The stock market is fundamentally different than it was a decade ago. The Internet, frankly, changed everything.
While we take it for granted now, the Web democratized the buying and selling of stocks in an unprecedented way.
Party at the moon tower
Equities, for one, have become more accessible in two fundamental ways:
- Internet-based discount brokerages provide a dirt cheap alternative to buying stocks through very costly full-service brokerages. Not only are investors saving money on commissions in general, but we're able to buy shares in small lots and still keep commissions to less than 2% of our investment.
- The volume of information on stocks and funds is arresting. Anyone with a computer can now access the same information and tools as professional investors.
That's not just theoretical, either. According to a recent study by the Investment Company Institute, of the millions of households that own shares in mutual funds, "the Internet has become central to many shareholders' management of their finances. About eight in 10 shareholders with Internet access go online for financial purposes, such as to check their bank or investment accounts, obtain investment information, or buy or sell investments."
With great power, though, comes great responsibility. And data shows that such empowerment sometimes backfires.
As Fool co-founder David Gardner has said time and again, "The market is so short term." The real-time streaming quotes, daily news stories, frequent analyst upgrades and downgrades, and quarterly earnings reports program investors into a certain mindset, where minute-to-minute information becomes more significant than it needs to be. Investors, in short, outsmart themselves.
That's a conclusion from the work of Professors Brad Barber and Terrance Odean, who studied the investing habits of 60,000-plus individual investors in the 1990s. They found that investors moved in and out of stocks far too frequently, thereby suffocating returns and generating excess tax and trading costs to boot. Put more simply, they concluded that "trading is hazardous to your wealth."
Why, then, do investors trade so frequently? In the words of Barber and Odean, "We believe that these high levels of trading can be at least partly explained by a simple behavioral bias: People are overconfident, and overconfidence leads to too much trading."
See, information breeds confidence. Many investors today -- pros and amateurs alike -- believe that they can know more than their fellow investors. But here's something we pretty much take as gospel these days: If you discovered a "trading signal" on the Internet, hundreds of thousands of other people did as well.
Get out of that mindset
If you're seeking long-term wealth from the market, break the industry mold and live by two rules:
- Buy great companies.
- Be patient.
The first point is paramount. "Buying companies" is much, much different from "trading stocks." It's also a lot easier and a lot more reliable. So if you want to make serious money in stocks, start with great companies.
Easier said than done
What makes a great company? That's the rub. There can be a lot of ways to measure greatness. eBay
Those are the kinds of companies you should be buying (not trading!) right now -- and holding for the long term. All of the aforementioned businesses have made for fine long-term investments, and two of them -- eBay and Starbucks -- have been recommended in our Motley Fool Stock Advisor investing service. And that's not surprising -- Fool co-founders and Stock Advisor analysts David and Tom Gardner have long track records of discovering great businesses. They believe that they have many of the best long-term holdings racking up returns on their scorecard. Since its inception in 2002, their picks are nearly 40 percentage points ahead of the S&P 500.
Ready to stop trading stocks and start buying great companies? Click here to see the companies that have made the cut in Stock Advisor. A trial is free for 30 days and gives you full privileges to the service. All you have to do then is show a little patience and reap the rewards.
This article was originally published Dec. 8, 2006. It has been updated.