What could be a bigger thrill? You get a fabulous tip, buy a stock cheap, and two years later — bam! — the stock price has skyrocketed, and now you’re rich. That fantasy is why some people get into stock trading. Who wouldn’t like the idea of picking a winner and being set for life?
Plus, it’s exciting. “There’s the prospect of possible wealth, pretty much the same emotional high as buying a lottery ticket and following the drawing of the winning numbers,” said William Bernstein, a neurologist and financial theorist. “It’s human nature to savor the anticipation of a novel experience.”
But while stock picking can be enticing, it’s not always the ideal way for most people to build long-term wealth. Instead, you’re likely to have better results with a “boring” approach to investing. Here’s why Bernstein recommends avoiding picking stocks.
1. In stock trading, there’s someone on the other side
“There’s always someone on the other side of the trade, and that person is generally called Goldman Sachs or Warren Buffett,” said Bernstein. “There’s almost a century of data that show that almost no one reliably succeeds at stock picking.”
Instead of trading stocks individually, consider indexing — buying a whole group of stocks in one fund — so you the chance to benefit from the performance of a wider swath of the market. You don’t have to worry about who’s on the other side of the trade because you’re riding the growth of a collection of investments.
2. It’s harder to obtain diversity on a small budget
When you buy individual stocks, you have to apportion your money. Beginning investors might not have enough money to buy shares of several different stocks and bonds.
Diversification is one of the keys of investing. It protects you from complete portfolio annihilation if you get it wrong. However, if you don’t have a big budget for investing, you’ll have all your eggs in one basket. What happens if you drop that basket?
When you have a small budget, indexing with the help of dollar-cost averaging — investing the same amount regularly, such as each month — can go a long way toward ensuring you have diversity in your portfolio. “You can buy the entire stock market in a mutual fund or as an ETF for next to nothing,” said Bernstein. Mutual funds and ETFs (exchange-traded funds) allow investors to buy small pieces of a much larger basket of stocks or other securities.
3. Avoid the fees associated with frequent stock trading
When you trade stocks frequently to pick the “right” investment, it can get costly if you use a traditional broker. Paying a fee each time you trade a stock adds up. And the more you pay when trading, the less you end up with in your portfolio over time.
“Keep your expenses low,” said Bernstein. “Buy the lowest-cost index funds and ETFs you can find.” (Shop around when buying ETFs since they can usually be purchased with no commissions or extra fees. With mutual funds, look for no-load funds.)
New investing apps do make it possible to buy individual stocks without paying fees. The Robinhood app specializes in letting you trade stocks for free. However, it’s important to realize that even when you aren’t paying a dime for your transactions, frequent stock trading has its own hidden costs, especially when the odds are stacked against you.
“There’s an inverse relationship between entertainment value and return. Think lottery tickets and casino gambling,” Bernstein continued. “They’re enormously entertaining, and you pay for that.” It’s fun while it lasts, and it might not cost you more than the price to buy in, but if you get carried away, it could be devastating — especially if you need that money for the future.
4. Timing the market is hard — and ineffective
So what about stock picking and “timing the market”? What if you could pick the right stocks while they are low, ride them to the top, and then sell just before the stock (or the market) crashes? We’d all be rich if we had that ability. However, most of us aren’t fortune-tellers.
Instead, we’re far more likely to get out of the market when things are bad, and get back in when things are good. But major financial firm Morningstar shows what happens when you move in and out of stocks instead of keeping your money in the market.
Plus, let’s not forget that someone else is on the other side of that trade. If everyone around you is talking about a “hot stock,” or about how it’s “time to get in the market,” there’s a very good chance that the prime time for getting in on it has already passed. The more knowledgeable person on the other side of the trade wants to sell now (and sell to you) for a reason. You could buy just in time to watch the stock — and maybe the market — plummet.
When it comes to investing, boring is beautiful
Rather than trying to time the market or pick the right stock, Bernstein said, it makes more sense to put your money in boring, plain vanilla index mutual funds and ETFs.
“A domestic and international stock fund, along with a total market bond fund, will do most folks just fine,” he said. Use dollar-cost averaging to buy what you can each month, and choose the makeup of your portfolio according to your risk tolerance. Keep the money in for the long haul, and you are more likely to see positive long-term results.
Yes, stock trading can be exciting and even lucrative. There are people who make money at it. However, it can take years of practice and big losses to get to see a measure of success.
And if you do decide to try your hand at stock picking, remember that Bernstein classes it with entertainment and gambling. It can make sense to use “fun” money that you can afford to lose.
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