Trading Stocks: How Do I Find Good Stocks?
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 of 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.
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There are 64 comments to "Trading Stocks: How Do I Find Good Stocks?".
I think one thing you don’t mention strong enough is that the different investment strategies carry differing risks.
For example, while technical analysis is believed to offer the highest potential returns, it also offers the highest potential losses. Someone who views trading with an economist’s mindset is going to look at a basket of options and weight that risk appropriately. We’re going to want to minimize our risk while maximizing our investments.
As a primary vehicle of saving, individual stock purchases do not make much prudent sense, because of their risk potential. As a strategy of diversification (ie, different investment strategies) once one has a base of investing (say, one is contributing 10% to a 401K and maxing their ROTH), then individual stock ownership can make some sense.
The Motley Fool recommends VALUE investing. An easy way to identify companies with VALUE is to look at what you purchase. Hopefully, you believe in the products you are purchasing.
“No index or fund will ever offer the upside potential of investing in individual stocks. It’s a matter of math.”
It is also a matter of math that the probability of achieving that “potential upside” is less than 50% (worse than coin flip odds). Most of the people that try to pick stocks believing they posses the necessary knowledge and skills and think they will be the exception to the rule will have been better off buying the market than trying to beat it. It’s a matter of math.
I am an index fund guy and probably won’t try my hand at individual stocks. Although most people (and professionals) can’t beat the market, I think the argument for doing it is if you are a risk taker and want to add potentially greater returns with greater risk. Of course it is probably not a good idea to do this with a significant percentage of your portfolio.
JerichoHill: I was asked by J.D. to write about stocks, so that’s what I did. Naturally, one must consider stock market investing in terms of an overall financial plan.
In terms of your comment “..while technical analysis is believed to offer the highest potential returns, it also offers the highest potential losses..”, I completely disagree. Technical analysis is not necessarily seen as the highest return strategy. Certainly not by me, anyway. Also, fundamental or value investors are perfectly capable of losing at least as much as technical traders. It all comes down to the risks the individual takes, not the approach used. You seem to be making the assumption that those trading based on technical analysis don’t properly diversify or asset allocate the way fundamental/value traders presumably do, which is not something you should be doing.
I won’t disagree with the idea that value investing is a good way to go for most people. I do it myself quite a bit. The problem is that sometimes it takes a long time for the market to realize that value.
As far as any type of investing/trading being “easy”, that’s a dangerous word which gets a lot of folks in trouble in the markets.
Dylan:
“It is also a matter of math that the probability of achieving that “potential upside” is less than 50% (worse than coin flip odds). ”
Certainly so, but odds don’t matter. Expectancy is what matters.
I will agree with you 100% on folks thinking they’ve got what it takes. And you’re right, many of them should stick to index funds.
By far the biggest problem I see with individual traders/investors is that they don’t take playing the market the same way they would other other things like learning a language or playing guitar. Doing well in the markets requires education and practice and skill development. Most people never get themselves on the path to doing those things.
Andy:
I honestly believe that individuals have a better shot of beating the market than the pros for the simple reason they don’t have the overhead costs or the constraints of the funds. Of course they have a learning curve to overcome first.
Interesting post for those with the time to research individual securities in the depth they need to be scrutinized, and cites some excellent books on the topic, but–
“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.”
because I turn this statement around like this–
“Index funds include many stocks which move in all different directions. One of those stocks could be halved in price for the year, but because most others in the collection will tend to rise over the course of years, the index fund’s performance will be much less volatile than that one stock’s possible decline. An investor who held that stock by itself, though, would have risked significant price fluctuations.”
–I sleep very well at night.
All that said, I have a recurrent interest to the CANSLIM method of stockpicking, which is behind the Investors Business Daily method of investing. It’s tantalizing due to the possible gains, and intellectually challenging, but requires more experience and research than I can hope to muster right now.
I have been investing for awhile now and all I know that helps is to buy and hold. It is a long term investment and by watching the market on a weekly basis, you will get yourself educated sufficiently by learning what are good stocks to invest in. Time is the one element that is crucial in investing. I use the money I don’t need immediately so as I would not be pressured to sell them when market is down.
I think that many readers know the arguments for index funds, but still want to pick the occasional stock or two. I’ve certainly been that way in the past. (Though I seem to be cured for the moment.)
I’d rather that these folks had an idea of where to turn for actual stock-picking methods instead of doing what I’ve done in the past: pick by gut. I was happy to see this post from John — I think it’s a fine overview.
I still need to share the story of our ill-fated investment club: we started at the height of the tech bubble and picked stocks purely by gut. Needless to say, we lost money. A lot of it.
