Why do investors lose money in the stock market?

I recently reconnected with a schoolmate of mine whom I've not seen for many years. He wanted to learn more about investing and I was happy to help. We had a wonderful time chatting in person and catching up with each others' lives.

During our conversation, he asked a great question that I've never been asked before: "Why do investors lose money in the stock market?" I came up with two reasons, and I think they're worth fleshing out in an article. 

REASON 1: GREED AND FEAR

I think the theme of greed and fear in the market is best illustrated with the histories of the Fidelity Magellan Fund and the CGM Focus Fund, both of which invested in US stocks.

During his 13-year tenure running the Fidelity Magellan Fund from 1977 to 1990, Peter Lynch produced one of the greatest track records of all time: A 29 per cent annualised return. That rate of return turns $1,000 into more than $27,000 in 13 years.

But what's stunning is that Lynch's investors earned far lower returns than he did. Spencer Jakab, a financial journalist with The Wall Street Journal, explained in his book "Heads I Win, Tails I Win" why that was so (emphasis is mine):

"During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 per cent annualized return. But Lynch himself pointed out a fly in the ointment.

He calculated that the average investor in his fund made only around 7 per cent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery."

In essence, investors got greedy when Lynch had a purple patch and poured into the Fidelity Magellan Fund. But the moment Lynch's fund hit some temporary turbulence, they fled because of fear. Greed and fear had led to investors buying high and selling low.

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A similar tale befell the CGM Focus Fund. In the decade ended 30 Nov 2009, the CGM Focus Fund was the best-performing US stock mutual fund, with a gain of 18.2 per cent annually. But shockingly, its investors lost 11 per cent per year over the same period.

How? CGM Focus Fund's investors chased performance and bailed at the first whiff of trouble. That's greed and fear, again.

It's the same problem when it comes to investing in individual stocks. Some investors blindly chase a stock that has been rising (because of greed), only to sell at the first sign of temporary trouble (because of fear).

What they don't appreciate is that volatility is a feature of the stock market, not a bug. Even the best-performing stocks over the long run suffer from sickening short-term declines.

REASON 2: NOT KNOWING WHAT THEY'RE INVESTING IN 

The second reason is that many investors do not have a sound framework for investing. They buy a stock based on hot tips. Or they focus on superficial factors, such as a stock's yield.

It's dangerous to invest this way. If you're investing based on a hot tip, you have no idea what will make or break the investment. You're essentially gambling.

The risk of investing based on superficial factors can be illustrated with Hyflux. The water-treatment firm issued perpetual securities and preference shares in 2011 and 2016.

They came with fat yields of 6 per cent and attracted a large group of yield-hungry investors, many of whom focused on the yields. They did not notice Hyflux's weak financial picture.

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Back when Hyflux issued its 6 per cent perpetual securities in May 2016, I wrote an article pointing out that the securities were risky. I said:

"According to data from S&P Global Market Intelligence, Hyflux has been generating negative cash flow from operations in each year from 2010 to 2015. Meanwhile, the company currently has a net-gearing ratio (net debt to equity ratio) of 0.98, which isn't low."

Hyflux ended up filing for bankruptcy protection in May 2018, and investors in the company's perpetual securities and preference shares now face the prospect of suffering painful losses.

THE GOOD INVESTORS' CONCLUSION 

The stock market can be a fantastic place for us to build lasting long-term wealth. But it can also be a money-burning pit if we're not careful. Fortunately, the problems are easy to solve.

To tackle greed and fear, we can keep an investment journal that contains entries on our reasons for each investment we make. When we pen our thoughts down, we actually force ourselves to review our thought processes, thus improving our investment decision-making.

And when the markets inevitably go through short-term declines, we can study our journal and determine with a cooler mind if our investment theses still hold.

The second big reason why investors lose money in the stock market that I see is ignorance. And here's the balm to soothe this issue: We just need to understand what the stock market really is, and figure out a sound investment framework.

This article was first published in The Smart Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.