The New York Stock Exchange (NYSE) was created on May 17, 1792, when 24 stockbrokers signed an agreement under a buttonwood tree at 68 Wall Street. Countless fortunes have been made and lost since that time, while shareholders fueled an industrial age that’s now spawned a landscape of too-big-to-fail corporations. Insiders and executives have profited handsomely during this mega-boom, but how have smaller shareholders fared, buffeted by the twin engines of greed and fear?

Key Takeaways

  • According to a 2011 Raymond James and Associates study on long-term buy and hold performance trends from 1926 to 2010, small stocks averaged a 12.1% returns, while large stocks trailed with an average 9.9% return. 
  • Both small and large stocks outperformed government bonds, treasury bills, and inflation during that time period.
  • The two main types of risk are systematic, which stems from macro events like recessions and wars, while unsystematic risk refers to one-off scenarios like a restaurant chain suffering a crippling food poisoning outbreak.
  • Many people combat unsystematic risk by investing in exchange-traded funds or mutual funds, in lieu of individual stocks.

The Basics of Stocks

Stocks make up an important part of any investor's portfolio. These are shares in publicly-traded company that trade on an exchange. The percentage of stocks you hold, what kind of industries in which you invest, and how long you hold them depend on your age, risk tolerance, and your overall investment goals.

Discount brokers, advisors, and other financial professionals can pull up statistics showing stocks have generated outstanding returns for decades. However, holding the wrong stocks can just as easily destroy fortunes and deny shareholders more lucrative profit-making opportunities.

In addition, those bullet points won’t stop the pain in your gut during the next bear market, when the Dow Jones Industrial Average (DJIA) could drop more than 50%, as it did between October 2007 and March 2009. 

Retirement accounts like 401(k)s and others suffered massive losses during that period, with account holders ages 56 to 65 taking the greatest hit because those approaching retirement typically maintain the highest equity exposure.

The Employee Benefit Research Institute

The Employee Benefit Research Institute (EBRI) studied the crash in 2009, estimating it would take up to 10 years for 401(k) accounts to recover those losses at an average 5% annual return. That’s little solace when years of accumulated wealth and home equity are lost just before retirement, exposing shareholders at the worst possible time in their lives.

That troubling period highlights the impact of temperament and demographics on stock performance, with greed inducing market participants to buy equities at unsustainably high prices while fear tricks them into selling at huge discounts. This emotional pendulum also fosters profit-robbing mismatches between temperament and ownership style, exemplified by a greedy uninformed crowd playing the trading game because it looks like the easiest path to fabulous returns.

Making Money In Stocks: The Buy-and-Hold Strategy

The buy-and-hold investment strategy became popular in the 1990s, underpinned by the Nasdaq’s four tech horsemen—big tech stocks that financial advisors recommended to clients as candidates to buy and hold for life. Unfortunately, many folks followed their advice late in the bull market cycle, buying Cisco, Intel, and other inflated assets that still haven’t returned to the lofty price levels of the dotcom bubble era. Despite those setbacks, the strategy prospered with less volatile blue chips, rewarding investors with impressive annual returns.

The Raymond James and Associates Study

In 2011, Raymond James and Associates published a study of long-term buy-and-hold performance, examining the 84-year period between 1926 and 2010, during which time small stocks booked an average 12.1% annual return, while large stocks lagged modestly with a 9.9% return. Both asset classes outperformed government bonds, Treasury bills (T-bills), and inflation, offering highly advantageous investments for a lifetime of wealth building.

Equities continued their strong performance between 1980 and 2010, posting 11.4% annual returns. The real estate investment trust (REIT) equity sub-class beat the broader category, posting 12.3% returns, with the baby boomer real estate boom contributing to that group’s impressive performance. This temporal leadership highlights the need for careful stock picking within a buy and hold matrix, either through well-honed skills or a trusted third-party advisor.

