The pitfalls of investing in the stock market

In previous posts of the Personal Finance Basics series we covered:

• How the stock market works
• What the S&P 500 and the Dow are

After these posts, we have a solid understanding of today’s stock market—we know how it works and how its performance is tracked.

Before we start investing, however, we should know exactly what we’re getting ourselves into.

The stock market can be an unforgiving place—if you don’t go in with your eyes wide open, you’ll come out with empty pockets.

Let’s go over some of the pitfalls we would do well to avoid.

Let’s buy a share of Apple

It’s April 30, 2010 and the world is starting to climb out of the Great Recession.

A couple weeks ago, on April 3rd, Apple, best known for its iPod and iPhone, released the first iPad.

It’s pretty much an iPhone with a larger screen—minus the ability to make phone calls. You can use it to read your email and browse the Internet so it can sort of replace a laptop. But not really.

People aren’t sure what to make of it.

Some are convinced that the iPad marks a turning point, a new pinnacle of technology; others think it’s no big deal.

Whatever the case, 300,000 iPads are sold on the first day and a million in the first month—half the time it took Apple to sell a million iPhones. It’s a smashing commercial success.

You get yourself one and find yourself absolutely amazed. This is the future. You can watch funny cat videos on YouTube while laying on the couch. You can read the newspaper with your morning coffee and check your email during your post-coffee poop.

Apple is the bee’s knees and you won’t let anyone tell you otherwise.

You go online—your head buzzing with caffeine—and see that a share of Apple stock is trading at $9.32. In your fury of excitement you buy 10.

You’re now an Apple stockholder.

Let’s buy a share of General Electric

Riding the high, you decide to follow up your purchase of 10 Apple shares with another purchase, this time of General Electric (GE).

While Apple is glitz and glamour, GE is the old, trustworthy mule.

It was founded in 1889 by Thomas Edison (yes, the Thomas Edison) and is consistently among the top 10 most valuable companies in the world.

Your refrigerator, microwave, and dishwasher are all made by GE. None of these have given you any trouble.

GE is a shining symbol of American dominance and you unexpectedly feel your heart swell with patriotic pride.

Shares of General Electric stock are trading at $145.08. Without allowing a moment for doubt to creep in you hit Confirm and buy 10 shares.

You’re now a General Electric stockholder.

How did we do?

Let’s flash forward to 2022. Much has happened in the past decade. It’s a whole new world.

Music streaming services (Spotify) killed the CD and video streaming services (Netflix) killed the DVD.

Credit cards and electronic payments (Venmo) made much progress in eliminating the use of cash.

We began staying in other people’s houses instead of in hotels (Airbnb) and getting rides from strangers instead of taxis (Uber).

Pretty much everyone has a smartphone by now and drones, 3D printing, and electric cars became a thing.

The highs and lows

You’ve been busy enjoying life. So busy, in fact, that you never again checked your shares of Apple and General Electric.

On April 30, 2022—a sunny Saturday morning, exactly 12 years after your purchase—curiosity overtakes you and you log back in to your account.

Apple is now trading at $157.65. That’s a gain of $148.33 per share. Your amazing foresight has netted you $1,483.30.

This gain is highlighted on the screen in a beautiful shade of green.

You pump your fist in celebration and beat your chest like a gorilla. You do the moonwalk and throw in a few dabs for good measure.

You are the king of stock trading. Midas himself begs you for advice.

Hello? Wall Street? Oh, I’m the greatest thing since sliced bread? Don’t I know it!

Your neighbor is looking at you through the window of your office, confusion on her face, but you don’t notice. It’s just as well.

When you calm down enough to sit your stock-picking-genius of a tushy back on the chair, you spot an ugly, vicious shade of red under the beautiful green.

Shares of General Electric are trading at $74.55. That’s a loss of $70.53 per share. Multiply the loss by the 10 shares and your wallet is $705.30 lighter.

Your heart sinks into your stomach. Midas kicks you in the shin and runs away laughing. Wall Street calls back and asks if your refrigerator is running.

In your despair, you actually go check. It’s running just fine. Then you better go catch it! You hear the HAHAHAs and HOHOHOs and HEE-HEE-HEEs of the bankers right before they hang up.

You can imagine them perfectly—their spiffy suits and gelled-back hair—laughing at you, throwing darts at a picture of your face, a tasteless mustache drawn in with permanent marker to add insult to injury.

How could you have gotten it so right? And so wrong?

GE was the symbol of American dominance. One of the biggest companies in the world. How could Goliath fall so low?

You look at the time. You’re late with the breakfast you promised your wife and kids. They’re clamoring for your famous Saturday morning waffles. You can hear them laughing in the kitchen, calling your name.

Without another moment’s thought you sell all your shares of Apple and GE and close the account.

Stock trading is not for you, you think.

The rush of being right, the luscious green, the gain felt so good. But the pain of being wrong, the bloody red, the loss felt so awful.

As you go to close your laptop a voice in your head whispers seductively, “Try again. There’s so much money to be made. You’ll make it back.”

You open your laptop again but quickly close it. No more.

A strange magnetism pulls you back towards the computer as you head to the kitchen. You feel like you’re walking against the wind.

Your legs keep moving without you being aware of it and the magnetic pull weakens at the sight of your happy family.

You dab and moonwalk with them. Your kids do all sorts of new dances with strange names—nobody’s dabbed in years, they say.

Breakfast is happy and delicious. As you do the dishes, though, the seductive voice starts whispering again. You’re scared you won’t be able to resist its allure.

Investing is easy

Starting to invest in the stock market is easy. All you have to do is open an account with a stockbroker¹ and buy shares of a company.