Schizohedron:
CANSLIM is the basis for my own personal stock trading, though I have made a number of adjustments along the way to suit my own situation. The core of the approach, though, made immediate sense to me all those years ago when I first read the book. I give it credit for putting me on the path to where I am today as a trader/investor and market analyst.
Another thing to keep in mind with index funds is the expense of the fund versus being more active trading. An index fund from Vanguard can have an expense as low as .15%. If your expense for a stock or fund is closer to 2%, you’ll have to bet that your individual stocks can not only BEAT the index, but beat it by 2%.
That said, I know this article isn’t about funds, it’s about individual stocks, and I really appreciated the talks about different types of trading. I would like to invest a small portion of my portfolio into individual stocks one day, and it’s hard to find information between the different types of trading and reading charts. I’d really like to see more stuff in the middle in the future.
“Certainly so, but odds don’t matter. Expectancy is what matters.”
John, I really have to disagree with this. Try cashing a check in the future for what you expected to have.
There is no “one size fits all” investment philosophy. I’ve made and lost money on a variety of market programs.
I do believe that one sure-fire way of losing money is ‘buy and hold'(whether or not you buy stocks or funds). There are many articles regarding ‘buy and hold’ indeces -vs- ‘buy and homework’ (to borrow a phrase from Cramer) and it is clear to me that you stand to gain little if you do not closely follow and sell whatever you have at intervals. Clearly not all investments do well in all phases of the market. You only have to point to 2001/2002 or the present real-estate market as reasons to have a plan to exit your holdings at appropriate times. To borrow another market quote, ‘nobody ever lost money selling a stock and taking a profit.’
In my humble opinion, we are in, and will continue to be in a very volatile sideways market. That means that although overall, stocks will not go up, or down for the foreseeable future, we will see daily and weekly spikes and drops in the price of equities. In other words, I expect that until at least the middle of next year, you will experience a lot of ‘Maalox moments’ and not see any real appreciation in your holdings at the end of this turbulence.
My answer to this issue is to use fundamentals to find solid stocks and use technicals to determine their trading range then buy low and ride them up, then sell.
Thx jegan 😉
jegan:
I think Buffett would disagree with you about the value of buy and hold investing. It can work, if you truly have a long term timeframe and pick good companies. His advantage is that he’ll never need to sell to fund his retirement spending. He can literally sit in a stock forever.
For the rest of us things are a bit less straightforward. I agree with your last statement. Look for good stocks using the fundamentals and time your trades with the technicals. It’s worked well for me over the years, so I’m not going to change the course any time soon. 🙂
Dylan: I’m not sure I’m following. Are you trying to make a statement about present value?
What is CANSLIM?
Katharine:
CANSLIM is a stock trading methodology outlined by William O’Neill (founder of Investor’s Business Daily) in his book ‘How to Make Money in Stocks’. There’s no space to go into the details here, but I’m sure if you Googled it you could find a breakdown of what the accronym stands for and the basic rules.
In my optinion: Forget stockpicking. If not even the experts who do it the whole day can pick the right stocks (and they cant, otherwise most of the funds would perform better than the index) why should I as a hobbystockpicker be better?
Especially when you consider that in the time I am researching stocks I could also educate myself in a way to maybe just get a better job or just work more to get more money.
In my opinion stockpicking just isn’t worth the trouble. Of course: If you like doing it, than do it. But see it as a hobby and not a way to let your money grow in a most effective way.
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.
This might as well be an article on how to play blackjack.
Back in ’95 when I went from saver to investor, I also made my stock choices on something I heard an Uncle say once – If the economy ever went really bad, you should be in something that people would still need (he owned a pet shop!).
If/when the economy tanks, will people stop going to MacDonalds? I think not. Will they still use electricity? Definitely. Will leisure/hobbie activities suffer? Probably.
Not too scientific, I grant you. But look around today at what sectors are suffering.
Adam:
Did you actually read the article? At any point was specific advice as to the best way to pick stocks (or anything else, for that matter) ever provided?
The answer is no. This article is a discussion of the primary methods (broadly speaking) employed by stock pickers. That’s it. Nothing more.
You’re right, though. No one is going to master stock selection by reading an article or even a book. It takes education and experience – and a bit of guidance along the way never hurts either.
Nancy: While there’s certainly value in your uncle’s advice, it’s more of a long-term sort of view when you know you’re likely to be riding through economic downturns. You can flip it around when things are going well, though.
Gentle readers, remember this: 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!
This guest poster’s summary states he is a *professional* stock analyst. While I’m sure his methods are great for his job, they’re not going to translate well to the average person who doesn’t do stock trading for a living.
