There is an almost sexual allure to the stock market which makes it attractive to many people. For generations the stock exchanges were the playgrounds of the rich but over time as retirement savings plans that could be managed by individual workers were developed the stock markets began to feel the presence of small investors. The rapid influx of small traders to the US stock markets began in the 1980s as 401(k) retirement plans and similar government-sanctioned programs began to replace the old pension funds.
Small investors cannot approach the stock market in the same way that wealthy individuals and large investment banks can. That is simply because when you have limited capital to invest the risks you must navigate have a greater impact on your financial well-being. The difference between investing $10 million in a stock that loses 90% of its value and investing $10,000 is that the $10K investor ends up with only $1000 to begin rebuilding wealth. The $10 million investor still has $1 million. Although a 90% loss in capital would be devastating for anyone, it is far more catastrophic for small investors.
Seasoned investment strategists always advise less experienced people to never risk more in an investment than you can afford to lose. Exercising wise money management over your capital supersedes picking the best possible investments. That means that sometimes you have to ignore what look like great opportunities. That is because you can only spread yourself so far before your capital becomes ineffective.
Risk Management Entails Careful Thought
We have all heard the old adage, “never put all your eggs into one basket”. That is one form of risk management and we usually describe this philosophy in terms of diversification. You diversify your investment portfolio by dividing your capital across several investments, but just how many components your portfolio needs is a matter open to debate.
Experienced professionals advise small investors to leave some of their money in “liquid” form. This means keeping some cash value in what is often called a “money market fund”. You use this money to buy into new stocks and mutual funds; when you sell assets you deposit the proceeds of the sale into this fund. If you have enough cash reserve you can make opportunistic purchases before selling off older assets. You control your schedule.
Savvy investors may also drop some money into CDs and bonds. These assets are more stable than stocks but they are not “liquid”. You will get some growth but usually not enough to grow your wealth unless you invest a lot of money in them. Bonds and CDs preserve capital.
Your diversification strategy thus relies most heavily on your remaining choices for investment, in terms of growing your wealth. You’ll hear about “small cap” and “large cap” investments, domestic vs. foreign, industrial versus service, etc.
The safest way to cover these areas of opportunity is to invest in mutual funds, where the fund managers are responsible for buying into and out of the stocks. The most aggressive way to cover these areas of opportunity is to manage your trades personally.
Every Trade Has a Cost
One of the most common mistakes new self-managed traders make is to execute a large number of small trades. One of the reasons why you do better when moving large sums of capital around is that your fees remain unchanged whether you execute a trade for $100 or $100,000. The $100 trader eats up his profits (if any) and quickly incurs losses with the fees for his activity.
The online trading exchanges encourage this behavior by offering a limited number of free trades. They forego their fees on the first few trades (on the account or each month) knowing that many investors will lose track of how many free trades they have and start incurring fees.
Buying shares of a mutual fund and walking away is not necessarily any less expensive. Someone has to buy and sell the securities for the fund, as well as manage investor cash inflow and outflow. The fund manager and his staff charge fund investors basic administrative fees. And everyone investing in the fund shares in its profits and losses.
Beware the Deceit of Projections
Every prospectus sent to potential investors contains a disclaimer that reads similar to: “Past performance is no indication of future results”. And they also contain other disclaimers, including one similar to “the projections in this proposal are intended for illustrative purposes only; actual results may vary”. There are many laws and lawsuits behind these kinds of disclaimers. But you should take them seriously.
Sometimes successful funds just get lucky, plain and simple. Sometimes good funds are caught up in the wrong securities through no fault of their own managers. Bad news and good news can be random even for the most seasoned investment professionals.
One of the biggest deceits in personal investing is the projection of growth per year. If you put this much money into your investments you may earn this much year over year.
Although no one knows how much money they will make in a given year, it is better to assume less-than-optimal growth and plan for that. Your goals should be reasonable but competitive. Your budgets should be more conservative, though. That way every win is more of a windfall than a vindication of a self-deluding sense of accuracy.
Even Warren Buffett, the world’s most successful investment strategist, has made huge blunders in picking the wrong stocks. When someone who has become the wealthiest man in the world through his investment strategies admits to making multi-billion dollar mistakes, you have to look yourself in the mirror and admit, “I am NOT better than that.”
Good projections are more than guesswork but the best projections may be made on the basis of incomplete data. Captain Kirk may be happy when Mister Spock makes a guess because he doesn’t know something, but Spock was only meddling with time travel and the fate of all life on Earth. It feels more personal and world-shattering than that when you pin all your investment hopes on a “sure thing” that fails, fails spectacularly, and drains your capital.
Prudence with a Sense for Adventure Rules the Stock Market
Investors are notoriously superstitious and spooky. No matter how good you are at picking securities, your investments are still at the mercy of the collective whims of all the other investors. That includes the huge retirement fund managers, the mutual fund managers, investment companies, corporate raiders, day traders, and moms and pops who are just trying to save for their retirements.
Sometimes your instincts will serve you well. They will tell you to get in or to get out and you’ll make the right decision.
But sometimes you just get the Willies for no reason whatsoever. The excitement of the financial markets is infectious, and it can be pumped up excitement or anxious excitement. You need to be prudent and protect your choices but you also need to make some adventurous decisions. Sometimes it pays off to take a little risk.
Just remember to never risk more than you can lose; better yet, only risk as much as you can replace through other investments.