Over time, the stock market has consistently proven to be the best way to create long-term wealth and secure your financial future. Sure, there have been short periods where housing prices and commodities -- be it gold or crude oil -- have outperformed the broader market, but nothing beats the historical average annual return of 7% for the stock market, inclusive of dividend reinvestment and when adjusted for inflation.
Since 1950, the broad-based S&P 500 (^GSPC 1.18%) has undergone 37 corrections totaling at least 10%, not including rounding. In each and every instance, these retracements have been completely put into the rearview mirror by bull market rallies. Often, this occurs within a matter of weeks or months.
But regardless of whether you're an experienced investor or possibly someone readying to make their first stock purchase, there are three blunt investing truths you need to know.
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1. Wall Street professionals really struggle to beat their benchmark index
For starters, you might be surprised to learn that professional money managers aren't as good as you think they are at managing your money. According to the SPIVA U.S. Year-End 2018 report from S&P Dow Jones Indeces, 68.83% of all domestic funds lagged the S&P Composite 1500 in terms of total 1-year return, with 88.13% lagging the five-year return and 88.97% underperforming the 15-year return.
The results are even worse for the professional money managers of targeted funds. Over a 15-year period, 96.73% of small-cap fund managers underperformed the S&P SmallCap 600, while 92.71% and 91.62% of mid-cap and large-cap money managers lagged the S&P MidCap 400 and S&P 500, respectively.
To put this data into another context, you'd be much better off buying an index fund and holding onto it over the long run, or learning the ins and outs of investing so you can build your own financial foundation, rather than relying on a Wall Street professional to do it for you. Wall Street is fallible, and the data proves it.
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2. A higher yield can actually lead to a lower long-term return
The stock market can also be a tempting source of dividend income for most investors. Dividends are great because they usually are paid out by profitable and time-tested businesses, can be used to hedge against inevitable stock market corrections, and can be reinvested back into more shares of dividend-paying stock via a dividend reinvestment plan, or DRIP.
But dividend stocks can also trick unsuspecting investors. The fact is, income seekers want the highest payout possible with the lowest risk. However, the data shows that yield and risk tend to be correlated, meaning that the higher the yield, the higher the risk to investors.
And that's not all.
According to an analysis released in 2016 by FactSet Research Systems and Mellon Capital that examined forecasted dividend yield versus realized dividend yield for S&P 500 stocks between 1996 and 2015, high-yield stocks are usually a trap. Whereas most investors received realized yields that were pretty close to forecasted yields up to about the 6% to 7% yield level, a widening gap emerged between forecasted yield and realized yield for S&P 500 stocks with yields 8% or higher. In fact, companies with an average forecasted yield of 16% had a realized yield of closer to 3%, which is a lower realized yield than S&P 500 companies with yields in the 3% to 4% range.
The reason this gap exists with high-yield companies is because yield is a function of price. A declining share price, which may be indicative of a struggling business, could inflate a company's yield and lead unsuspecting income seekers into a trap. Long story short, there's more to income investing than seeking out the highest-yielding stock.
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3. You're going to be wrong
Lastly, it's important to realize that whether you've been investing for 40 years or just bought your first stock last week, you're going to be wrong at some point. The world's best stock pickers only tend to be right in the neighborhood of 60% of the time, meaning that you, too, should see losses in your portfolio at one time or another.
However, you should also keep in mind that it's OK to lose money if you're letting your winners run. As an example, consider the following question:
Assuming equal investments, would you rather buy five stocks and have all of them gain 30%, or have one gain 500% and the other four lose 50%?
If you chose the latter, give yourself a pat on the back. Sure, your accuracy wouldn't be that great, having chosen only one stock out of five that increased in value, but the important thing is that you chose a game-changing business that increased in value by 500%. Even with four stocks losing half of their value, the aggregate return on your initial investment would be 60%, which doubles the average return of 30% for the fictitious portfolio where every stock rose.
Picking duds is just part of investing and the ongoing learning experience. From novice investors to Warren Buffett, they/we've all done it. Learn from your mistakes and attempt to minimize those errors in the future.
