If you know the enemy and know yourself you need not fear the results of a hundred battles,” said Sun Tzu, the ancient Chinese military general.

Defeat your biggest stock market enemy

And although his words are thousands of years old, they still ring true today, especially with investors who are fighting stock market battles all the time.

But I’ll cut to the chase and not beat around the bush: the enemy, when it comes to investing, is YOU.

How so?

Well, most investors fail because they have a profound misunderstanding of how the stock market really works and they allow greed, and other emotions, to cloud out logical thinking in an attempt to get rich quickly.

Nowhere else do rational people buy more of something when prices rise and buy less when prices decline. Add the fact many investors pay absurd mutual fund management fees for the privilege of purchasing funds that consistently underperform less expensive index and Exchange Traded funds and it’s no wonder most people don’t become wealthy in the stock market.

These same investors also feel they can predict where the market will go despite the fact study after study shows even the professionals, who spend most of their time looking at the markets and have large research staffs to do their bidding, have a terrible track record attempting to do just that.

Stir in a smidgen of overconfidence and the fact we’re all wired to focus on good things, such as stock market profits, and minimize bad things, such as losses, and we can see why most investors do so poorly in the stock market year after year after year.

But when you think about it, when you distill everything down to their bare, atomic facts, it’s clear where the blame lies. It’s not with the mutual fund companies or the big banks and their multi-million dollar advertising budgets, nor is it with the lack of information or secretive Wall Street deals.

Not at all.

The blame lies squarely with investors themselves. They are the ones who let emotions rule their investing decisions and sabotage their own portfolios.

However all is not lost.

You can remove yourself from this unreasoned group because once you understand how your behavior is negatively affecting your investments, you can put systems in place to eliminate that behavior and experience the joys of investing based on pure logic rather than deadly emotions.

As an example, let’s look at a hypothetical stock that has averaged 12% a year for the past 25 years. In some years it returned more and in other years it returned less, but on average it gained 12% annually over those 25 years.

Now, if I were to ask you what the average return would be for people who invested in that stock over the past 25 years, you would probably say, “12%.” Obvious right?

Not so fast bucko!

The fact is, most investors would have made about 2.7% less (or about 9.3% on average) and some would have done far worse.

But how can this be? The stock returned an average of 12% annually, didn’t it?

Well, yes it did. However many investors let their emotions get in the way and ended up behaving illogically.

You see, most small investors follow the crowd and buy a stock when its price is rising. They listen to the hype and fall for the siren song of why this or that stock is so great and how its meteoritic rise is bound to continue until the end of days.

So they give into greed and purchase more and more shares as the price continues to rise.

On the other hand, when a stock’s price starts to fall, they, once again, follow the crowd and bail out because they get scared. They believe the stock will crash and never recover and run around like Chicken Little proclaiming how bad things are becoming. In essence they give into fear and let their emotions dictate their investing decisions.

At the end of it all, they’ve bought more as the price rose and sold when the price fell. They buy high and sell low. And the cycle repeats over and over and over again. In fact many studies have shown this, including some famous ones done by the Vanguard Group’s founder, John Bogle.

But let’s get back to our hypothetical stock that returned an average of 12% over 25 years. If an investor simply purchased the stock and let it ride for 25 years, he would have indeed been rewarded with a 12% compounded annual return.

However that’s not what the typical investor does. He jumps in and buys more when prices are rising and then ditches his shares when prices fall. Then when the stock turns around and a new cycle of hype begins, he starts buying again. Then he sells when the inevitable reversion to the mean occurs.

On average this illogical behavior costs your typical investor about 2.7% a year.

But what is 2.7%? It sounds small. Surely it can’t make that much of a difference.

Think again!

A 2.7% annual difference over 25 years is positively huge. If you invested $100,000 for 25 years and received 12% annually, you would end up with about $1.7 Million. However if you received 2.7% less per year (that is, 9.3%), you would have just $923,642 in your pocket. That’s a difference of $776,358.

An irrational fear of low prices combined with the illogical embracing of high prices ends up costing more than $776,000. And that number doesn’t include the short-term taxes and transaction fees our irrational investor would have incurred over the years.

So if you’re serious about investing in the stock market, take a long, hard look at yourself first. Don’t blame others for your poor showing but look in the mirror and get to know your weaknesses very well. Then put automated systems and proven strategies in place that remove those weaknesses from the equation.

Your investments will thank you for it.

 

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