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Simple Facts You Have To Know If You Invest In Shares

Over the weekend, I happened to be at the Investment Opportunities In The Singapore Stock Market event jointly organised by Singapore Exchange and Shareinvestor as my colleague David Kuo was speaking (check out The Motley Fool Singapore’s Facebook page for photos).

Toward the end of the event, I happened to have a chat with a pleasant lady who was a member of the audience. In our conversation, she mentioned that most of what she has heard about the stock market is that the key to making a profit lies with making as many trades as possible. She was curious to know my thoughts on the matter and so I shared with her just why exactly I think long-term investing – and not frequent trading – is the way to go.

As I shared with her the reasons for my stance, I realised that important but simple facts about the usefulness of having a long time horizon in investing might perhaps be not widely known amongst many investors. It’s for this reason that I wanted to compile a list. Some of them would seem very familiar if you’ve read my previous articles, but they’re done for the sake of investors who have never come across such information. So, here goes.

1. The ones who trade the most end up performing the worst

Finance professors Brad Barber and Terry Odean once did a seminal study on 66,465 households with accounts at a U.S. brokerage firm during 1991 and 1996.

What Barber and Odean found was that in that six year block, investors who traded the most had returned 11.4% per year on average while the market actually grew by 17.9%. That’s a gap of 6.5% per year and for a starting investment of $10,000 with a five-year holding period, it represents the difference between an ending sum of $17,156 (at an annual return of 11.4%) and $22,780 (17.9%).

2. The ones who trade the most sometimes can’t even make any profit at all

Barber and Odean also once collaborated with Taiwan-based finance researchers Lee Yi-Tsung and Liu Yu-Jane to find out how Taiwanese day traders (a day trade is made when a stock market participant buys and sells the same share on the same day) fared.

They studied the records of thousands of day traders over a five year period and found that as a group, the day traders’ “profits are not sufficient to cover transaction costs.” Furthermore, “in a typical six month period, more than eight out of ten day traders lose money.”

3. There’s a big difference between an investment’s returns and an investor’s returns because investors typically aren’t patient enough

In the 20 years ended 2003, the S&P 500 (a market index in the U.S. and the investment in this case) had delivered a compounded annualised return of 12.98%. Meanwhile, the average equity mutual fund (equivalent to unit trusts here in Singapore) investor in the U.S. had earned just 3.51%. This phenomenon has been ongoing for a long time as seen in the chart below.

Graph of investor's returns versus the S&P 500

Source: John Maxfield, Fool.com

Investment research firm DALBAR, the provider of these figures, credits investors’ inability to time the market as the reason for the phenomenon. In other words, the average fund investor in the U.S. weren’t patient enough to give their investments time to work and instead, had tried to pick out tops and bottoms in the market with disastrous consequences.

4. In the share market, it can be easier to make long-term predictions than it is to make short-term ones

Statistician and political forecaster Nate Silver once asked, “How could stock prices be so predictable in the long run if they are so unpredictable in the short run?” He asked this question in his book The Signal and the Noise: The Art and Science of Prediction partly because of the following charts (click for a larger view) which appeared in said book.

Nate silver's charts on the S&P 500

Source: Robert Shiller’s data; author’s calculations

The charts, which uses data going back to 1871, compares the annual returns of the S&P 500 against the index’s starting valuation for a holding period of 1 year and 10 years. With a 1 year holding period, the share market is essentially a crap shoot; cheap shares can easily fall and become cheaper while expensive shares could just as likely go roaring on and become even pricier.

When we extend the holding period to a decade, a much clearer theme emerges: Buy shares when they’re cheap and you’d likely end up with a good outcome; buy them when they’re pricey, and you’d have poor odds of turning in a profit.

5. The longer the holding period in the share market, the higher the odds of you making money

If we measure returns at the start of every month from 1988 to August 2013, there’s a 59% chance of sitting on positive nominal returns (returns which are not adjusted for inflation) if the Straits Times Index (SGX: ^STI) was held for a year. Hold it for 10 years however, and the chances of making a gain increase to 81%. If we double that holding period to 20 years, no losses had occurred.

My colleague Morgan Housel also once looked at more than 140 years of market history in the USA and came to the conclusion that “the odds of success grow perfectly with time. If you hold for five, 10, 15 years or more, the odds of earnings a positive return on stocks after inflation quickly approach 100%, historically.”

6. It is easier to tell what will happen to a company’s share price than it is to tell how much time it will take for it to happen

Companies with fast growing businesses would tend to see their share prices increase over time.

For instance, healthcare provider Raffles Medical Group Ltd (SGX: R01) had seen its share price grow by almost 600% from S$0.545 at the start of March 1999 to S$3.81 today as a result of profits that had ballooned from S$3.7 million to S$88.8 million.

But, did you know that Raffles Medical’s investors had spent more than eight years suffering through essentially flat returns before the company’s share price really took off? On 15 November 2008, Raffles Medical was trading at S$0.56 a share despite its profits having grown to S$31.5 million by then.

With the way profits had grown for Raffles Medical over the years between March 1999 and November 2008, investors would likely have come to the conclusion at any time between those two dates that this is a company that would likely see a much higher share price in the future. Problem is, timing when the share price would rise is the tricky part – and that’s why having a long time horizon in investing can be advantageous as it makes you stay in the game to capture great returns from growing companies.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Raffles Medical Group.