Before an individual decides to trade stocks for themselves, they must know themselves intimately. If this self-awareness exists, then the individual can proceed to determine if there is a “non-financial” return in trading stocks…
In other words, if you do not think you will truly enjoy trading stocks, then it won’t be worth all of the extra hours and effort to have a 20% chance of out-performing the market over the long-term.
@ John – My comment is not a statement about present value. It is about the likelihood of stock picking resulting in a favorable outcome. Regardless of how devoted one is to learning the methods, the odds are against you. Stock picking will not work for more dollars than it possibly can work for. So, why should anyone give any weight to the expectation that it will beat the market when it’s more likely it won’t? My point was that you can only spend the money you actually have in the future, not the amount you had hoped for by using market beating strategy.
@ JD – If you believe the markets are efficient enough and that news is random enough, there is no reason to believe that any “actual stock-picking methods” are any better better than a gut guess. I don’t think you can really identify whether stock picking success is skill or luck, but in either case, it’s rare.
I believe Dylan is referring to the efficient market hypothesis.
jtimberman: Point of note. I am a profession analyst, not a professional trader. I don’t trade for a living. I am a part-time trader myself, and quite happy to be.
As for my methods and their applicability, I haven’t actually presented my methods, so I’m not sure how you can make that kind of statement.
The Financial Philosopher: I definitely agree. While long-term wealth building is the main practical focus of investing (in any form), to achieve that objective takes a deeper involvement than something casual.
Dylan: No matter how you invest – even if it’s just bank CDs – there is an expectation of future value. That expectation is based on the probabilities of various potential outcomes. Obviously, in the case of CDs the expecation is based on a very high probability that the quoted rate will be achieved and the near zero chance that something else will happen.
As for the odds being against an individual trader, that’s likely true, though people toss that out all the time with no stats to back it up. Either way, in my experience it has less to do with the ability to identify good stocks and more to do with poor decision-making in other aspects of the process. A lot of traders blow themselves up early – mostly by being foolish, taking ridiculous risks, and thinking the market will go up forever – and that’s it. They never stick around long enough to learn anything. It’s the equivalent to any other activity. If you can’t keep at it long enough, you can’t possible ever get good at it. I would love to see a break down of performance of investors/traders based on time in the markets.
I have no idea what “Stock picking will not work for more dollars than it possibly can work for.” means. What can it work for? There’s an implication in that statement of a zero sum game, which the stock market is not.
Re the section on Fundamental Analyses – you are NOT Warren Buffet.
The idea of the small investor using Fundamental Analyses to choose a stock is absolute Bird Poop. The information necessary to really analyze a company is just not available. What you can find are a few facts and a lot of “spin”.
Suppose you had used fundamental analyses a couple of years back on Countywide Financial? Would you have seen the subprime mortgages, then present, that eventually brought the company down?
Humans are fallible. Is it reasonable to believe that a market that moves at the will of the masses will accurately value every stock on the market on a per second basis? I don’t believe it is. The crowd is not right simply because they’ve all decided to travel the same path. Benjamin Graham said it best, “the stock market in the short run is a voting machine, in the long run it is a weighing machine.” Yes the day traders can influence the day to day value of any given share, but ultimately the company itself drives long-term value.
For the record, I’m not a believer in the Efficient Market Hypothesis. This probably won’t surprise most of you. I have very specific experience based reasons for it. The EMH is founded upon the rational behavior of market participants and upon the near instantaneous distribution of new information. Neither of those assumptions has any basis at all in the reality of the markets. People trade and invest emotionally. Information gets to people and incorporated into their decision-making process in a more gradual fashion is assumed.
Are high volume, high participant markets mostly efficient? Sure. Most of the time they are. In particular, the more institutions involved in a market the more efficient it will tend to be. Here’s the rub, though. Individual traders can trade in the less efficient ones where the big boys don’t play, where there is more opportunity.
Mr. Forman,
I don’t think anyone can argue with Warren Buffet, (and who doesn’t like his little earthy asides…) In fact I have posted here generally about his philosophy and recommended a book based on his basics. Also, principally, I agree with his method of valuing companies.
However, I am not Warren Buffet. I did not show any extraordinary abilities to add large columns of numbers in my head at an early age. Nor did I grow with a stockbroker as a father and I do not have his present wealth. And, of course, Warren buys companies. Something I can’t afford to do. Also, even Mr. Buffet has made mistakes, missed opportunities and in fact is not afraid to sell. I believe he stated on CNBC that you have no profit until you do sell.
I’m a simple guy, who really has no intention of becoming rich, and if truth be told, I don’t really pursue money, except as a means of remaining comfortable throughout my life, leaving something for my kids and most importantly (and Warren would agree) not losing my nest-egg.
