The stock market is like a daily compilation of instinctive reactions. Emotions like fear and greed control the market, often swinging with every passing headline.
Algorithms, the computers hedge funds use to buy and sell in milliseconds based on pre-programmed formulas, actually make up most of the market’s day-to-day trading activity. Yet the big funds that employ these methods, with millions of dollars to hire the brightest minds to set them up, underperform the S&P500 on a long-term annual basis.
In other words, it’s hard to generate outsized returns when you’re constantly buying and selling stocks. But that’s what the majority of investors are doing today. I’ll explain why that might be, and how you can make real money in the stock market.
The good and bad of technology
In previous decades, think of the 1940s to 1970s, investors would typically have buy and keep a stock for years, usually between four and nine years at a time. It was a pain in the neck to trade stocks back then, requiring paperwork and involving a heavy commission for the broker.
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Investors today are lucky to live in an age where you can buy and sell stocks on your phone, view key financial statements in seconds, and get endless amounts of analysis from people on the website. It’s easier than ever to learn and educate yourself about stocks, investments, or quilt knitting if that’s your thing.
But as technology has improved, investors have become more nervous about the buy and sell buttons. Today, investors hold their stocks for weeks, days or minutes, not years. The rise of retail investor-centric brokerages like Robin Hood changed things up again, bringing commission-free trading into the mainstream. The average number of trades executed each day by major retail brokers has increased over the past two years.
The fine print of retail
Many studies show that frequent buying and selling generally hurts long-term investment returns, including a ratio of the wall street journal from 2000. Remember that investors have become much more impatient in the 22 years since.
So why are things like this? It’s about making money in many cases. Hedge funds are under constant pressure to show short-term results to prevent you from withdrawing your money and putting it in someone else’s fund.
These commission-free brokers? They often get paid to route your orders to large market makers, a practice called “payment for order flow”. These market makers can execute your trade at a lower price than you could have had. The brokerage receives a small commission for sending your order, sometimes a fraction of a penny. Remember: if something claims to be free, you are probably the product.
In the case of order flow payout, these commissions add up to big deals when there are millions of trades, which means it is in the brokerage’s best interest that you buy and sell. as often as possible. Some brokerages may encourage this with a flashy, game-like user experience or by offering attractive terms on options contracts or margin loans, speculative tools that encourage more buying and selling.
These commissions probably won’t make a big difference to your portfolio, but the fact is, there is a conflict of interest. You are encouraged to trade your way to bad returns!
How to be a long-term winner in the market
Good investing is often boring, but it’s a simple formula. Investors might be surprised at how much they can simply buy and hold index funds Where AND F designed to replicate the S&P 500 index, like the Vanguard S&P 500 ETF (NYSEMKT: VOO), for example. The S&P 500 averages returns of around 10% each year, which is enough to generate wealth for a decade and beyond.
If you want to invest in individual stocks, remember that stocks are parts of real companies, living businesses with people and products behind them. The stock price doesn’t always reflect the health of the company, so keep a long-term mindset and build a diversified portfolio to avoid putting all your eggs in one basket and taking on too much risk.
If you start approaching investing as a partnership with real businesses, not a game or game, you can crush hedge funds and build life-changing wealth. You just need to be patient enough to see it through.
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