Investment Capital. Efficiency Capital.
Call it what you want—there's a chasm of difference between traders and investors with long-term growth goals. The distinction is poorly understood and rarely considered, yet it makes all the difference in the world.
Most investors I meet are conditioned to have a "transaction" mentality. That is, they see investing as a series of transactions—profits and losses on stocks, bonds, real estate, commodities, whatever. Over time, they expect those separate transactions to add up to some larger return. Did you "book" a profit on that stock, or not? Conversely, rarely do you hear anyone say, "My portfolio made great headway toward my long-term goals this year."
Flip on CNBC any hour of the day and you'll see it—commercials full of trading products showing a triumphant John Everyman sitting at his desk, smiling at the "profitable" trades just executed.
But the transaction mentality is usually the wrong perspective for investors with long-term goals.
Transaction mindsets are fine and well for a big chunk of the market. Specifically, traders need it. Their bread and butter, generally, comes from transaction fees. This is the "efficiency capital" in markets—traders provide liquidity, "make markets" for others, and look to arbitrage whatever advantages they can to eke out profits. To "book" a profit is the key for traders, and each day they seek a new set of transactions. Over and over again. Often, the sheer amount of trading volume by itself is what makes the money—all transactions have a cost (a feature which can insidiously erode your profits if you're not careful).
Transactions represent the alluring, romantic side of investing, and scads of folks—including professionals—fall prey to it over and again. Its psychology is often analogous to gambling—we think and dream of locking in that huge profit on a single stock the same way we think of winning the big hand in blackjack. We think somehow we're geniuses and can beat the system. The lights on the big board at the NYSE aren't so different from the blinking lights of the casino. It's fun and addicting—investing as a hobby and sport.
Problem is, most folks aren't traders—they're long-term investors looking for long-term growth. Long-termers need a holistic mindset. Growth over the long run isn't "manufactured" via transactions—it's about going along for the market ride appropriately. (The opening two chapters of my book, 20/20 Money detail the right attitude toward investing for a long-term investor—as a discipline and a science.)
Successful long-termers ditch the transaction mindset and refocus on things like diversification and following an appropriate benchmark. The way to do that is holding a portfolio that's mostly, well, market-like.
This should be said over and over again because it cannot be said enough: Stocks' long-term returns are better than any other liquid asset class, inclusive of the biggest, baddest bear markets. If you have long-term growth goals, always make sure you capture market-like returns, and then if you're savvy enough (or have a manager who is), try to call the occasional bear market or achieve slightly higher than benchmark returns while keeping transaction costs low. That's literally it—way more boring than the romantic, genius trade.
Prime example: Folks constantly want to sell the "dogs" for "better" stocks in their portfolio, or "take profits" on those that gained. They look at each holding as if it were an island—unconnected to their larger portfolio. But they forget that the greatest lasting insight of Modern Portfolio Theory (MPT) is to think about return in the holistic sense. Of course, you always want to get the best price you can for the stocks you own. But a holistic-thinking long-termer knows stocks within their portfolio shouldn't all behave alike—they should zig and zag a bit—diversification is a key mode of risk control. The total return of the portfolio is all that ultimately matters. That means, necessarily, you'll probably have some "dogs" if you're diversified correctly, even in the best of markets. And that's ok if your portfolio is tracking or beating your benchmark as planned. (And anyway, yesterday's dogs have a nasty habit of becoming tomorrow's winners—usually just as folks lose faith and jettison them.)
Let's say you doubled your money on a particular stock. Maybe it even went up 2000%! Good for you! But how did the totality of your portfolio perform? Said another way, what does it matter if you quadruple a single position but the rest of your portfolio lagged? You'll accumulate pride on that one transaction—convince yourself of your genius—but will have actually been left behind by the market.
All this would be near impossible to fathom for a transaction thinker, whose focus on individual dealings blinds them to holistic portfolio return and the lessons of MPT. And that's why transaction thinkers tend to lag.
The romantic side of investing—the genius trade you fantasize will make you rich-beyond-reckoning—is wrong for those seeking to grow their money over the long haul via stocks. Call it stodgy, call it boring, but discipline makes you richer. Ditch the transaction and think about the whole.