Learning what little I know of the market has been a complex task, but a critical process in our up-coming troubling times.
Oh! And I might add; My approach to investing is just based on my opinion… And Lord knows, opinions are a dime a dozen. Today I heard T. Boone Pickens suggest buying energy stocks and Dennis Gartman telling everyone to dump them.
Thx jegan 😉
John, The stock market is not a zero sum game, but trading is. For every dollar won one over the market, one must be lost. There cannot be more capital outperforming the market than underperforming the market. Because trading intermediaries get paid, regardless of whether you win or lose on a trade, trading is actually a negative sum game. This is why odds are against stock picking.
The question is whether you can do better investing in part of the market (stock picking) versus investing in the whole market (indexing). This is the negative sum game, not whether you can have a positive return. If you have a positive return through stock picking but could have achieved better results by simply investing in the market as a whole, what was the benefit of stock picking? This is a loss in the trading vs. indexing game.
As to future value, you keep bringing this up. I do not dispute what future value is.
NO NO NO! Read John Bogle or David Swenson or any other giant in the field, and they will say -choose an INDEX FUND! Keep your fees low (use Vanguard) and just buy an index. I know lots of Wharton grads who’ve lost their entire retirements making stock pics.
I completely agree with the notion that the market isn’t efficient, but that it follows an imperfect approximation of efficiency.
I think one of the problems here is that a short summary of trading strategies can’t fully express the risks and benefits of each, or to present case studies.
Well speaking from someone who grabbed a stock because Jim Cramer said it was great because it’s a REIT I’m a bit said about now but then I looked back over the past 1.5 years (wow long time) of owning that stock I have gained about 4-6 shares of that stock just by reinvesting the dividends.
Now I know most of you will be going “you should not have done that, you should have sold a while ago”
Myself I’m thinking on long term with this stock and since it is growing at a good clip I’m going to stick with it for a LONG time to come. I am hoping to put some more money into it soon to get more so i get more dividends. Even thru this hard time on the market it is only down about a buck when I first bought it.
my advice is don’t be a “day trader” its those types who drive worthless stocks up other people buy them and then it falls like a bolder in a lake. AND use money you’re not afraid to louse as well. Don’t “bet the farm” on stocks indexes or even funds of any type. It’s one very good piece of advice I got from watching the market for about 5 years before I bought my first share.
I am a huge fan of index funds. For people starting out, I recommend index funds and tons of research. Paper trade individual stocks and read the financial page EVERY DAY. Make this a habit and after a while you’ll start to get to a point where you’ll “know” a little bit of what you’re talking about. Then start researching individual stocks. Paper trade them, take your time, no rush. It takes years to “get” this stuff at the most basic level.
Once you’re ready, pick out the one or two individual stocks you really think are good choices and buy them as if you’re never going to sell. Slowly, take your time, this is no race.
I think that a portfolio of 85% index funds and 15% individual stocks is a perfect way for the individual investor to profit from the market averages and from trying to boost that a little over the averages.
The key is this takes TIME
miracletech: My, that’s a negative attitude! Keep in mind that not everything in fundamental analysis comes from the company. More macro elements come into play. You can absolutely get a great deal of it from them – with low hype from the required filings, at that. Plus, you can get on conference calls and all that stuff that used to be only open to analysts. What you do with that information, of course, is what determines whether fundamentals are of any use to you.
As for Countrywide, given the number of people who saw problems coming in housing well ahead of time, it seems likely that an investor looking at the bigger picture could have seen a fall coming.
Chris: Well said – the very point of long-term fundamental trading.
jegan: Spoken like a very reasonable and ration individual. 🙂
Dylan: I totally agree that one must weigh the opportunity cost of investing in individual stocks against index returns (or any other vehicle). If you can’t do better, then stick to index investing.
As for trading in stocks being zero sum (really negative sum), please lay it out for us. I want to hear how you are defining things, especially when investing is considered.
DC Economist: Exactly!
brooklynchick: I’m not disagreeing at all with the value of index investing. J.D. asked me to write something about stock picking, which I did.
That said, the concept of index only investing has a foundation in classic financial theory. I’m well versed in that (for better or worse) having that as my educational focus at both the undergrad and grad level. That foundation, however, is very shaky. Read Mandelbrot’s The MisBehavior of Markets sometime. Very interesting stuff.
Writer’s Coin: Very good points. The big problem most investors have is that they dump a big portion of their money into the markets and starting trading/investing it with no education and no experience. Paper trading is readily available these days. Use it. Developing your understanding and analytic skills. Then slowly start moving into live trading.
