How You Trade Your Way to Poor Investment Returns

The stock market is like a daily compilation of knee-jerk reactions. Emotions like fear and greed control the market, often swinging with each news headline that passes.

Algorithms, computers that hedge funds use to buy and sell in milliseconds based on pre-programmed formulas, actually make up most of the market’s daily trading activity. Yet the big-money funds that employ these methods, with millions of dollars to hire the brightest minds to configure them, underperform the S&P 500 on an annual basis over the long term.

In other words, it’s tough to generate outsized investment returns when you’re constantly buying and selling stocks. But that’s what the majority of investors are doing today. I’ll explain why this might be, and how you can make real money in the stock market.

The good & bad of technology

In previous decades, think the 1940s to 1970s, investors would typically buy and hold a stock for years, usually between four and nine years at a time. It was a pain in the neck to trade stocks back then, requiring paperwork and involving a hefty commission for the broker.

Investors today are fortunate to live in an age where you can buy and sell stocks on your phone, pull up key financial statements in seconds, and have endless amounts of analysis from people on the web. It’s easier than ever to learn and educate yourself about stocks, investing, or knitting quilts if that’s your thing.

But as technology has improved, investors have gotten more twitchy on the buy and sell buttons. Today investors hold their stocks for weeks, days, or just minutes — not years. The rise of retail investor-centric brokerages like Robinhood further changed things, bringing zero-commission trades to the mainstream. The average number of executed trades leading retail brokerages make each day has surged over the past couple of years.

Image Source: Getty Images.

The fine print of retail trading

Many studies show frequent buying and selling typically hurt long-term investment returns, including a report by the Wall Street Journal from 2000. Remember, investors have gotten far more impatient in the 22 years since then.

So why are things like this? It’s about making money in many cases. Hedge funds are under constant pressure to show near-term results to keep you from pulling your money out and putting it into the next guy’s fund.

Those zero-commission brokerages? They often get paid to route your orders to large market makers, a practice called “payment for order flow.” These market makers may execute your trade at a worse price than you could have had. The brokerage gets paid a small commission for sending your order to them, sometimes a fraction of a cent. Remember: If something claims to be free, you’re likely the product.

In the case of paying for order flow, these commissions add up to big business when there are millions of trades, which means it’s in the interest of the brokerage that you buy and sell as often as possible. Some brokerages may encourage this with a flashy, game-like user experience or offering attractive terms on options contracts or margin loans, speculative tools that encourage more buying and selling.

These commissions aren’t likely making a big difference in your portfolio, but the point is that there is a conflict of interest. You are being encouraged to trade your way to poor returns!

How to be a long-term winner in the market

Great investing is often boring, but it’s a simple formula. Investors may be surprised by how well they can do just buying and holding index funds or ETFs designed to replicate the S&P 500 index, like the Vanguard S&P 500 ETF (NYSEMKT: VOO), for example. The S&P 500 averages roughly 10% returns each year, which is plenty to generate wealth over a decade and beyond.

If you want to invest in individual stocks, remember that stocks are pieces of actual companies, living businesses with people and products behind them. The stock price might not always reflect the company’s health, so keep a long-term mindset and build a diversified portfolio to avoid putting all of your eggs in one basket and taking on too much risk.

If you start to approach investing as partnering with actual companies, and not like gambling or a game, you can crush the hedge funds and build life-changing wealth. You just need to be patient enough to see it through.

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Justin Pope has no position in any of the stocks mentioned. The Motley Fool owns and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.

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