Large stocks underperformed between 2001 and 2010, posting a meager 1.4% return while small stocks retained their lead with a 9.6% return. The results reinforce the urgency of internal asset class diversification, requiring a mix of capitalization and sector exposure. Government bonds also surged during this period, but the massive flight to safety during the 2008 economic collapse likely skewed those numbers.

The James study identifies other common errors with equity portfolio diversification, noting that risk rises geometrically when one fails to spread exposure across capitalization levels, growth versus value polarity and major benchmarks, including the Standard & Poor’s (S&P) 500 Index.

In addition, results achieve optimal balance through cross-asset diversification that features a mix between stocks and bonds. That advantage intensifies during equity bear markets, easing downside risk.

The Importance of Risk and Returns

Making money in the stock market is easier than keeping it, with predatory algorithms and other inside forces generating volatility and reversals that capitalize on the crowd’s herd-like behavior. This polarity highlights the critical issue of annual returns because it makes no sense to buy stocks if they generate smaller profits than real estate or a money market account.

While history tells us that equities can post stronger returns than other securities, long-term profitability requires risk management and rigid discipline to avoid pitfalls and periodic outliers.

Modern Portfolio Theory

Modern portfolio theory provides a critical template for risk perception and wealth management. whether you’re just starting out as an investor or have accumulated substantial capital. Diversification provides the foundation for this classic market approach, warning long-term players that owning and relying on a single asset class carries a much higher risk than a basket stuffed with stocks, bonds, commodities, real estate, and other security types.

We must also recognize that risk comes in two distinct flavors: Systematic and unsystematic. The systematic risk from wars, recessions, and black swan events—events that are unpredictable with potentially severe outcomes—generate a high correlation between diverse asset types, undermining diversification’s positive impact.

Unsystematic Risk

Unsystematic risk addresses the inherent danger when individual companies fail to meet Wall Street expectations or get caught up in a paradigm-shifting event, like the food poisoning outbreak that dropped Chipotle Mexican Grill more than 500 points between 2015 and 2017.

Many individuals and advisors address unsystematic risk by owning exchange-traded funds (ETFs) or mutual funds instead of individual stocks. Index investing offers a popular variation on this theme, limiting exposure to S&P 500, Russell 2000, Nasdaq 100 and other major benchmarks.

Both approaches lower, but don’t eliminate unsystematic risk because seemingly unrelated catalysts can demonstrate a high correlation to market capitalization or sector, triggering shock waves that impact thousands of equities simultaneously. Cross-market and asset class arbitrage can amplify and distort this correlation through lightning-fast algorithms, generating all sorts of illogical price behavior.

Common Investor Mistakes

The 2011 Raymond James study noted that individual investors underperformed the S&P 500 badly between 1988 and 2008, with the index booking an 8.4% annual return compared to a limp 1.9% return for individuals.

Top results highlight the need for a well-constructed portfolio or skilled investment advisor who spreads risk across diverse asset types and equity sub-classes. A superior stock or fund picker can overcome the natural advantages of asset allocation, but sustained performance requires considerable time and effort for research, signal generation, and aggressive position management.

Even skilled market players find it difficult to retain that intensity level over the course of years or decades, making allocation a wiser choice in most cases.

However, allocation makes less sense in small trading and retirement accounts that need to build considerable equity before engaging in true wealth management. Small and strategic equity exposure may generate superior returns in those circumstances while account building through paycheck deductions and employer matching contributes to the bulk of capital. Even this approach poses considerable risks because individuals may get impatient and overplay their hands by making the second most detrimental mistake such as trying to time the market.

Professional market timers spend decades perfecting their craft, watching the ticker tape for thousands of hours, identifying repeating patterns of behavior that translate into a profitable entry and exit strategies. Timers understand the contrary nature of a cyclical market and how to capitalize on the crowd’s greed or fear-driven behavior. This is a radical departure from the behaviors of casual investors, who may not fully understand how to navigate the cyclical nature of the market. Consequently, their attempts to time the market may betray long-term returns, which could ultimately shake an investor’s confidence.