Seems more like a topic for GetRichOrPoorQuickly.com.
John, There is not much more to it for me to lay out. Every trade has two sides (buyer and seller). The result of the trade will at any future point be better than the market for one side and worse than the market for the other by equal amounts, not counting transaction costs which includes spreads.
As for investment growth, you can participate whether or not you trade along the way. Whether you buy and hold a slice of the entire market through an index fund or trade parts of it by picking companies, you still get to participate in the price appreciation and growth of the companies you own. All the trading in the market identifies market value, but it doesn’t create value.
Acknowledging that this is about opportunity cost (indexing vs. stock picking), the question is whether you can make more money selectively buying stocks than investing in the entire market proportionately to capitalization. In trying to answer that question, one should consider that, among all investors in a market, more money couldn’t be made above the market than must be lost. It has to come from somewhere, and it’s not form growth because that is already included in the market. This holds true whether a market is completely efficient or highly inefficient.
So, by advocating the use of trading strategies, know that everyone doing so will collectively lose more money than they will gain compared to the market. And you can’t advocate it only for those that can do better because that result is mathematically impossible. It’s like saying, only go to school if you can graduate in the top half of your class.
I’ve done my best to explain this. These are real concepts, not just my own theories. It is a matter of math. If you disagree, perhaps you can explain how it’s possible for more money to out perform the market than under perform it.
@John, Oops, I misunderstood the summary then.
Dylan – I absolutely agree that trading identifies value. The movement of prices is essentially a value discovery process.
Saying each transaction has a buyer and a seller, though, is not the same as saying that there is a long and a short for each trade. Big difference. A long benefits from price appreciation, and a short benefits from price depreciation. The same cannot be directly inferred for buyers and sellers.
In the futures market, where traders are either long or short (or flat, obviously), but no actual purchase or sale is made until delivery (if they stay in that long), it is absolutely a zero sum situation. A gain for one is by definition a loss for the other in equal proportion.
In stocks there aren’t shorts matched up against longs, in most cases. As a result, it’s generally just a long who gains or loses with price change. It’s therefore not zero sum because the owner who sells his shares to a new owner is not impacted thereafter by changes in the stock’s value.
To extend your better or worse than the market argument, we can see that in stock trading it is not a one better, one worse situation. The person long the stock after an exchange of ownership, depending on how the stock performs, could do better or worse or the same as the market. The person who sold the stock to the new long, who is now flat, could also to better, worse, or the same as the market. They could both do better. They could both do worse. That means it’s not zero sum, by definition.
You’re absolutely right. Opportunity cost should dictate investment decisions. If you cannot outperform the market by being more selective than index investing, and do so by an amount that justifies the added time required to do so, then it’s not worth it – assuming your objective is long-term capital appreciation, of course. If your objectives are other than that (income, for example), the index investing might be a horrible idea.
I would toss one thing into the opportunity cost discussion, though. Is there an added benefit of doing the stock picking work (individually and/or taken in mass)? If so, that needs to be factored in the grand equation.
OK – may as well jump into the fray…
I doubt anyone’s going to take me seriously, but how I pick stocks is a lot like how I used to pick antique/collectable type items. I didn’t buy things based on how much they could possibly go up in value – I made sure first that I actually liked the item. Was it attractive, in nice shape, when with the decor in my house, etc. If the answer was yes, there was a good chance that I’d buy it. If the item didn’t hold or increase it’s value I still liked it and didn’t mind it gracing my home.
Translated to stocks – I pick stocks from companies I feel strongly about. I’m a big advocate of energy conservation so I recently invested in a natural gas company that is doing a lot of reserch on non-petrol based energy. I feel good about my purchase because I’m helping a company that I believe is doing good.
I also like companies that make products for the aging. My Mum is in her mid-80’s and although she gets along fine without assistance, there are some things that make life easier. This is another thing I have no problem standing behind.
I also like communications companies because I work for an association that supports the public safety communications industry. I’m comfortable with the scene, know some of the emerging issues and because of my position, know a lot of the companies that supply this industry.
I still do some homework so I don’t invest in some oddball fly-by-night company. So far my instincts have served me well. My portfolio has increased over 40% since it’s inception in 2004. I’m no expert, but I think that’s pretty good.
Bottom line – if you are passionate about something, you will have an underlying knowledge of the topic that transcends the statictics. And if you lose some money – well at least you know some of your money when towards something you felt strongly about.
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!
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.
@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 🙂 )
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.
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.
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.
@ 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).
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:
“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! 🙂 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…
@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.
@ 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%.
@ 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.
@ 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?
@ 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.
@ 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.
@ 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.