Why Most Investors Never Make Money... and How to Ensure This Isn't You

You come to my site for "no-BS" money and investment advice.... so here it is.

It’s highly unlikely you’ll ever make any money investing in individual stocks.

As someone who spends lots of time everyday thinking about where I should tell you to put money in the markets, it makes absolutely no sense for me to tell you this. You might "Unlike" me for saying it. You might unsubscribe to my news feed. You might even send me a nasty email note.

It’s happened before, and it will happen again now I’m sure. So, I'm not afraid to tell you that I'm going to keep saying it until it sticks. After all, my guideline for giving advice is that always give you the information I’d want if I were in you shoes.

For example, some advice I’d like to get, if I were in denial, would be, “Don’t be a fool, face the reality.”

Here’s the reality. Before you get angry at me, or start the personal attacks, let’s look at some facts about individual investor performance. Once we know how average investors do over the long run, we can start looking at what is causing the problem...

When I say that most investors won’t “make any money,” what I’m really saying is that most investors will screw up royally while trying to grow their money. This is defined as either A) Losing money in the long term, or B) Making very low or subpar returns in the long run due to their investment strategies.

Consider a recent quantitative research study released by research and consultancy firm Dalbar:

“For the 20-year period through 2010, annualized returns for equity investors were 3.83 percent and 2.56 percent for asset allocation fund investors, compared to the S&P 500 return of 9.14 percent, according to DALBAR's 2011 Qualitative Analysis of Investor Behavior.”

A return of 3.83% is horrendous. That doesn’t even keep up with real inflation.

The data further showed that investor behavior—such as following the “herd” during market panics—had a dramatic effect on portfolios. Bad timing of the market such as this resulted in investors losing 0.27% a year because they “bought high and sold low.”

Market data is one thing, but I was curious about whether or not these returns were actually observed, so I spoke with a friend who runs a CPA firm. He said that in a majority of cases, his clients are losing money in their personal trading accounts, year after year. And to him, 0.27% seemed low. The only benefit they get from their own trading is a tax write-off for a loss on capital gains, in some cases maxing out the $3000 write-off in just small accounts.

It looks like the average investor isn’t really an investor. She’s a speculator. That’s the inconvenient truth you need to know. The questions you should ask yourself are... “Is this me? Am I screwing up time and time again?”

Entrusting Your Money to Someone Else Is a Mistake

It doesn’t help that the finance industry in general—Wall Street, the talking heads on squawk-boxes like CNBC and Bloomberg TV, investment banks, mutual fund companies, “wealth advisors”, and other institutions—doesn’t exist for the benefit of you, its client, as it purports. After all, the clients aren’t the ones who own yachts and mansions... it’s all for the investment bankers...

The clients simply provide all the wealth to keep the game going.

Banks don’t exist to enrich clients. They’re in business for themselves. Investment banks don’t exist to give you a great investment advice or help you preserve your capital. They exist to sell you something, earn a commission or a fee, and cash out.

When you do have the courage to buy an investment on your own, one of the biggest problems you face is that it’s likely you don’t even fully understand the business you are buying, nor its value. Don’t feel bad, you’re not alone. The average “investor” doesn't really know anything about this either.

A recent poll indicated that 70% of “investors” actually thought that their brokerage accounts were insured against losses, much like a savings account. The level of ignorance about investments is absurd, and it’s clearly epidemic.

Here’s the problem: If you know less about the value of something than the individual who is selling it to you, it’s very likely you’re going to be taken advantage of.

You know this is true. Just walk onto a car lot, and tell the car salesman that you don’t really know what you are looking for, and that price doesn’t matter. You’ll walk off the lot with their most expensive, overpriced vehicle, and a financing plan that would make rich people blush.

The problem is, learning how to value a business or security takes time, attention, and discipline. You probably don’t have that. For most people, this kind of learning is dry and dull. Most people have no basic financial skills, and they couldn’t care less. They just want a hot stock tip.

They screw up from the very beginning of their money management journey by eschewing knowledge.

Here’s a truth I hope you’ll take to heart: Nothing can compensate for real learning. Not a crystal ball, not this investment advisory, not technical analysis, stock charts, tarot cards, tea leaves, or crystal balls.

One of my cardinal rules of investing is that if I don’t completely understand the investment, I don’t get into it. If I want to get into it, I learn enough about it to be comfortable with how it works, and with the risks involved.

Learning is the first important step in investing. First you learn how to invest. Then you learn how to identify opportunities. And last, you follow your risk management plan. This last part is where most investors screw up catastrophically.

So, you’ve spent years learning about investments. That’s great. And you know how to spot opportunities. But this is all in vain if you don’t know how to manage the risk you’ve taken on in your investments.

If you don’t manage your risk, eventually you will blow up your brokerage account. Baron’s states that investors are only right about their investments roughly 60% of the time. This means that eventually, you will be wrong. And if you regularly take on positions that are too large for your account, or if you don’t have a strategy to take profits or cut your losses, when you are wrong you will suffer a loss that is nonrecoverable.

Learn to Properly Manage Risk

Managing your risk involves mainly three things: Following strict rules of position sizing, defining price exit points to minimize losses (trailing stops), and conditioning yourself to stick to the plan no matter what.

Position sizing involves making the decision to limit any single investment to a small percent of your portfolio, usually no more than 3-5%. If you lose 100% of the investment, you can still recover from this. Conservative investors may even make these sizes smaller.

Trailing stops are points you’ve defined where you’ll sell an investment if shares drop to this level. I’ve written about these things knows as "trailing stops" here. It really doesn't matter what your strategy is here, as long as you have one.

In the heat of the markets, your head can lose control of your account to your emotions. You must not let this happen. If you disregard what you know about valuing a security, and you don’t follow your risk management plan, eventually you will suffer a loss that wipes out all previous gains you’ve made... and you start from scratch. You can't afford to start from scratch too many times without winding up in a situation where you have to work for the rest of your life--this is what I'm trying to help you avoid . Escaping this unpleasant reality of "working for a living" can be done in less than two decades.

Don’t let it happen.

What I hope from you’ve gleaned from reading this article is this: It’s likely you have a lot of work ahead of you if you want to be successful in getting your money to work for you. My hope is that you’re motivated enough to see that the benefits of learning far outweigh the cost and time commitment involved to train yourself.

If I’ve told you today that you won’t succeed at investments, and any of the above applies to you, or if I’ve struck a nerve—I challenge you to stick around and prove me wrong.

When someone tells me I can’t or won’t succeed at something I feel passionate about, I get indignant—and it motivates me more than ever before to prove that person wrong.

So far, it’s working. I hope you’ll do the same for the sake of your wealth and freedom.

Live long and invest,

Jeremiah