The quickest ways to lose money on the ASX
Here are the top three ways that investors kill their returns.
The stock market can make it seem like making money is as easy as picking it up off the sidewalk. Over the past 30 years, the S&P/ASX All Ordinaries index has risen almost four-fold. With a record like that, you have to wonder how anyone could have lost money - yet many did and still do. We'd bet the following three investing sins caused the bulk of those losses.
'If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring.' - George Soros.
If you feel you have a knack for stock picking, active trading seems like a logical step. Unfortunately, great ideas aren't that common - if you're buying 50 stocks a year, you're probably investing in mediocre opportunities at best. If instead you stay patient and wait for opportunities with a wide margin of safety, you'll avoid more disasters and concentrate your money in your best ideas, which improves returns.
The other problem with active trading is that it increases 'frictional costs', such as brokerage fees and taxes, and the nature of compounding means that small disadvantages in any one year - that may seem trivial at the time - can mount up to large losses over the long term.
Take taxes, for example. Let's say you have $10,000 to invest and spread it across a dozen stocks, which return an average of 9% over 40 years (the long-term average market return). If, once a year, you shuffle around your money, buying and selling each holding, you'll lose roughly a third of your return to the taxman as capital gains - which means you'll have a little less invested the following year. Your compounded return would then run at about 6%, and you would end up with a little over $102,000. A more patient investor, on the other hand, who buys and holds the full 40 years, paying capital gains tax once at the end, would finish with $209,000 after tax. And the more you trade the worse it gets.
'I've seen more people fail because of liquor and leverage - leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing.' - Warren Buffett
When the sun is shining, almost nothing will supercharge your returns as much as a margin loan. Unfortunately, borrowing to buy stocks almost always comes with a long list of unfavourable caveats, such as the lender's right to sell your assets without notice. Margin loans have a tendency to crystalise your losses when stock prices have fallen rapidly, which removes one of the key advantages you have as an investor - a long-term orientation and the ability to ignore short-term price movements.
Even more benign forms of borrowing, such as using a home equity loan to buy stocks, can have counterproductive effects on our psychology. A home equity or personal loan may not crystalise losses in the same way that a margin loan does but, when the market is falling, your losses will still be magnified. If another financial crisis came, your equity could be completely wiped out 'on paper', which may cause anxiety or other psychological effects that would diminish your ability to stay calm and act rationally.
'There are two times in a man's life when he shouldn't speculate: when he can afford to and when he can't.' - Mark Twain
The best test for whether you're buying a stock for speculative or investment reasons is to ask yourself this: 'Do I want the share price to go up so I can sell to a higher bidder, or am I indifferent to the share price because my long-term return is derived from the asset's cash flow, dividends, or buybacks?' If you're in the latter camp, you're an investor.
The problem with speculation is it's a 'greater fool' game - you are relying on someone else to pay a higher price than you yourself thought the asset was worth. Maybe this works occasionally but it's better to have a stream of cash being generated to support an asset's valuation and which can be reinvested in yet more cash-producing assets - compounding will take care of the rest.
More stealthy forms of speculation include having an overly concentrated portfolio, which adds risk, or buying complex securities with 200-page product disclosure statements where the risks are hard to understand. Trying to predict what the market will do next and time your purchases is another beloved but counterproductive form of speculation.
What do you consider the quickest way to lose money in the stock market? We'd love to hear in the comments section below.
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