Let's say you're a new investor and you want to start investing in stocks. You're not used to watching stock prices change. You decide to invest in an index fund that tracks the S&P500. That's basically a group of 500 really big companies. Whatever you decide to invest in, the following principles are the same.
You decide to invest $2000 total, but you're only going to start with half of that to see how it goes. So you buy $1000 worth of shares in the index fund at the beginning of 2017. Things are going well for a year. The market is up 20% and you've made money! Note: For for sake of brevity we will refer to the S&P500 index fund as "the market".
So you put the remaining $1000 you initially decided to invest into the index fund. Now you have $2200 in the market ($1000 from now, and $1200 from your initial investment). You're confident. Then the market drops 8% suddenly, and you lose $176. You've never seen this happen, so you get scared and sell.
But after a brief period of volatility, you see the market has continued its steady upward trend. You determine that sometimes the market goes down a bit, but you should hold if it's only a small drop. So you buy in again with your $2024.
Shortly after you buy, the market goes down 17%. You now have $1680.
You decide maybe investing is just too risky and you'll let other people do it. But you keep an eye on the market anyway from the sidelines. A year goes by and the market is up 33%. You're kicking yourself for selling after such a sharp decline and missing out on the following gains.
You buy your shares back in the beginning of 2020 with your $1680 with the resolution to hold. Then...
You sell. You cash out your $1176 and wait for the market to stabilize. Many months later once it's "safe" you buy back in.
What happened here?
Because you let your emotions determine your investing decisions, you bought when the market was doing well and sold when it dropped. Your emotions made you buy high and sell low over and over. So after 4 years of investing your net result is a loss of 41%.
But if we zoom out and look at the bigger picture we see a different story. Another investor begins investing at the exact same time in the exact same index fund with the exact same $2000. However they don't even check their portfolio for 4 years. When they finally do, they saw they have a gain of 77% and now have $3540.
What made the difference? Since the other investor didn't look at their portfolio, they couldn't get emotional when the market got fearful and went down.
The lesson is don't get emotional. When you buy a stock, resolve to hold it for at least 3 years. To quote David Gardner, "stocks go down faster than they go up, but they go up more than they go down."
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