Be Pennywise..

We have shared much of our learning about stock market investing sofar for all who are interested in getting rich through investing, not as a full-time profession, but as a means to having your money work for you, while you concentrate on your main purpose in life. In this article, we want to fundamentally examine the reasons why, in spite of getting great advice on winning stocks, most investors, including diligent ones, take a long time to accumulate significant wealth? For the purposes of this article, we will call significant wealth as a total liquid portfolio of $1 million at least – that is, not counting primary house, cars and so forth. In fact, the average citizen who does increase his or her net worth quickly into the $1 million+ range typically does so through real-estate investments or their own small business. It is less common to see millionaireswho have built their wealth entirely through savings and investing in stock market, unless they have been doing this for 20 years or so.

The core question is – why is that the case? Why is a Warren Buffett the exception and not the rule? Even in Mr. Buffett’s case, he became a full-time money manager, and thus does not quite qualify for the criteria we have set here. So what holds the average investor back, who does not have 8-10 hours/day to devote to the market, from making the big money in the stock market quickly? Why does he or she have to take the “get rich slow” path and suffer through multiple recessions and stock market swoons before accumulating worth of $1 million in assets?

Studies that favor long term buy and hold approach have shown that excessive trading is not good for your portfolio, and that holding steady helps you earn a few extra percentage points in returns. That advice may shave off a few years from your 20 year horizon, but no more. While excessive trading certainly does not pay off unless you are a full-time, professional day-trader, pure buy and hold with a little asset re-adjustment buys you only a few years from this cycle. So neither extreme gives us the answer we seek.

In our view, the average investor is held back by the one thing that characterizes most aspects of his/her life – and that is, being conservative. In other words, if you have $10,000 to invest, it is not unnatural for an investor to spread that on 10 different stocks – or to put it in a mutual fund – and thus significantly dilute any chance for major gains through winning investments. And what is worse, as the portfolio size of the average investor grows – say to $50,000 or $100,000, you will find yourself spreading that money across 50 stocks or multiple mutual funds. This is loss aversion at its best – we spread money across all these different stocks and funds with the hope that winners will outpace losers and we will get either the market average returns or perhaps even get ahead by a few percentage points. And so the cycle runs and your savings rate, more than the rate of return from your portfolio, becomes the primary determinant of when you hit the million dollar mark.

There is good reason for this conservatism, for unlike the well-heeled, the average investor is depending on this portfolio for retirement, and believes that he/she cannot be aggressive with this investment, and loss aversion controls the portfolio mix. Is it any surprise then that the rich get richer, and do so faster?

There is a second reason for the average investor to be conservative – and that is a lack of understanding of investment methodologies and how to play the odds. For example, if there were a guaranteed way to quintuple your money in three years, I am sure you will take a healthy portion of your portfolio and invest in that guaranteed investment technique. But of course, the world of investment offers no guarantees. Unfortunately for the average investor however, in spite of the availability of several advisors & many investment methodologies that significantly raise odds for success in the market place, you do not fully comprehend how and when to use those advisors and raise your own odds of success. And worse, the loss aversion principle is so dominant that you do not know what to do when an investment method offers you say an 80% chance of success versus another that offers you a 55% chance of success. It all looks the same to you, and you continue to bet small, insignificant chunks of your portfolio, perhaps equally spread across multiple investment styles and recommendations, with the hope of getting a few percentage points ahead of the market (well, your hopes may be to get unbelievable gains, but the best case would be to end up just ahead of the market).

With these two causal factors identified – namely, not hurting one’s core nest egg and not understanding how to play the odds – what is an average investor to do to overcome these? There is no single silver bullet answer, but the first thing to do is to pick one investment style and master it.

As you are likely aware, there are many investment styles and techniques available to you: value investing, growth investing, fundamental analysis, technical analysis, momentum chasing, mechanical investing, value at a reasonable price, growth at a reasonable price, finding new bull markets and riding them, commodity investing, growth geography investing, ETF techniques, options, short selling, hedge funds, mutual funds – the list, styles and techniques are literally endless. And all of them can and do work for those who master those styles. But there is something that characterizes the masters of each of these techniques, and we will list some of their common qualities:

1. Understanding what the market is telling them regarding whether it is a favorable period for their investment style or not. Every style has a market, and every market favors certain styles – and there are times to simply step aside and a time to bet the farm

1. Understanding which sectors of the market offers them the best profit proposition for their investment style (for example momentum investors do not frequently visit the utilities sector, but exceptional economic conditions can change that)

1. Ability to pinpoint specific stocks within favored sectors to gain the maximum benefit from the conditions for their investment style

1. Understanding when to bet big – master investors know when all the conditions have aligned in their favor for their investment style, including their having found stocks that stand the best chance of success. This is when the market is giving its near 75-80% assurance of success – those are strong odds, and also the time to not be timid.

1. Having a clear understanding of when to lighten up and when to hold their investments, following their stocks all the way to the top. Sometimes a mechanical technique (selling 10% of holdings on 20% growth in portfolio) may serve you well as well.

The one common theme in the abilities of a master investor is devotion to an investment style. This will give you the depth of knowledge and feel for the market necessary to become a master – and prevent your vacillation from one technique to another and will focus your energies.

Once you have picked one technique and mastered it, you have to overcome the other fear of investing – that of losing your entire nest egg. While there are many ways to overcome this fear, one of the best ways might be to divide your capital into two big piles – one for investing according to your investment style, and the other to be put away in a safe asset allocationstyle investment (broad indexes tracking US markets, international markets, commodities, precious metals and real-estate). This way, you get a chance to build serious wealth with at least half of your portfolio and hone your investment style as well. Of course you could work with smaller sums for your investment style – but at the end of the day, you have to learn to bet big. And in any investment style, you do not typically get a chance to bet big more than three times in a decade – since the big bet situations always need 3-4 years to develop and play out. And thus it is important to master your style first so that you have the courage to bet big.

We have spoken about investment styles on this site fairly extensively, but we will revisit each technique in the coming weeks so that you will pick your favored style and make your way to riches. Remember that the capital markets offer you a way to participate in the wealth creation process through the stock market – so treat the market as a friend, and fight for its independence and transparency. And master the art of investing to reap its benefits.

Happy investing!