The Downside of Stock Investing

The stock markets, especially the U.S. markets, have arguably been one of the most successful wealth-creating machines on the planet, besting all other asset classes' returns over the long haul. But some aspects of the market can trap investors, destroying wealth.

The market's dangers are firmly rooted in human nature -- specifically, our ability to feel the pain of loss more acutely than the pleasure of gain. Too many bad losses can rob us of our investing discipline. When we consequently make bad decisions, we have no one to blame but ourselves. That said, the ease and speed with which investors can trade stocks, and the barrage of market data now available to us, certainly don't help.

Too liquid
The same liquidity that provides many of the stock market's advantages can also produce the most severe consequences. I'd argue that less liquid investments are better for investors' well-being, providing fewer opportunities for investors to make impulsive and costly buy or sell decisions. If the market were only open a few times a year, I believe many more investors would enjoy far better performance.

Warren Buffett has aptly stated that he invests as if the markets will be closed for several years. His refusal to subject Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) to stock splits reduces trading volume, keeps short-term investors away, and conversely attracts dedicated long-term investors. Other businesses that seem to agree with Buffett's thinking include White Mountains Insurance (NYSE: WTM  ) , Washington Post (NYSE: WPO  ) , NVR (NYSE: NVR  ) , and Google (Nasdaq: GOOG  ) . None has yet split its stock.

For another example, consider today's real estate market. By all accounts, home values are declining across the board, reaching double-digit percentages in some areas like California and Florida. But whether they realize it or not, homeowners actually benefit from houses' inability to be sold as quickly as stocks.

With stocks, a quick call to your broker or click of a mouse is all it takes to unload your shares. Selling homes requires more time. Of course, if you're in default on your mortgage or in dire need of cash, you'd probably welcome stock-like liquidity for your real estate. But if houses were bought and sold as quickly as shares of stock, most homeowners and real estate investors would likely sell at the first sign of trouble -- and thus sell too low.

Meaningless data
Today's investors are bombarded with rapid-fire market quotes. While such plentiful information might seem like an advantage, it can often do more harm than good. Seeing a stock decline 20% in a single day is very unsettling to most investors, and can often prompt them to reach for the "sell" button. But absent any news of bankruptcy or other permanent business setbacks, ask yourself: What really happened to make the aggregate value of the business worth 80% of the previous day's value?

Stock prices are only important on two occasions: First, when you are presented an opportunity to buy a good business at a cheap price, and second, when you can sell a once-undervalued business at or above fair value. Any other time, they're meaningless. Sure, if you're investing for future major expenditures, like a child's college tuition, knowing the value of your portfolio at a certain time is quite helpful. Still, if you buy at the right price and base your asset allocation on your specific needs, daily price changes won't mean much.

The stock market exists to let investors buy stakes in businesses, and business owners know that temporary setbacks are inevitable. You don't see them rushing to sell their business to the lowest bidder, and neither should you. The market should serve you, Fool, but you shouldn't let it guide you.

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