This is a guest post from John Forman from The Essentials of Trading. Forman is the author of a book by the same name. He has been a trader of the stock and other markets for over 20 years, and is a professional stock market analyst for Thomson Reuters.
The wealth building potential of the stock market is enormous. I think we all realize that. The long-running debate, though, is whether one is better off investing in individual stocks (or funds that do just that), or whether it’s best to just put your money in an index fund. Most funds fail to beat the market, so it would seem index funds are the better choice.
While it is certainly true that index investing has some advantages, and some mutual funds do perform better than the indices, no index or fund will ever offer the upside potential of investing in individual stocks. It’s a matter of math.
Indices and funds include many stocks which move in all different directions. One of those stocks could double in price for the year, but because most others in the collection will do much less well, the index’s or fund’s performance will be much lower than that one stock’s gain. An investor who held that stock by itself, though, would have done quite well.
Of course you need to be able to find the stocks that will beat the indices and funds.
How Do I Find Good Stocks?
The requirements for success in the stock market are much like the requirements for success in any other undertaking. Proper preparation is one of them — potentially the biggest — and a major part of preparation is having a firm objective in mind. As an investor, that normally means either seeking capital appreciation or pursuing income, or some combination. For the purposes of the discussion here, I will focus on the capital appreciation.
Another part of the equation is timeframe. I’m not talking about how long you have to retirement. There’s plenty of literature in financial planning circles about how you should structure your investments from that perspective. What I’m referring to here is how long you will expect to hold any given stock position in your portfolio.
Are you a patient long-term buy-and-hold investor who will have no problem sitting through the inevitable ups and downs of the market? Or are you someone who wants more action, doesn’t have the patience to hold stocks for years at a time, and/or cannot stomach the idea that at points your positions could go well against you for long periods of time?
You may not always be one or the other. It is, however, important to know which mode you are in when you are looking to pick good stocks. A lot of stock market players get themselves in trouble because they go into a position thinking they are one type of player only to change their minds once prices start moving.
Fundamental Analysis
If you are in the first category, then your focus in trying to find good investment stocks is to look at the big picture. You are Warren Buffett. You look at the company and its management team. You look at its business and, in many cases, the broader economy. What you are trying to identify is a company which will steadily increase in value over time.
How do you do that? By thinking about what it takes for a company to grow and profit in a sustained fashion.
What do companies like that have? They have strong management teams who know what they are doing, who have a long term view and who aren’t worried about the quarter-to-quarter results or stock price fluctuations. They are in growing business sectors (or niches) where the competition isn’t so intense that no one can really make any money.
This sort of approach to looking at companies is generally referred to as fundamental analysis. Fundamentals are the underlying elements that determine the long-term growth and profitability of a company.
The idea is that you are giving your money to some really capable people and having them put it to good use in their business. Then you let them do their thing in the way they best see fit. So long as they continue to do good things and keep the business on track for positive growth in value, you stay invested. Maybe somewhere down the line you will cash out your investment. Maybe you’ll leave it to your kids or donate it to charity. Whatever the case may be, you would expect the value of your stake in the company to have grown nicely in value by that time.
Security Analysis by Benjamin Graham and David L. Dodd is the classic text for stock market fundamental analysis. You can also find a brief overview at StockCharts.com.
Technical Analysis
Now, if you are in the second category where you’re not just going to buy a stock and lock it away, you need to think more specifically about your holding period. By this I don’t mean to imply that you will hold a stock for an exact period of time and that’s it. I just mean you should have an idea of how long you would expect to be in the position. That could still be years, or it could be months or weeks.
The advantage of the long-term investor is that they need not worry about the fluctuations in the price of the stock. They are investing on the basis of the long-term growth of the company with the assumption that the stock price will generally follow along at about the same pace.
Less long-term players (often referred to as traders) have to be cognizant of the intermediate and shorter-term price action. Generally speaking, the shorter your expected holding time horizon, the more you will have to focus on the price action. This is because the fundamentals mentioned above are usually slow moving elements which play out over the longer timeframes. They don’t change quickly, so they can’t really influence short-term price movements much.
What I mean by that is stock prices can move in the short-term on a great many factors. It could be news, economic data, changes in interest rates, the general market environment, and lots of other things. Just because a company is making money hand over fist doesn’t mean the stock price will be rising. If the company continues to do that, the stock will probably move higher eventually, but in the meantime other factors could cause it to go sideways or to even fall. This is something that baffles a lot of new investors.
Focusing mostly on price moves you into the realm of technical analysis. This approach seeks to identify patterns of price movement in the market for the purposes of determining likely future direction. This is also referred to as market timing, which basically means seeking to define good points at which to buy and sell. A lot of stock investors use fundamental analysis to find good companies, then use technical analysis to try to pick the best time to buy the stock.
Technical Analysis of the Financial Markets is widely considered the ultimate source on the subject. StockCharts.com offers an introduction to technical analysis.
Value Investing
To this point you’ll notice that I haven’t used the term value investing yet. Many people would refer to Warren Buffett as a value investor, and as such would put value investing in the long-term investing category.