Investors often become emotionally attached to the companies they invest in, which can cause them to take larger than necessary positions, and blind them to negative signals. And while many are dazzled by the investment returns on Apple, Amazon, and other stellar stock stories, in reality, paradigm-shifters like these are few and far between. This demands a journeyman’s approach to stock ownership, rather than a gunslinger strategy that chases the next big thing. This can be difficult because the internet tends to hype stocks, which can whip investors into a frenzy over underserving stocks.

Know the Difference: Trading vs. Investing

Employer-based retirement plans, such as 401(k) programs, promote long-term buy and hold models, where asset allocation rebalancing typically occurs only once per year. This is beneficial because it discourages foolish impulsivity. As years go by, portfolios grow, and new jobs present new opportunities, investors cultivate more money with which to launch self-directed brokerage accounts, access self-directed rollover individual retirement accounts (IRAs), or place investment dollars with trusted advisors, who can actively-manage their assets.

On the other hand, increased investment capital may lure some investors into the exciting world of short-term speculative trading, seduced by tales of day trading rock stars richly profiting from technical price movements. But in reality, these renegade trading methods are responsible for more total losses, than they are for generating windfalls.

As with market timing, profitable trading requires a full-time commitment that’s nearly impossible when one is employed outside the financial services industry. Those within the industry view their craft with as much reverence as a surgeon views surgery, keeping track of every dollar and how it’s reacting to market forces. After enduring their fair shares of losses, they appreciate the substantial risks involved, and they know how to shrewdly sidestep predatory algorithms, while dismissing folly tips from unreliable market insiders.

In 2000, the Journal of Finance, published a University of California, Davis, the study that addresses common myths ascribed to the trading game. After polling more than 60,000 households, the authors learned that such active trading generated an average annual return of 11.4%, from 1991 and 1996—significantly less than the 17.9% returns for the major benchmarks. Their findings also showed an inverse relationship between returns and the frequency with which stocks were bought or sold.

The study also discovered that a penchant for small high-beta stocks, coupled with over-confidence, typically led to underperformance, and higher trading levels. This supports the notion that gunslinger investors errantly believe that their short-term bets will pan out. This approach runs counter to the journeyman’s investment method of studying long-term underlying market trends, to make more informed and measured investment decisions.

Authors Xiaohui Gao and Tse-Chun Lin offered interesting evidence in a 2011 study that individual investors view trading and gambling as similar pastimes, noting how the volume on the Taiwan Stock Exchange inversely correlated with the size of that nation’s lottery jackpot. These findings line up with the fact that traders speculate on short-term trades in order to capture an adrenaline rush, over the prospect of winning big.

Interestingly, losing bets produce a similar sense of excitement, which makes this a potentially self-destructive practice, and explains why these investors often double down on bad bets. Unfortunately, their hopes of winning back their fortunes seldom pan out. 

Finances, Lifestyle, and Psychology

Profitable stock ownership requires narrow alignment with an individual’s personal finances. Those entering the professional workforce for the first time may initially have limited asset allocation options for their 401(k) plans. Such individuals are typically restricted to parking their investment dollars in a few reliable blue-chip companies and fixed income investments, that offer steady long-term growth potential.

On the other hand, while individuals nearing retirement may have accumulated substation wealth, they may not enough time to (slowly, but surely) build returns. Trusted advisors can help such individuals manage their assets in a more hands-on, aggressive manner. Still, other individuals prefer to grow their burgeoning nest eggs through self-directed investment accounts.

Younger investors may hemorrhage capital by recklessly experimenting with too many different investment techniques while mastering none of them. Older investors who opt for the self-directed route also run the risk of errors. Therefore, experienced investment professionals stand the best chances of growing portfolios.

