What is the key to your long term investment success? It all comes down to your ability to hold onto your investment even when the market declines. This is arguably the most important principle of successful investing, and many inexperienced investors fail this test because of the way they think about the markets.
The Difference Between Realized and Unrealized Returns
A common mistake people make when thinking about their stock investments is that they confuse unrealized gains for realized ones. Realized gains or losses refer to the cash return or loss you incur on your investments. If you bought something for $10 and sold it for $15, you’ve earned a realized gain of $5.
However, if you’ve bought something for $10 and its price is now sitting at $7, you have an unrealized loss of $3. In other words, you haven’t lost any money as yet. The problem is that most people see the red $3 in their investment accounts and think that they’re $3 poorer and hurry to sell in case they ‘lose’ even more.
People sell for all kinds of reasons, most of them emotional ones. You might switch to your favorite financial channel and see that everything is falling and that ‘investors have lost $1 trillion in value’ or some such nonsensical headline. These numbers are a picture of the unrealized losses in the market. You will realize them only by selling your investment.
Over the short term, emotions are what drive market prices. The father of value investing, Benjamin Graham coined a term to describe this phenomenon. He created a persona called Mr. Market to represent how the market behaves. Mr. Market is an extremely irrational person, and every day, he comes up to you and offers you prices for his products.
One day he might come to you and tell you that Coca-Cola stock is worth $2,000. The next day, he’ll be supremely dejected for some reason and will offer to sell you Coca-Cola for $80. The notion that a giant of a company such as Coca-Cola can have such huge fluctuations in value over a single day makes no sense to him. He listens to his emotions, and that’s it.
Many people get carried away by the turmoil that Mr. Market experiences. They believe his words when he tells them that everything is going to fall apart. They believe him when he tells them that COVID-19 is going to result in Chinese hegemony over the U.S for the foreseeable future and that 5G marks the complete destruction of all American enterprise and so on.
They listen to these notions and invest in unknown Chinese stocks and then wonder why they’ve ended up losing all of their money. We’re not saying that Chinese stocks are bad. The point is that following your emotions when investing and not taking a look at the business is a surefire way to lose money.
Law of Averages
The companies mentioned in this guide are in a great position to perform well over the next two decades. Will all of them fulfill this promise? Probably not. Business is an uncertain thing, to begin with, and no one can ever promise surefire returns. However, the objective here is to line up as many factors in our favor as possible and then let the probabilities take over.
One company might not work out. Two might not. But all 20? This is pretty unlikely. The probabilities tell us this. Think of it this way: If you’re tossing a coin, you know that you have a 50% chance of calling the result correctly. Does this mean you’ll be right every single time if you call heads? Probably not.
However, can you reasonably guess how many times you’ll be right over 1,000 coin flips? Yes, you can. You’ll be right calling heads roughly 500 times. How about 10,000? In this case, you can be even more certain since the longer you flip the coin, the more you give the probabilities a chance to work out.
It’s the same with building a stock portfolio. Invest in sound companies with a long term vision and sit back and let it do its thing.
Emotions are not Facts
On February 19th, Duke played North Carolina in a college basketball matchup that always draws a ton of attention. Duke’s star player and future number one NBA draft pick Zion Williamson tried pivoting two minutes into the game and discovered himself on the floor shortly thereafter. It turns out, his Nike shoe had exploded.
By exploded, we mean exploded. It didn’t tear or come apart at the seams. One side of his shoe literally burst open, and Williamson was done for the game. The next day, a ton of negative press followed. It turns out that Nike’s shoes were making a habit of exploding during critical times.
The press accused Nike of downplaying the incident, and soon, financial news was full of speculation as to whether Nike was now a good short or whether its stock was overvalued. In the hysteria, everyone forgot to ask a simple question: Was this crisis large enough for an entire generation of NBA and sports fans to dump Nike? Would they really dump the brand that owned the Jordan brand of shoes? Can a single exploding shoe really sink a $100 billion-dollar company?
Similar hysteria surrounds Disney at the moment, as we’ve already outlined. Basing your investment decisions on such short term emotional cues is a surefire way to lose money. Always keep the principles we’ve outlined in mind before making any decision.
A good way to minimize your chances of doing something irrational is to avoid any chances of being so. This means you need to have your personal finances in order before investing in the market, as we’ve already mentioned. If you feel the need to make quick money from the market, you’re unlikely to succeed. We refer to our earlier quote about the best way to make $1 million quickly in the stock market. Start with $2 million and go from there.
For example, if you find that you’re short of cash to pay your phone bills, you’re more likely to sell your investment holdings to raise cash. Eliminating the need for this cash is the best option to pursue. It is best to save at least three months’ worth of living expenses along with any emergency cash you might need.
Do not invest money that you might need for the next ten years, at the very least. This way, you’ll be able to stay out of your own way and won’t sabotage yourself. Do not look at your investments as a savings account that you can tap into in times of need. This will lead you to sell at lows and buy at highs, which is the opposite of what you should do to make money.
Another point to remember is that if your investment principles are sound, and if the original conditions that caused you to invest in the company still exist, then declining stock prices are good news for you. This allows you to get into the stock at discounted prices. Often, investors look at it the other way and see falling market prices as proof that they were wrong.
Use intelligent investment principles, and you’ll find that stock market investment will work wonders for you over the long run.
Read Books to Learn The Right Investment Mindset
A large part of successful investing is about Mindset. So I read many mindset books.
Recently, I read Rich Dad Poor Dad and found it quite interesting.
Through autobiography and personal experience, Rich Dad Poor Dad explores the steps to becoming financially independent and wealthy.
The writing style and framework of this book are narratives. This book focuses primarily on anecdotes with nuggets of supposed wisdom, not technical insight or investment math.
He compares the lessons he learned from his biological father (an intelligent, but financially inept father) with the lessons that he learned from his friend’s father (an uneducated, but smart and wealthy father).
It weaves through Kiyosaki’s life as he learns from his rich father and rejects advice from his poor father (thereby eclipsing typical working-class mindsets).
Some of the concepts in this book are, however, questionable. Read my Rich Dad Poor Dad review to learn more about my insights about the book.