Value investing need not be a “buy it and bury it” type of approach, however. In fact, I’d guess that most people consider it the process of identifying stocks trading out of line with the value of the company in question. They use any number of metrics to determine what a company’s stock should be worth. If the stock isn’t close to that value, they will either buy it or sell it in expectation that it will eventually get back in line. In most cases, once that happens, the stock position will be exited.
This probably all sounds very familiar. You’ve no doubt heard of Wall Street analysts putting out price targets and ratings and such. They generally use fundamental analysis to come up with what they think is the value of the company right now (adjusting it for new information, of course). Then they look at current price to see how it matches up with what their valuation calculations tell them.
If you’d like to learn more about value investing, consider Benjamin Graham’s classic, The Intelligent Investor. The Motley Fool has an interview with Bruce Greenwald about the three steps of value investing.
It Takes Work
Regardless which type of stock market player you are, there are no approaches which don’t require effort on your part to pick the good stocks. Even if you have someone giving you recommendations, you should still be doing your own due diligence to see if they really fit in with what you are trying to do in the market.
Also keep in mind that no matter what timeframe investing/trading you do, you should always take the longer-term view. It’s extremely unlikely that any one stock position is going to make you rich in a short period of time. If you try to score it big on any one trade you’re probably going to end up losing a lot of money. Wealth accumulation in the markets is best sought by steady growth, putting the power of compounding to work in your favor.
This article is part of Financial Literacy Month.
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Brigid – Yours is an example of a benefit to stock picking that generally doesn’t get accounted for in the classic thinking about it. You get something more out of doing it than just the returns. It’s not really a measurable return, per se, but it’s a return nevertheless. Good for you!
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John, This is not a long/short issue. It is about a finite amount of capital at any given moment. Again, as I have stated earlier, equity markets are not zero-sum; however, trading to beat the markets is a zero-sum game.
Take two people that each own a representation the entire US stock market as an example. One sells some IBM to the other. Now one is over weight in IBM and the other is under weight in IBM. That trade cannot benefit both or be detrimental to both at the same time. The amount gained by one will match the amount lost by the other. One will be above the market and one will be below. This logic continues to apply as more trades occur involving more investors on a trade by trade basis, so in aggregate (the whole market) equals itself.
In order for money to be beating the market money has to be losing to it. Otherwise there is more money in the market than is in the market which doesn’t make any sense.
I’ve done my best to explain this and am ready to move on.
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@Brigid:
Sure, 40% since 2004 is good. But would you have invested the money simply in a FoF witch invests in Indexfonds over the whole world (how much defined by the Gross domestic product of that spesific region) you would have made more. And that completely without stockpicking just by participating at the economic growth.
And with (I guess) much less volatility.
(Sorry for my bad english. I am not used to debating financial stuff in english
)
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Paethon – You’re missing Brigid’s point. Capital appreciation is not the sole objective. Brigid is gaining an additional return above and beyond the capital appreciation by investing in that way. This is one of the things academics and economists and others who focus only on totally rational behavior don’t account for when they talk about efficiency and beating the market and all that. They have to assume away non-financial motivations because they can’t really be quantified.
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I absolutly understand that. See comment Nr. 18. All I am saying is: To maximize the return on investment stockpicking is not the way to go.
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Interesting discussion. I don’t agree with Dylan. I think trading stocks can be beneficial for everyone involved.
For example: If a stock is at $30 a share.. Person A buys the stock. The stock rises to $40. Person A sells the stock to person B. The stock continues its rise to $50.
Now, both person A and person B have made $10. It’s a positive sum game.
Alternatively:
The stock is at $30. Person A buys the stock. The stock decreases to $25 dollars. Personal A sells the stock to person B. The stock continues to decline to $20.
Now, both person A and person B have lost $5. But since in general (yes, there are exceptions) stocks tend to move upwards, there are more people that win through trading stocks than lose trading stocks. So, it’s still a positive sum game.
That’s my opinion anyway.
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@ Rick – The question being debated is not whether people can make money trading stocks. Yes, more money can be made than lost in absolute terms by owning stocks just because companies generally increase in value over time. That is not the subject of the debate. The debate is about trying to beat the market, and whether beating the market is a zero-sum game.
The disagreement seems to be whether the sum of money earning higher returns than the market itself can be greater than the sum of money earning lower returns than the market. I am pointing out that this a mathematical impossibility.
For traders to out perform a market, there must be under performance by others because they are all part of that market. They can’t all beat themselves. To beat the market, you must have more dollars than if you just invested in the market as a whole. Where did those dollars come from? Someone else *MUST* have less dollars than if they had just invested in the market as a whole.
The negative sum actually results from costs incurred by all market participants, whether they are ahead or behind the market.
Learning to pick stocks and beat the market is not like learning to play guitar or a second language because those are not contingent on it not working for others. Because the market is the sum of all stock picks, you can’t have more winning picks (ones that beat the market) than loosing picks (ones that don’t, even if the returns are positive).
