Did it come to a point in your stock trading history where looking back you can say, – I realized that I kind of suck at picking stocks?
Well maybe, just maybe that marks a point in time when you decided to stop trying to pick the stocks of individual companies and move into broader ETFs and mutual funds.
These are often rare moments in the lives of many traders and investors where we fess up to what’s really happening.
I know from my own experience when we talk with friends or family about our investing success rate. We are either presenting a rosy picture or doling out generalized cliches about how most traders lose. But we might be more than a little ambiguous on the subject of whether we are ahead of the game or not.
And here’s another dose of rare honesty …
Many websites like this one are presenting information on trading and investing in the hope of getting sales through affiliate links of investing and trading products and services.
As a publisher of information on investing and trading products and services, you have to decide what kind of spin you are going to put on the whole realm of investing and trading.
Which of the two messages below is the right message to send, message #1 or message #2?
1. Come on everyone, open a brokerage account if you don’t already have one, and start investing in stocks, ETFs, commodities, Forex, cryptocurrencies, whatever; this is your route to financial security, etc.
2. Be careful. Most people who start trading on their own account do worse than the market benchmarks and many lose money and some will lose their entire nest egg.
The temptation will be to convey message #1 because you are more likely to create an environment encouraging people to buy such services. After all, isn’t this what the whole financial industry is about?
We will see why, but the honest answer should be #2 with some caveats and qualifications, of course.
How most traders and investors pick stocks
I have always thought that the way most traders and investors go about picking stocks for a portfolio comes about from some generally accepted ideas that we gather at an early age when we first learn about the stock market and investing.
Some of that will be down to Hollywood and other media portrayals of successful stock traders and how they go about their craft. But are these memes a true representation of what really happens?
There was even some advertising copy from a large broker that has been much in the news recently, that reinforces this message, and I would even say in a cavalier, irresponsible and careless manner. It went something like this, I am paraphrasing:
Pick a stock you or your family or friends like, or something that’s trending.
And I note that this particular broker markets itself to beginner and young investors and has a brand that could be characterized as young and street-credible.
The voiceover suggesting this approach is also encouraging in a sort of – go on, you can do it – kind of way.
I hope you are getting my point here that this has to be about the worst possible approach you can take to investing.
Many will say that they have read, Benjamin Graham’s Intelligent Investor, or his other big reference work, Security Analysis.
By the way, if you don’t want to wade through 400 pages, here is a comprehensive review of the Intelligent Investor.
From the stories people tell, many individual investors get frustrated with lackluster results when they follow Benjamin Graham’s and Warren Buffet’s advice to build a portfolio with the stocks of robust and valuable companies.
The investing competition
One important observation to make, if you are trying to build a stock portfolio and beat the institutional competition, is to understand what you are up against. Of course, that is if this is what you are trying to do.
Institutional investors, and by that we mean professional fund managers, live eat and breathe investment analysis. The large banks, insurance companies, pension funds, and other large companies with funds to invest employ small armies of specialists to study particular industries and branches of the economy. They can also afford to subscribe to the best and most powerful sources of information.
You have to wonder, what are the chances of an individual investor out-performing the institutions at their own game. Also know that 85 to 90% of the trading volume you see in the stock market is due to the trading activity of institutions, and most of that is driven by computer programs trading under their directions.
Conclusion – where the institutions’ money goes, drives prices.
While Peter Lynch claimed in his bestseller, One up on Wall Street that the individual investor can outsmart the institutions. Many people find in practice that isn’t as easy as it seems.
Low interest rates, low dividends, and rising inflation
There is a long-term approach to portfolio building that is essentially constructing a collection of stocks that will pay an increasing stream of dividends over time. You could say this is the old-school approach. If this is your strategy, you will be less concerned with stock price appreciation and much more concerned with stable and increasing dividends and bond coupons.
Viewed from this perspective, the investor is not concerned with the overall value of the portfolio, just with the income stream it generates.
In practice, this has been very difficult to achieve over recent years. Interest rates are at historic lows and show few signs of rising soon. Low interest rates also mean low returns from bonds and less competition for companies paying dividends, so dividends tend to be low as well.
Low interest rates, low bond returns, low dividends, and the prospect of higher inflation all point to the difficulty of the classic approach to funding retirement through a portfolio that just generates streams of income. All this has led many financial advisors and professionals to recommend a total portfolio approach. This article explains the total portfolio approach.
Value vs growth
Once an individual investor has decided to build a portfolio of stocks, so the rationale goes, the decision is whether to buy value stocks or growth stocks.
But what is everyone saying about what is working for them?
From testimonials, you can make a case that neither approach is working particularly well.
The successful growth stock stories are often those told about – someone I knew who knew someone who – etc, with some rare exceptions of real people who did hold stock that rose tenfold and can show their brokerage statements to prove it.
