Don’t be an ignorant investor
“Calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic.” - Warren Buffett
Warren puts this very well. Essentially what he is advocating is that the best approach to investing is buying and holding for the long-term. Warren Buffett is obviously one of (if not the best) the best investors who have ever lived. He runs Berkshire Hathaway along with his long-term friend Charlie Munger. Both Charlie and Warren practise what they preach and most of their success can be attributed to long-term investing.
Now, Warren and Charlie both pick individual stocks when running Berkshire Hathaway but it is worth noting that Warren has often advocated for investing in index funds for most people (check out this video).
This raises the question, should more investors be more realistic when it comes to their investing capabilities? P.S. this is nothing to be ashamed of, quite the opposite.
I think if you want more certainty on the probability of achieving positive stock market returns over the long-term, you need to look to index funds and diversification. Predicting the probability of individual stocks producing positive returns is very difficult and the statistics are actually pretty bleak. A paper written by Hendrik Bessembinder “Do Stocks Outperform US Treasury Bills?” suggests nearly 60% of global stocks over the past 28 years did not outperform one-month treasury bills (a cash equivalent). Bessembinder also notes that a mere 1% of companies accounted for all of the global net wealth creation. You can read more about this in this article.
So really if you pick individual stocks you are almost trying to find a needle in a haystack. With diversification, you increase your chances of including the stocks that provide the more extreme returns (those that Bessembinder suggests to account for all global net wealth creation) in your portfolio and this is why index funds have been so successful. Baillie Gifford have spent a lot of time trying to understand these types of topics and apply the philosophy that the biggest risk to their portfolios is selling too quickly and not capitalising on the returns that some of these extreme companies can provide. I have to admit, I am also a big fan of Baillie Gifford and hold a few of their funds (including their flagship fund Scottish Mortgage Investment Trust).
There was a study performed which looked at the probability of positive returns if you were to invest in an index fund which tracks the world stock market. They looked at returns from 1971 to 2021. What they found was that the longer you held this index fund, the higher the probability of positive returns.
For example, if you had invested your money for a quarter, or 65 days, during the 49-year period, your chances of making a profit were 66.1%. Investing for any one year would have generated a positive return 72.7% of the time, while investing for ten years increased your chances to 94.15%. You can read more about this in this article.
So as you can see, the risk most of the time is selling too quickly and not capturing the gains you might have realised if you held on for longer. It might be difficult when stock markets are choppy and your portfolio fluctuates significantly. But you need to think long-term and hold on.
I used to think that timing the market was possible but here are a few problems with trying to time the market:
Stock markets go up most of the time
How will you know that the market has peaked?
If you do sell, when do you decide to buy again?
If you are not invested during those days with the highest returns, it can significantly reduce your long-term returns (see this article)
Trying to time the market is likely to hinder your returns most of the time. If you are worried about a downturn, why not just add some allocation to bonds in your portfolio?
It is also worth reminding yourself of this quote from the CEO of GitHub when you are starting to feel pessimistic about stock markets: “Pessimists sound smart. Optimists make money.”
Let me know in the comments section - have you ever sold too early and regretted it? Has this article been useful and something you are considering or will consider when making your next investments?
