History has shown that the stock market has been one of the greatest sources of long-term wealth, compounding at an average of 10% per year over the past century for long-term investors who bought a low-cost index, reinvested their dividends, took advantage of tax rules, and let compounding do all of the heavy lifting. During that same period, inflation ran approximately 4%, leaving a 6% real rate of return. Ibbotson & Associates, now part of Morningstar, has extensive data on the sources of these returns in its annual yearbook, which is one of my favorite investment publications.
Unfortunately, we also know from a study at Morningstar that during one period of 10% market returns, the average investor earned only 3% on their money because they made stupid decisions, traded too frequently, used high cost brokers, paid mutual fund sales loads, and committed a host of other foolish transgressions. It was this study that led me to write an article called For Investors, Being Average Is Underrated, as well as a follow-up article, If You Don't Know How to Value a Business, You Shouldn't Own Individual Stocks.
Some New Investors Aren't Cut Out for Investing In Stocks
Here is the deal. Some of you will never have the temperament to invest in stocks. Does it put you at a handicap? Sure. You have one less tool in your toolbox of wealth building. But knowing that about yourself is important because it can help you avoid further mistakes. Not that long ago, I even answered a reader question that inquired as to how I would invest if I couldn't invest in individual stocks.
How do you know if you are one of the investors who, due to their own psychology, should avoid investing in publicly traded stocks? Here are a few signs:
- You get physically ill seeing stock prices fall as other investors panic instead of seeing it as an opportunity to be seized.
- You can't explain what the bid price / ask price / spread / and market maker are or do.
- You lose sleep over owning stocks.
- You have thought, or said, that "the stock market is like a casino".
- You think a stock split is a good thing (fact: it's meaningless).
- You don't understand how, in some situations, a $100,000 per share stock can be cheaper than a $3 per share stock.
- You can't read an income statement or balance sheet.
- You can't make sense of an annual report or 10K.
- You don't know what the earnings yield is.
- You don't know what the price-to-earnings ratio is.
What Investments Should You Consider If You Aren't Emotionally Capable of Investing in Stocks?
If you want to earn a good after-tax net-of-inflation return and you aren't capable of investing in stocks, you really only have two reasonable alternatives unless you get into specialty areas (e.g., buying music copyrights or writing movies). These are:
- Owning a business that you operate
- Owning a portfolio of real estate assets that generate rental income
Basically, that's it. The unfortunate thing is, some people aren't cut out for running their own business. In fact, I know some very intelligent people that, if they had to run a simple business like a Dunkin' Donuts franchise, would be bankrupt in a year. It takes a unique skill set to be a "good operator" as it used to be called in the old days. These include attention to detail, an eye for cost control, knowing when to invest in capital expenditures that improve customer experiences and increase profits, and monitoring the return earned on your total investment, while simultaneously protecting cash flow, vetting employees, handling business licenses, and putting the right advisers in place. For many people, this is not their bailiwick and it never will be. (For more information, read this article about why most people aren't cut out to run their own company.)
From a purely anecdotal basis, it seems like more investors are capable of responsibly managing real estate investments because they are tangible. You can see a rental property. You can touch it, improve it, and physically count the cash you collect from owning it. There are many sub-specialties for those who invest in real estate, including individual rental houses, apartment buildings, storage units, car washes, office buildings, industrial buildings, and even real estate options or tax lien certificates. Each have their own benefits and pitfalls, appealing to different types of people.
What If You Don't Like Real Estate, Stocks, or Private Businesses?
If you are incapable of owning real estate, stocks, or private businesses due to temperamental or emotional considerations, you're out of luck. Be content to stick your money in the bank, never earn more than the rate of inflation, and live off your paychecks and savings. If you can't tolerate a little uncomfortableness in the name of improving your own family, you deserve sub-par returns. It's the nature of the world. No one ever gets what they want sitting at home doing nothing.
Originally Published on About.com on December 31st, 2011 at 7:15 p.m., Central Standard Time