The value stock investor has a harder time persuading themselves that this approach is the best when the market indexes just continue relentlessly clocking new highs. This is especially so when the rest of the market still hasn’t caught on to just how undervalued the value investor’s stocks are.
One day, the market will come to its senses and my value stocks will be rewarded with their true valuations – goes the line. However, in the face of continuing dog-eared paltry stock price performance, while the S & P 500 breaks through higher ceilings, that statement becomes more like an affirmation of belief than an inevitable assurance.
Unless we can tell ourselves that when we look at risk we are better off.
Here is an article the explains the Sharpe ratio and risk-adjusted returns. A value investor is sometimes able to persuade themselves that their portfolio is in good shape if their returns are good on a risk-adjusted basis.
The simplified version of the Sharpe ratio is that you adjust returns for risk by dividing the returns in excess of the risk-free rate, by the standard deviation of those returns.
But let’s look again at the analysis of some of the major stocks and market indexes. The risk-adjusted returns of the Standard and Poor’s 500 Index for example, over the ten-year period from 2010 to 2020 were at a Sharpe ratio of 1.43.
As the analysis showed that is hard to beat with a portfolio of hand-picked stocks when the majority of them don’t exhibit a Sharpe ratio anywhere near as high.
Sectors, factors, quality, low-volatility. momentum
Then there are all the other approaches and investing strategies available. These include:
- Focusing on the strongest sectors
- Adopting different investing factors
- Focusing on quality stocks only, which is slightly different from a value stocks approach
- Building a portfolio with low volatility, this is a refinement of considering risk-adjusted returns
- Using momentum to guide investing.
Each of these approaches has an argument to make in its favor. But I suppose the point is that the more an investor follows these kinds of systems, and the more rigorously the system is applied, they are no longer just picking stocks.
Passive vs active
Many who come to the realization that they suck at picking stocks, complain they would have done better taking a purely passive approach to investing.
We can dodge around this issue in multiple directions. But I think when it comes down to it, much of the evidence suggests that they probably would have been better off just taking a passive approach.
And the easiest way to take a passive approach to investing is to buy regular dollar amounts of a handful of index-linked broad market ETFs and/or mutual funds. Here is an article that explains the main differences between active and passive investing.
Another important reason why picking stocks doesn’t work is that the stock picker is effectively saying that the market is not efficient because the stock picker can do better. Effectively any portfolio of picked stocks that isn’t the market portfolio will have assumed greater risk than the market portfolio.
That will result in lower returns after adjusting for the greater risk even if you have a lucky period.
Importantly, stock-picking feeds off one of humanity’s main cognitive biases, that of overconfidence.
What do you measure against?
There is some debate about what benchmarks professional fund managers should be compared with. Some would claim that it only makes sense to benchmark the performance of an actively managed fund against a passive fund that has the same investing objective.
OK. That might make sense for big fund managers, but does that make sense for a small individual investor. I would argue probably not. Fund managers are required to stick to their published investing strategy so it would be possible to calculate a forward-looking benchmark composed of a blend of passive indexes that matches the blend of the fund.
But an individual investor picking stocks is hardly going to check whether entering or exiting specific positions would dramatically change his or her target asset allocation, for example. Assuming that he or she had a target asset allocation in the first place.
Let’s assume then that the individual investor should measure their performance against the main market index, the Standard and Poor’s 500 Index. That is the assumption most people make.
But if you are approaching retirement or already in retirement, then the chances are you have a proportion of your assets providing income streams. If that is the case then you could argue that your portfolio should be benchmarked against an index of bonds.
On the other hand, if that is where you are with your portfolio and you are managing it, it’s far more likely you will just hold a mix of fixed interest funds, i.e. you will be holding your benchmark.
There will be some investors who are picking through and selecting among different grades of bonds. That is a specialization in its own right. We will leave that for another time.
Do I really suck at picking stocks?
For myself, the answer is probably yes. I’m not really sure as I have never actually tried picking stocks using subjective qualitative criteria. But I am sure, like most other people after a stretch of beginner’s luck, I would be hopeless at it.
And the evidence suggests that many people come to the same conclusion.
Questions and answers
Q. Is picking stocks a waste of time?
A. Yes. The evidence suggests that picking stocks is likely to lead to underperforming the market.
Q. Are stock picking services worth it?
A. That depends on the cost of the service and the profitability of the recommendations. Stock picking services that do deliver value will be recommending stocks on the basis of a proven system of fundamental and/or technical analysis.
Q. How do I get better at picking stocks?
A. Don’t pick stocks on the basis of what is in the news or rumors. Find a proven system and strategy that meets your levels of risk tolerance and risk appetite and stick with it.
For a system to be viable, it needs to define for you at what price and when you enter a position and at what price and when you exit with a profit and at what price and when you exit taking a loss. If any of those elements are missing, vague, or hard to follow, it is not a viable system.
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