feeling bad about market declines, you may actually feel good because you are picking up more assets at better prices.
Think buy, not sell. Hunt for bargains. The recovery, by the way, is not over. For example, GE trades today at $26, still about one-third below its 2007 high. Cisco sells for under $23, also about one-third off its high. Bank of America is at $16, still down about 70 percent. I recommend them all.
In urging a buy-and-hold strategy, I am not suggesting that you mindlessly keep companies that have gone sour. The reason to sell, however, is not that the price of a stock has declined but that the business has deteriorated and is unlikely to recover -- a key new product has failed, a rival has started a price war, or the new CEO is clueless. If you have chosen stocks well, these events will be rare. And if you are wise, you will err on the side of keeping what you have. If you had done that five years ago, your portfolio would be up, oh, some 200 percent.
James K. Glassman is a visiting fellow at the American Enterprise Institute. His most recent book is "Safety Net." He owns none of the stocks mentioned.
Source: http://money.msn.com/how-to-invest/buy-hold-and-prosper-the-power-of-patient-investing
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