Despite the stock market volatility, the rules of the investing game haven't changed.
The stock market is fundamentally different from what it was a decade ago. The Internet, frankly, changed everything.
We take it for granted now, but the Web democratised the buying and selling of stocks in an unprecedented way.
Party At The Moon Tower
Shares, for one, have become more accessible in two ways:
1. Internet-based broker accounts provide a dirt cheap alternative to buying shares through very costly full-service brokerages. Not only are investors saving money on commissions in general, but we're also able to buy shares in small lots and still keep commissions to less than 2% of our investment.
2. The volume of information on companies and the stock market in general is frankly quite astounding. Anyone with a computer can now access the same information and tools as professional investors.
That's not just theoretical, either. According to a study by the US-based Investment Company Institute, about eight in 10 shareholders with Internet access go online for financial purposes, such as to check their bank accounts, obtain investment information, or buy or sell investments.
Too Smart For Your Own Good
With great power, though, comes great responsibility. And data shows that such empowerment sometimes backfires.
As Fool co-founder David Gardner has said time and again, "The market is so short-term."
The real-time streaming share price quotes, daily news stories, frequent analyst upgrades and downgrades, and regular earnings reports programme investors into a certain mind-set, where minute-to-minute information becomes more significant than it needs to be. Investors, in short, outsmart themselves.
That's a conclusion from the work of professors Brad Barber and Terrance Odean, who studied the investing habits of 60,000-plus US individual investors in the 1990s.
The Hazard To Your Wealth
They found that investors moved in and out of shares far too frequently, thereby suffocating returns and generating excess trading costs to boot. Put more simply, they concluded that "trading is hazardous to your wealth."
Why, then, do investors trade so frequently? In the words of Barber and Odean, "We believe that these high levels of trading can be at least partly explained by a simple behavioural bias: People are overconfident, and overconfidence leads to too much trading."
See, information breeds confidence. Many investors today -- pros and amateurs alike -- believe that they can know more than their fellow investors. But here's something we pretty much take as gospel these days: If you discovered a "trading signal" on the Internet, hundreds of thousands of other people did, too.
Get Out Of That Trading Mind-set
The recent market nosedive, and the subsequent doom-and-gloom news headlines were stressful. The market has jumped significantly higher in recent times, but the FTSE 100 still stands 30% off its 2007 high.
What should our next move be? As we see it, the rules of the game haven't changed -- if you're seeking long-term wealth from the market, live by three rules:
1. buy great companies ...
2. at good prices ...
3. and be patient.
The first point is paramount. "Buying companies" is much, much different from "trading shares." It's also a lot easier and a lot more reliable. So if you want to make serious money in the stock market, start with great companies.
Easier Said Than Done
What makes a great company?
There are many ways to measure greatness. Royal Dutch Shell (LSE: RDSB) and Tullow Oil (LSE: TLW) for example, have unique energy assets. Reckitt Benckiser (LSE: RB) and Cadbury (LSE: CBRY) have nearly unmatched brand and marketing savvy.
Smith & Nephew (LSE: SN) and ARM Holdings (LSE: ARM) have long histories of innovation and devote significant resources to R&D. Admiral Group (LSE: ADM) and Vodafone (LSE: VOD) are among The Sunday Times 2009 Best 20 Big Companies to Work For.
We're not advocating that you go out and buy those specific companies, but they are the kinds of companies you should be buying (not trading!) right now -- and holding for the long term.
In fact, one of them -- Vodafone -- has been recommended in our Motley Fool Champion Shares investing service. And that's not surprising – Chief Investment Analyst Maynard Paton has a long track record of discovering great businesses. If you are interested in buying great companies, click here to see the companies that have made the cut. A trial is free for 30 days and gives you full access to the service.
More on the economy and the markets:
> A version of this article was originally published on Fool.com, and was first published on Fool.co.uk on 16 April 2009. It has been updated by Bruce Jackson, who does not have an interest in any of the companies mentioned in this article.
