Stock market investing might sound easy; Buy low, sell high, and enjoy a stream of dividend income while you hold shares. But there are several reasons why It can be challenging…
Corporate ‘Darwinism’ concentrates the winners
For businesses, it's one thing becoming successful, and another staying so, especially over decades. As such, long-term stock market returns have been dominated by an astonishingly small number of companies. This is intuitively the case for venture capital, backing earlier-stage companies that are developing their business models and are typically not yet profitable. The failure rate is understandably high. Yet it's also true of larger businesses. The difference is the timeframe.
A study from Hendrik Bessembinder of Arizona State University found that just 4% of stocks accounted for half the wealth creation in the US stock market over 90 years. The remaining 96% of shares collectively matched short-term bonds. This lopsided nature of stock returns means it’s easy to miss out on the long-term stock market growth engine, especially if you have a concentrated portfolio, which helps explain why many actively-managed fund strategies struggle to outperform.
The past is not like the future, and risk is not always what it seems
“Past performance is not a guide to the future” or similar phrases are dotted around marketing materials and other financial literature. They are easy to gloss over but important to heed. Extrapolating strong performance into the future is a common pitfall.
A period of strong returns for a share or asset class often draws the interest of more investors that pushes prices up further, causing risk to build. As Warren Buffett put it, “You pay a high price for a cheery consensus”. When reality fails to live up to expectations an asset is likely to revert to a more credible level.
An obsession with volatility to define risk can also lay traps for investors. Volatility is the measure of how much and how quickly prices move over a certain time period. High risk is seen as a rollercoaster ride, low risk a lazy river. However, an asset widely assumed and earmarked as ‘low risk’ after displaying a long period of low volatility can suddenly become high risk when something changes.
The large decline in the price of government bonds over 2022 is a notable example. The risk of these assets is generally deemed low, and that’s true in respect of creditworthiness. The UK or US government is unlikely to renege on its debt. However, at the start of the year, these assets were inappropriately priced for the higher inflation and higher interest rate environment that unfolded. Low volatility existed only in the rearview mirror. In reality, the risk lies in the price you pay for an asset in the context of what might happen in the future, not what has gone before.
Predictions aren’t easy, especially about the future
Successful investment can rarely be an entirely ‘bottom-up’ process, which is to say entirely devoted to the analysis of individual securities. Companies do not exist in a vacuum and investors in shares need to take some notice of the surrounding political and economic environment. To take an extreme example, even the best stock picker in Russian shares will have come unstuck last year.
Renowned fund manager Peter Lynch once said, “If you spend 13 minutes a year on economics, you have wasted 10 minutes”. Perhaps that’s true in the context of US shares during a relatively stable period of history, but analysing macroeconomics can be useful in terms of deciding upon asset allocation and avoiding big areas of risk. Some events, by their very nature, are unpredictable. But for others, it is possible to build scenarios and assign probabilities, which can provide a useful framework for risk management.
Sentiment always plays an unquantifiable role
In the stock market, the price of a share is a group decision, determined by the balance between participants looking to sell and those looking to buy. It is essentially a voting machine for companies’ values.
Yet prices may not always be governed by purely rational actors. The ‘average’ judgment can be wrong, or a group can converge on an inaccurate answer. Often this is when, rather than investors making individual decisions, activity is centred around ‘confirmation bias’ or ‘herding’. People do something because others are doing it, for instance piling into assets because they see others making money rather than independently considering fundamental factors such as valuation.
In modern parlance, this is 'FOMO', or the Fear of Missing Out. In psychology, the fear of missing an opportunity for profit has been shown to be a hugely powerful motivator, and it can make investors do irrational things such as buying shares at a price that vastly exceeds any sober assessment of value and prospects.
Sentiment can also swing too far the other way and be too gloomy, beating down the price of asset below intrinsic value. Usually, this happens in a downturn when investors, collectively, have abandoned hope or have simply run out of dry powder to commit to markets. This is the point at which most people are thinking “I must be mad to invest now”. Such is the psychological challenge of investing: It tends to make you want to do the wrong thing at the wrong time.
This is also why it’s so difficult to ‘time’ entries and exits into stocks or markets. The unseen hand of sentiment can maintain overly expensive or overly cheap valuations over extended periods, thus temporarily proving the doubters, or the diehards, wrong – even if, in the fullness of time, they are right. As John Maynard Keynes noted, “There is nothing so disastrous as the pursuit of a rational investment policy in an irrational world.”
What's the solution?
Lots of people like to pit their wits against the market. It can be a rewarding pursuit to research individual companies or funds and put together a portfolio based on your thoughts and predictions. However, to do it properly you do need to dedicate sufficient time and effort to choosing and monitoring the constituent holdings.
Fortunately, there are some shortcuts for those with hectic lives. Hands-off index tracking funds or ‘passives’ can provide broad access to global stock markets. They won’t capture the best of the spoils from identifying the best-performing companies; their returns will be watered down by the mediocre and the poor. But they won’t miss them either, which is a risk with active strategies.
Another, way to take the weight off your shoulders is a ready-made diversified portfolio in the form of a multi-asset funds – such as those in the Charles Stanley range. These invest in shares, bonds and other assets, typically through a combination of carefully chosen passive and active funds. They look to provide more consistent returns by blending them together carefully, and in conjunction with the economic analysis from our investment strategists.
Each fund is a professionally-managed portfolio in a single product – which means you avoid having to buy, monitor and manage multiple funds, trusts, shares and other assets. Our experts decide on an appropriate mix to balance risk and reward, adapting to changing conditions and structural trends. Investors do, however, need to be careful in selecting the fund(s) appropriate for their needs.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
Stock market investing can be difficult, here are two ways to make it easier
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