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Why People Fail to Make Money in Bull Markets
by Steven Saville, Feb 06/03
The average stock market investor conspires with his/her inner self to avoid making much money in a bull market. Here are some of the ways people manage to trip themselves up.
1. Trying to get rich quick
Very few people who set out to get rich quick in the stock market actually become rich and the small minority that do succeed do so purely as a result of chance (and will therefore probably not keep their riches for long). This is because trying to get rich quickly causes people to take on too much risk, either via excessive leverage or by investing too much money in one particular trade/investment. In other words, people who are in a hurry to make a lot of money tend not to do a good job of managing risk.
Managing risk involves focusing more on the potential downside of a trade/investment than the potential upside and having an objective method to limit draw-downs in the value of your portfolio. If you do not do a good job of managing risk you will almost certainly lose money over the long-term even if probability is on your side, that is, even if you are buying during a bull market. For example, if you continually bet everything you have on a trade in which the probability of success is 90% you will eventually lose everything. Sure, you will most likely look like a genius for a while, but the one out of every ten trades that happens to be a 'loser' will wipe you out.
2. Watching stock prices too closely
The people who make the most money in a major bull market are the ones who don't pay much attention to the daily, weekly, or even monthly price fluctuations. The best course of action for most people is to keep the big picture in mind at all times, observe the short-term volatility with detached amusement, and take advantage of the periodic buying opportunities that occur when those who are influenced by the short-term swings in the market 'puke up' their shares.
We get the impression that a lot of people these days - people who are not professional stock traders - follow the hour-by-hour or even the minute-by-minute price fluctuations of the stocks they own. But by doing so these people are only increasing the probability that they will make a buy/sell decision based on an emotional reaction to a price change, that is, they are increasing the probability of failure.
3. Trend-following
The 'investing public' is, by nature, a trend follower. By this we mean that it typically does most of its buying after prices have already gone up a lot and ends up doing the bulk of its selling after prices have already fallen by a long way. This is, of course, the opposite of what it should do.
Peter Lynch, one of the most successful mutual fund managers of all time, has said that the majority of people who invested in his fund didn't make money even though the fund's average annual return over many years was excellent. This is because people would often buy into the fund after a period during which large returns had been achieved and then sell after the fund had experienced a brief period of poor performance.
Further to the above, all the talk during the 1990s equity bull market about the public 'buying the dips' was rubbish. Most of the public's money went into the market during those periods when prices were at their least attractive levels, for example, during the first quarter of 2000.
In a bull market, buying the dips is the right approach. It is, however, difficult to do because it involves going against the trend-following urges that are inherent in most of us. Correspondingly, waiting for prices to move substantially higher (when everything appears to be rosy) before buying is an ill-conceived approach that will result in losses, or mediocre gains at best, even in a bull market. During a secular bull market prices will continue to make higher-highs so those who prefer to buy when everything looks rosy might still be fortunate enough to get bailed out by the longer-term trend. But, the greatest gains will be achieved by those investors who have enough understanding of the big picture and enough courage to fade the periodic sharp sell-offs that happen during bull markets.
Hong Kong
February 6, 2003