With only five or six clicks you can become a stockholder in whatever company you want—Nintendo, GameStop, Chipotle, Tesla, Coke, Lululemon, you name it.

Stock trading apps like Robinhood make this whole process super easy.

Their aim is to turn stock trading into a game.

They do this by combining a sleek UI—vibrant colors and fun animations—with elements of social media (e.g., inviting your friends, notifications, newsfeeds.)

All of this is aimed at triggering FOMO and impulse purchases. Many young people have been lured in and are gambling without knowing it.

Our friend who bought Apple and GE stock felt dumb for being wrong and losing money. And yet he was hooked. The seductive voice threatened to suck him back in.

As every gambler well knows, winning and money are powerful motivators. There’s a rush of dopamine with each right bet, with each dollar won.

We can try to be ‘rational’, but our primal instincts are not easily overpowered—we’re not that different from rats who will choose cocaine over food to the point of starvation.

Two truths to remember

In light of this, there are two truths to remember.

The first is that the gambler’s high and subsequent anxiety brought on by the stock market, by the mixing of money and primal human emotions—excitement, worry, anger, grief—is a tale as old as time.

Here’s Jeronimus Velters, an ordinary Dutchman, writing to a friend about his experience in the Dutch stock market back in 1672:

I have to admit that I don’t just regret selling the share. I also felt a strong urge to buy again. But I didn’t do so because I was anxious, and it’s just as well I didn’t because since then the price—for reasons I’ve not been able to discover—has dropped in an atmosphere of panic.

This has been such a shock to me that I’m barely able to think about what is prudent for me to do. If prices were higher, I would sell now. But I don’t want to do that at the current level. I hope to God I’m doing the right thing.

The poor guy was on the brink of losing it. And he was the norm, not the exception.

The stock market can play nasty games on your head if you allow it. This isn’t a shortcoming on your part—it’s how our brains are wired. So we must remain vigilant.

The second truth is that 95% of Wall Street bankers—people who eat, sleep, and breathe stocks—fail to beat the market over time.

In other words, they fail to choose winning stocks (Apple) over losing stocks (General Electric) in the long run.

As if this wasn’t bad enough, these money managers charge high fees for their underperformance.

You can have monkeys throwing darts at the page, and, you know, take away the management fees and everything, I’ll bet on the monkeys [over the financial advisors].

Investing is hard

Buying the “right” stocks is terribly difficult because our world is unpredictable. Things change and they change fast.

Companies are routinely decimated by the competition, by new technology, by poor leadership and bad decisions.

Makers of horse carriages got wiped out with the invention of motor vehicles.

An infinitesimal percentage of the thousands of automobile companies that were created in response to demand for cars have survived the test of time.²

Warren Buffett, the famed investor, made this point elegantly during a speech in 2021 by asking the crowd to guess how many of the 20 largest companies in the world in 1989 had maintained their dominance to the present day.

Quiz time. What’s your guess? 5, 7, 11, 15?

Here’s the list of the 20 largest companies in the world in 1989:

And here’s the list in 2021:

The answer is zero. Not a single one of the 20 largest companies in the world in 1989 has maintained their place.

How did you do?

Here’s what Buffett had to say³:

If you look at the top 20 from 1989, there’s two things that should grab your interest. At least two.

None of the 20 from 30 years ago, are on the present list. None. Zero.

There were then six U.S. companies on the list. And their names are familiar to you. We have General Electric. We have Exxon. We have IBM Corp…

And I would guess that very few of you, when I asked you to play the quiz a little—a few minutes ago—would have put down zero. And I don’t think it will be zero.

But it is a reminder of what extraordinary things can happen. Things that seem obvious to you.

Complicating matters a bit further is the fact that buying the “right” stock isn’t enough—you also have to buy (and sell) at the right time.

If you bought Apple stock in 1991 and sold it in 1996, you might have been a visionary, but you’d have made no money. Apple wouldn’t start becoming a behemoth until around 2006.

Stock prices fluctuate based on thousands of variables and investors all too often buy and sell stocks at the wrong time.

Investing is no easy task.

Summary

If you take anything away from this post, it should be this:

1. Companies routinely fail due to competition, new technology, poor leadership, and bad decisions.
   • Blockbuster could have bought Netflix in 2000. By 2010 Blockbuster was bankrupt and Netflix was a billion-dollar business.
   • In 2006, Borders had over 1,000 book stores across 4 countries. Amazon ate their lunch and by 2011 Borders no longer existed.
2. This “survival of the fittest” makes it supremely difficult to buy stock in companies that will remain Goliaths over time. Even bankers who do this for a living fail at it.
   • Every one of the top 20 biggest companies in 1989 fell out of the top 20 by 2021.
   • And the rate of change in our world is still accelerating. The average lifespan of a company in the S&P 500 was 61 years in 1958. This has since decreased to 18 years.
3. Timing is even more difficult—buying when the price is low and selling when it’s high is a Herculean task. Stock prices constantly fluctuate and a prince today can be a pauper tomorrow.
4. Buying and selling stock can easily turn into gambling. The rush of being right and making money is a dangerous lure. But the stock market is no game and we must be cautious.

So what’s the way out of this conundrum?

One solution is to avoid choosing any particular stock and not trying to perfectly time our buying and selling.

Instead we can buy stock in every single company on a consistent basis and then hold these stocks over the long term.

We’ll cover how to do this in the upcoming posts.

I hope this was helpful. Send me an email if you have any questions.

And if you’re looking to learn more, you can check out the whole Personal Finance Basics Series.

Video for this post

If you prefer watching to reading, here’s an easy-to-follow video I made with all this info:

Slides for this post

If you’re interested, check out the slides I made for the video.