Why Unsophisticated Investors Should Invest Long-Term

This post was written by Tony Chou, who runs the Investorz’ Blog, a blog about investing and the financial markets.

     Investors can be divided into three types. There’s the short term, medium term, and long term. Short term refers to 1 – 3 months. Medium term refers to 3 months – 2 years. Long term refers to 2 – 20 years (I’m not joking). Before investing, you need to know what kind of an investor you should be. Let me explain.

     Short term is for the tech savvy, full time investor. The short term trader looks for trends, through which he uses technical analysis to determine which way the stock price is going to go. He looks at the chart of a stock price, and tries to find a trend. Then, he applies the rules of technical analysis to make money. Technical analysis acts as an indicator. For example, if this this this happens, then the stock price will increase. If that that that happens, then the price of the stock will decrease. Here are two examples of how a short term investor uses technical analysis to determine the future stock price.

Stock Price Chart for Company A  Analysis      

Technical analysis indicates that when a stock is trading within a range, and it breaks through that range on the up side, the stock price will further increase.(picture unavailable)

 

Stock Price Chart for Company B  Analysis      

 

Technical analysis indicates that when a stock is trading within a range, and it breaks through the range on the down side, the price of the stock will further decrease.(picture unavailable

 

     Learning how to interpret charts and using technical analysis is extremely difficult & time consuming for unsophisticated investors. It requires a lot of time to learn and discover the rules to technical analysis. Majority of people do not have the ability to identify a trend in the chart even when they see one. Short term investing is meant to be left to the highly dedicated and intelligent investor.

     The medium term investor depends on a mix between technical analysis/charts/trends and looking at the macro outlook of the economy. Let me give you an example. George Soros learns that there is a huge earthquake in Japan Buildings collapse, roads are destroyed, and electricity poles are demolished. George Soros then tries to figure out what this disaster means for the macro economy. He realises that Japan needs to rebuild, and they’ll need to import mass amounts of concrete. Japan will probably buy concrete from American Concrete Inc. This will cause the stock price of American Concrete to substantially increase. But, in order to maximise his profits, George Soros wants to buy American Concrete stock at the lowest price possible. To determine a good, low price to start buying that stock at, he looks at the chart for technical signals.

Stock Price Chart for American Concrete Inc.  Analysis     

This stock price is trading within a range. According to technical analysis, if it trades within a range, and the medium term prospects of the stock is good, then this is possibly the lowest price George Soros can get. He decides to buy at this price.

 

     Being a medium term investor can also be quite difficult. Not only do you need to understand and be able to utilise technical analysis very well (which is already very hard), but you need to have a strong knack for predicting the future. For example, what if Japan doesn’t decide to buy concrete from American Concrete Inc? George Soros is betting on the future here. He’s betting that Japan will buy from American Concrete Inc, which will cause the stock price to go up. If Japan doesn’t buy from American Concrete Inc, then George Soros most likely won’t make much money from his investment. Betting on the future is very risky, so unless you’re extremely smart (stock market wise) or are a genius, I don’t suggest unsophisticated investors become medium term investors.

     That is why, you, as an unsophisticated investor can only be a good, long term investor. Before I explain why, here is a list of the pros and cons of being a long term investor.

Pros

  • Being a long term investor, you spend less time worrying about your investments and more time enjoying life. Why bother wasting your time studying something you don’t plan on doing full time, when you sit back, relax, and squeak out a 10% year over year return?
  • Being a long term investor produces better investment results for unsophisticated investors. Here’s why. A good, professional investor may be able to accurately buy at extremely low prices, and sell at extremely high prices. Notice how I said the word ‘may’. That’s why some professional investors make on average 20-30% returns, year over year. However, the average unsophisticated investor SUCKS (I hate to say this). He or she usually buys at a very high price, and then sells at a very low price. Let me give you an example, aided by a chart.

 

 (picture unavailable)

The average investor buys at this point, because the stock market is in utter europhia. He or she believes that the stock market still has a lot more to go (on the upside), because everyone around him or her is screaming “BUY BUY BUY. It’s going up a lot more!” The smart investors get out at this stage. Remember how I said the stock market is a zero sum game? The smart investors sell their stock to the unsophisticated investors (who are the suckers in the stock market). Buy high.

 

This is where the average investor sells. Once the stock price has reached the peak (a few days after he or she bought the stock), the stock price starts to decline. The unsophisticated investor doesn’t sell, hoping for the market to turn around and reach previous heights. That doesn’t happen. The stock price gets lower and lower, until the unsophisticated investor loses a lot of money. Then, he or she starts believing that the stock price will go down even further in the future (by a lot), so he or she sells the stock. Not long after, the stock price rebounds, and he or she does not profit from the rebound of the stock market.

 

  • The diagram above is what a typical investor does. That is why the unsophisticated investor should not do short or medium term investors, simply because he or she does not have the capability to time the stock market (buy low sell high). But once the unsophisticated investor does long term investments, and is not intimidated by these stock market ups and downs, then he or she will not sell high buy low (and won’t lose money in the process).
  • If you do long term investments, then your average investment profits will be around 10% year-year (based upon buying the S & P 500 Index). However, the average unsophisticated investor does much worse. Unsophisticated investors on average lose 2-4% on a year to year basis. Let me tell you a story. I have a friend, and his dad has been doing investments part time (after work of course) for the past 17 years. He’s a very active investor (short – medium term). Every year, he contributes $10,000 to his investment portfolio. Guess how much his portfolio is worth right now? $30,000. Even if he hadn’t invested his money in anything, he would still have $170,000 right now.
  • As a long term investor, you’re not afraid of short term problems. Let me give you an example. In the 1970s, American Express had a scandal. It wasn’t such a big scandal; it’s just that the press and newspapers made such a big out of it. They made it seem like American Express was going bankrupt. The stock price dived significantly, and most unsophisticated investors sold rock bottom prices. Then, Warren Buffett swooped in, bought all the available shares, and made a killing; all at the expense of the unsophisticated investor. My point is, don’t be afraid of short term problems like this. Because unsophisticated investors did not have the judgment capability to know if American Express was indeed going bankrupt or not, they assumed the worst. If you didn’t pay attention to all the bullshit the newspapers were proclaiming, then you too would have made a killing like Buffett.
  • Hope for a good investment, not for a top of the line investment. You want to know the number one reason why most unsophisticated investors fail? Because they aren’t satisfied with a good 10% year-year investment. They aim for a 20% year-year investment. And what do they get? A terrible 2 – 4% year–year loss.

Cons

  • Some people do not have the patience to do long term investors. That is an especially deadly personality if you are an unsophisticated investor. Without patience, you are likely to buy and sell at the wrong times; thus losing a lot of money.
  • As a long term investor that makes 10% year over year, you won’t make as much money as some people make 30% year over year. But those are the professionals, they know when to jump in and out of markets.

 

     Stick to long term investments, because as I said, as an unsophisticated investor, you do not have the capabilities to jump in and out of markets at the right time.

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