Financial MarketsPersonal Finance

Q: How do I get rich investing in the stock market?

By January 22, 2014 No Comments

A: The same way you get poor.

This question actually gets to the heart of why we invest. You can approach it with the aim of making as much money as possible, or you can approach it in such a way as to maximise your chances of achieving your goals. Importantly, you must choose – you can have one or the other, but not both.

At one extreme, if you want to turn $1,000 into $1,000,000 in a year without joining your local motorcycle club, you could throw down on a 100 lottery tickets. In all likelihood, you’ll lose most of your money. Or perhaps retirement is just around the corner and you’re super balance isn’t what you’d like it to be. You need 30% per annum for the next decade to keep you in the lifestyle to which you’ve become accustomed. There are dozens of stocks that have had ten-year annualised returns in excess of 30%. But if you look closely, you’ll find a similar number that have disappeared altogether in bankruptcy. In fact, roughly only a third of the stocks even had returns above the market.

If you can identify the next Fortescue Metals or Commonwealth Bank before they hit their stride, concentrating your portfolio in these few stocks will maximise your chances of getting rich. Unfortunately, it will also maximise your chances of getting poor.

(If you really do think you can pick these winners, I recommend you reflect on this.)

You can minimise your chances of either outcome by securing yourself a spot in the middle – buy an index fund that owns the whole market, thereby guaranteeing you the market return.

You might think that you can achieve sufficient diversification by owning a few dozen stocks, but you’d be wrong. Look carefully at the chart below.

30-year wealth of non-diversified portfolios relative to the S&P 500.

30-year wealth of non-diversified portfolios relative to the S&P 500.
(Source: The Four Pillars of Investing, William Bernstein 2002)

This chart shows the dispersion of outcomes relative to the market for portfolios of 15, 30 and 60 stocks in the S&P 500 in the United States. Even with 60 stocks it’s still possible that you only earn half the market return if you buy the wrong ones. That’s the difference between dining out at nice restaurants and baked beans in front of the telly in retirement.

Stocks can generate significant wealth over the long term, but investing in them is not without risk. Why subject yourself to the additional risk of picking the wrong ones when you can guarantee a market return?

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