What percentage of people lose money in the stock market? How? 

The average investor does not do well at investing. Based on comprehensive work of Richard Bernstein Advisors, if you look at asset class performance between 1992 and 2012 then even inflation has outperformed an average investor by 0.1%. In summary, all investments, even cash, have elements of risk. It is hard for an individual investor to understand those risks, especially the subtle or indirect risks.

Why does an average investor underperform everything, here are a few likely reasons:

The game has changed: About 2/3rd of trading in the US is dominated by high frequency algorithm trades and ETFs. Active investing industry is a shrinking industry where even professional investors with an army of highly trained analysts find it hard to beat the market on consistent basis. Although, each one of us thinks that she is an excellent investor, the reality or results tell a different story. The major reason is market timing. Most individual investors do not get the timing right, largely because of lack of a disciplined process, and greed and fear. When most renowned investors like Howard Marks, Warren Buffet, and many others shy away from market timing commentaries in public, it is hard to imagine that an individual investor with a laptop and online brokerage account can call market top and bottoms with ease.

Most investors are hindsight futurists. I often heard “I knew it” exclamations after the fact. In my long career in investment management, I might have seen 2-3 real good market timers and even they would have a 50-60% strike rate.

Most investors follow their emotions when it comes to getting in or coming out of an investment. I still meet investors who have made the emotion mistake. What I learned throughout the years is that understanding one’s true, long-term horizon and sticking to a basic plan are critical to growing your assets safely.

Forget to differentiate between saving, investing, and trading: Most people might use some of these terms interchangeably but there is a huge fundamental difference among these terms. I once asked a retail investor about how long does he keep his positions and he answered about less than a year and he still call himself an investor. In my dictionary, anything that is kept for less than a year is simply trading.

Transaction costs: Too much of trading and portfolio turnover add to your costs, decrease your returns, and make your broker rich. Just to give you some perspective on how transaction costs can eat your performance, I would quote results from Barber and Odean study on performance on individual investors over long term horizon. They collected a total sample of about 65,000 investors between 1991 and 1996; the 20 % of investors who traded a lot earned an annual return net of trading costs of 11.4 % while buy-and-hold investors earned 18.5 % net of costs, a significant difference of 7% per year.

Diversification: “Of course, you have to diversify!” However, lack of diversification remains among the biggest mistakes I still see being made by even the “sophisticated” investors. The idea of diversification may be easy to understand, but too many times I have observed it is not easy for people to follow, even when they have been properly instructed.

So now you know why people lose money in the market, let us try to figure out how people can do better investing, by which I mean not losing money.

Creating your own customized Three Pockets:  You can create your own savings, investing, and trading pockets. Sticking to them for the rest of your life ensures you will get more growth than just leaving money in the bank. Three Pockets is easy to understand, but also easy to forget. The challenge remains in using this tool to channel your emotions throughout your life.

The Savings Pocket is your “rainy day” pocket for emergency money and short-term money you are using for short term expenses and parking of money.
The Investing Pocket grows more than savings but with less risk than trading. It should be the majority of your money.
The Trading Pocket is your ultimate manager of fear versus greed. This pocket fluctuates depending on whether you are greedy or panicking and feel the urgent need to convert at least some of your holdings to cash. The amount in this pocket should only be what you could afford to lose as often people concentrate their positions.

Develop an investing discipline: If you have enough money to invest, often more than $ 300,000, then you can choose hire an adviser and let them plan your investment planning based on your need and resources. However, if you do not have enough money for an adviser then you have three options. 1) Do it yourself (DIY) 2)  talk to a discount broker representatives, and 3) online advisors.

DIY: You can access a diversified portfolio of US Stocks, international stocks, and fixed income through Vanguard funds. You will need to setup a monthly deposit plan with your broker to take advantage of dollar cost averaging so that you do well over your entire investment cycle. Moreover, Vanguard funds have a low expense of about 0.16% which would take care of your transaction costs and help you increase your returns

The major Discount Brokers such as Schwab and Fidelity among others have trained representatives in their offices that don’t mind talking to customer that are not large enough for full service investment advisors.  They won’t make formal recommendations, but at least they can guide you in how to put together a portfolio.

Online advisors, sometimes called also “robo advisors, like Betterment and Wealthfront allows you automatic rebalancing for tax loss harvesting and customized financial planning to understand your investment goals. The total expense with Robo advisors could be 0.4-0.5% of your invested amount. Some of these online advisors also give you the ability to talk to an advisor on the phone if you need further assistance.

An individual investor can’t go much wrong with passive investing, especially if they “trickle invest”. Trickle Investing means that each year, you only invest a small portion. You don’t suddenly throw all your money into the markets. And then when you retire, you only take out a small portion each year.  That way, you completely eliminate any timing risk as your investing and withdrawing is spread across so many years. Your returns increase with compounding and with low cost, diversified, indexed, passive investments, which allow you to grow your investments and earn the best return possible for a given level of risk.

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Below is a diagram of the three pockets: as seen on page 102 of The Safe Investor

The Savings Pocket has two objectives for. First is to not lose any principal. Second is to be liquid in case of any emergencies. Trade offs for the savings pocket is that cash sitting here will not have a real return.

The Investing Pocket is for true investments. This pocket is used to successfully minimize risks in a diversified portfolio. You and your financial advisor can decide which funds to invest in, while the book The Safe Investor, will expand on possible investments and recommended allocations. You will want to invest with a long term time horizon in order to capture compounding returns and further minimize risks of cyclical stock market activities. Meanwhile, the periodic deposits into this pocket will act as a buffer in order to lower the average price of your investments in case of a possible market bubble and crash.

The Trading Pocket is a psychological release valve. An investor that is constantly watching what the market does is also aware of popular trends and hot ipo issues going around. Rather than risk the majority of an investor’s capital, the Safe Investor can save and invest, and have a third account that is proportionately smaller in order to make these sorts of bets. This will keep any investor looking to make 15%+ returns satisfied.

Lessons of The Three Pockets:

• Savings Pocket is your “rainy day” pocket or for emergencies. This is short term money used for short term expenses.
• Investing Pocket grows more than your savings pocket but less risky than your trading pocket. The key thing is to diversify across a variety of asset classes, and across many country types and geographies. Use time in order to trickle in your investments.
• Trading Pocket helps to alleviate your brain’s response to either panic when the market goes down, or become greedy when the market goes up. With this account, you can go ahead and make concentrated bets on stocks.

Information taken from The Safe Investor published by Palgrave Macmillan

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