It’s imperative that personal health and discipline issues be fully addressed before engaging in a proactive investment style because markets tend to mimic real life. Unhealthy, out-of-shape individuals who carry low self-esteem may engage in short-term speculative trading because they subconsciously believe they’re unworthy of financial success. Knowingly partaking in risky trading behavior, that has a high chance of ending poorly, maybe an expression of self-sabotage.

The Ostrich Effect

A 2005 study describes the Ostrich Effect, which found that investors engage in selective attention when it comes to their stock and market exposure, viewing portfolios more frequently in rising markets and less frequently or “putting their heads in the sand” in falling markets.

The study further elucidates how these behaviors affect the trading volume and market liquidity. Volumes tend to increase in rising markets and a decrease in falling markets, adding to the observed tendency for participants to chase uptrends while turning a blind eye to downtrends. Over-coincidence could offer the driving force once again, with the participant adding new exposure because the rising market confirms a pre-existing positive bias.

The loss of market liquidity during downturns is consistent with the study’s observations, indicating that “investors temporarily ignore the market in downturns—so as to avoid coming to terms mentally with painful losses.” This self-defeating behavior is also prevalent in routine risk management undertakings, explaining why investors often sell their winners too early while letting their losers run—the exact opposite archetype for long-term profitability.

The term "Black Swan" originated from the once wide-held belief that all swans were white. This idea resulted from the fact that no one had before seen swans of any other color. But this changed in 1697, when the Dutch explorer Willem de Vlamingh spied black swans in Australia, forever changing zoology.

Black Swans and Outliers

Wall Street loves statistics that show the long-term benefits of stock ownership, which is easy to see when pulling up a 100-year Dow Industrial Average chart, especially on a logarithmic scale that dampens the visual impact of four major downturns. Ominously, three of those brutal bear markets have occurred in the past 31 years, well within the investment horizon of today’s baby boomers. In-between those stomach-wrenching collapses, stock markets have gyrated through dozen of mini-crashes, downdrafts, meltdowns and other so-called outliers that have tested the willpower of stock owners.

It’s easy to downplay those furious declines, which seem to confirm the wisdom of buy and hold investing, but psychological shortcomings outlined above invariably come into play when markets turn lower. Legions of otherwise rational shareholders dump long-term positions like hot potatoes when these sell-offs pick up speed, seeking to end the daily pain of watching their life savings go down the toilet. Ironically, the downside ends magically when enough of these folks sell, offering bottom fishing opportunities for those incurring the smallest losses or winners who placed short sale bets to take advantage of lower prices.

The 84 years examined by the Raymond James study witnessed no less than three market crashes, generating more realistic metrics than most cherry-picked industry data.

Nassim Taleb popularized the black swan event in his 2010 book “The Black Swan: The Impact of the Highly Improbable.” He describes three attributes for this colorful market analogy.

  1. It’s an outlier or outside normal expectations.
  2. It has an extreme and often destructive impact.
  3. Human nature encourages rationalization after the event, “making it explainable and predictable.” Given the third attitude, it’s easy to understand why Wall Street never discusses the black swan’s negative effect on stock portfolios.

Shareholders need to plan for black swan events in normal market conditions, rehearsing the steps they’ll take when the real thing comes along. The process is similar to a fire drill, paying close attention to the location of exit doors and other means of escape if required. They also need to rationally gauge their pain tolerance because it makes no sense to develop an action plan if it’s abandoned the next time the market enters a nosedive.

Of course, Wall Street wants investors to sit on their hands during these troubling periods, but no one but the shareholder can make that life-impacting decision.

The Bottom Line

Yes, you can earn money from stocks and be awarded a lifetime of prosperity, but potential investors walk a gauntlet of economic, structural and psychological obstacles. The most reliable path to long-term profitability will start small by picking the right stockbroker and beginning with a narrow focus on wealth building, expanding into new opportunities as capital grows.

Buy-and-hold investing offers the most durable path for the majority of market participants while the minority who master special skills can build superior returns through diverse strategies that include short-term speculation and short selling.