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Seems like I’m late to this party…
@ John Egan:
“I do believe that one sure-fire way of losing money is ‘buy and hold’”
I second John Formans comment: “buy and hold” works! As long, that is, as you invest in a company you understand, a company that makes a reliable product, and a company that has a strong “moat.” Example: Coca-Cola, See’s Candies, Wrigley’s, etc. I’d strongly recommend that you read “Warren Buffett: The Making of an American Capitalist.”
“However, I am not Warren Buffet.”
True, but why can’t you ivest in his company? Berskhire-Hathaway’s B shares are rather affordable at $4,500.
@ Paethon:
“In my optinion: Forget stockpicking. If not even the experts who do it the whole day can pick the right stocks … Why should I as a hobbystockpicker be better?”
The so-called “experts” are usually anything but. Aim low and learn to be patient: a good investing opportunity doesn’t come often, but when it does, you should be ready. And always – always – invest into something you understand. Develop a field of confidence and stick with it. That’s all there is to it.
Or you can do what I do and put yor molney int Berkshire-Hathaway. Under Warren Buffett’s and Charlie Munger’s leadership, it has brought 20% annual compound returns over the past 43 years. Personally, I acknowledge that Buffett and Munger are great investors, and I sleep safely knowing that mymoey is in their hands. 
[and no, I don't work for Buffett - I'm just a big fan haha]
@ Adam:
At the risk of sounding evil and cynical, it’s in our best interest to get dummies to invest. Once they join the game, they’ll drive up the value of our stocks. Or help bring down the market faster in yet another bubble – whichever. 
If the prices go up, so will our net worth. If they go down, that would be a good time to buy your favorite stocks on sale. A silver lining of a mushroom cloud, if you will…
“The person that gets their stock investment advice from a one page article is exactly the type of person who needs to stay the hell away from individual stocks.”
Shhh, you’ll scare them off!
@jtimberman:
“The average amatuer day trader is losing money hand over fist trying to beat the market. Every day people are going broke doing this as a hobby!”
yes, but your average investor doesn’t know anythingabout Warren Buffett, or Ben Graham’s “Intelligent Investor,” or the elementary history and psychology. The average investor is a sheeple who followsthe flock… With a right mindset, determination and a lot of research, you can do better.
@ miracletech:
“The information necessary to really analyze a company is just not available.”
Yes it is. Buffett has never used any insider information – all of his data came from publicly available resources, such as annual reports.
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@ Dylan:
You ask “… whether the sum of money earning higher returns than the market itself can be greater than the sum of money earning lower returns than the market.” The answer, of course, is yes. It’s not the mathematical impossibility you think it is. Quite the opposite, in fact.
It’s a function of relative over/under performance. For example, if the underperforming money underperforms by twice what the overperforming money overperforms, then the overperforming money would have to be twice the size of the underperforming money to average it all out.
To put it in dollar terms, I could have my $100k portfolio outperform the market by 10% if $50k worth of portfolios underperform the market by 20%.
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@ John – So you’re saying you could have a portfolio beat the market by $10K if other portfolios underperform by $10K, right? That sounds zero-sum to me. In other words, for every dollar won over the market, one must be lost. You now appear to be arguing for my position, Bugs Bunny style. Is it rabbit hunting season or duck hunting season?
I wasn’t making a point about principal, although I’ll admit my attempt to paraphrase our debate was not very well articulated. My challenge all along has been to your notion the trading is not a zero sum game (or negative sum when you consider costs). Dollars won through trading cannot exceed dollars lost through trading compared to the market.
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@ Dylan – I was simply responding to your summary, which I will admit did catch me by surprise. I hadn’t thought that was the argument you were making, but since you stated it so simply and easily, I thought maybe I’d been misinterpretting you before. Glad to see I was wrong.
I finally see what you’re driving at. All the various performances of the market particpants relative to the market must net out to the change in value of the market. Am I correct that this is your contention?
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@ John – If I knew my erroneous statement would have lead to clarifying my actual argument for you, I’d have made it much sooner.
Yes, over performance and under performance must net out. This makes trying to beat the marked a zero-sum game.
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@ Dylan: Now that I’ve got you nailed down on that over/under performance thing, I can get to the real crux of the discussion.
You could maybe make the argument that trying to be the market is zero sum (though it strikes me as falacious) if everyone were trying to beat the market. They aren’t, though. The goals of market participants (institutions and individuals) are widely varied. Some actually pursue strategies which are expected to produce lower than market rates of return (income funds, for example) which implies that it could indeed be worth the effort to seek outperformance.
All that aside, index investing is traditionally held up as being the high efficiency way to make market returns. Indices, however, aren’t the market. They are merely partial representations thereof, ones which funds often attempt to benchmark to with their performance. Since those indices are not perfect matches for the market performance (maybe better, maybe worse) there exists a potentially exploitable gap at the margin.
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@ John – I’d love to continue this discussion, but have been facing time constraints. Why not start a new thread on this subject in the GRS discussion forums? If you do that, I’ll be happy to continue it there in a couple of days. Perhaps even a few more individuals would weigh in as well.
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