Simplistic investment question

[Eddie Dane]

We have all heard the test done by letting a four-year-old girl pick stocks at random and (in a growing market) outperforming professional traders.

So I came across a listing of buy-hold-sell advice from various banks.

Theoretically, if one just acted on a number of these, and strictly adhered to it.
Never really looking into the specifics of the companies listed or the theories behind the advice, how would a trader perform?

 

[drkitten]

We have all heard the test done by letting a four-year-old girl pick stocks at random and (in a growing market) outperforming professional traders.

So I came across a listing of buy-hold-sell advice from various banks.

Theoretically, if one just acted on a number of these, and strictly adhered to it.
Never really looking into the specifics of the companies listed or the theories behind the advice, how would a trader perform?

According to the studies that have been done -- Bogle and Malkiel (separately) have done many of the studies -- probably at the level of the market less trading costs. I.e. the level that chance predicts.

 

[Eddie Dane]

According to the studies that have been done -- Bogle and Malkiel (separately) have done many of the studies -- probably at the level of the market less trading costs. I.e. the level that chance predicts.

Do you mean, about as good as a four-year-old girl picking stocks at random? Or better?

It's not like the banks gave big warnings or were urging people to sell pets.com stock before the dotcom crash.

 

[timhau]

We have all heard the test done by letting a four-year-old girl pick stocks at random and (in a growing market) outperforming professional traders.

I'm pretty sure there are also 4-year-old girls (and parrots, and monkeys throwing darts at WSJ stock listings) who have underperformed professionals, but we seldom hear about them.

 

[Merko]

On average, the stock market cannot grow more than the economy as a whole in the long run. On top of that, any profits and losses are a zero-sum game. But there is a lot of money to be made from suckers in that zero-sum game. If you don't understand this, it probably means you're one of the suckers.

First, there is a fee for trading. This fee is not proportional to the volumes, so especially as a small trader, you will lose money if you trade without having any good information.

Second, professional traders are.. professional, meaning they are constantly trading throughout the business day. That means that when something significant happens, they will buy or sell much faster than you can do as an amateur. The difference is mostly what makes up the profit the professionals make out of the pockets of 'slow' small-scale investors. There's no objective, overall gain from having stock prices adjust over a matter of seconds rather than hours or even days.

Third, many people offering 'advice', whether in business columns or through more or less advanced rumour-spreading, have vested interests. Eg they are actually trying to hype or smear a particular stock in order to fool the masses and make a lot of money. Some of the most respected business journals have meaningful rules against this type of behaviour; most don't.

What this boils down to is that as a small time investor, the only way to make money is to use the stock market as it was originally intended, that is to study some particular industry and make a long-term prediction who will succeed or not, and then make an appropriate long-term investment.

 

[roger]

Do you mean, about as good as a four-year-old girl picking stocks at random? Or better?

It's not like the banks gave big warnings or were urging people to sell pets.com stock before the dotcom crash.

Well, it's a simplistic formulation. The market, on average, will perform averagely. It couldn't work out any other way, mathematically. It's not an indictment against professionals - they are making the market.

Allow me to explain. Historically you can make risk free money at around 6% by buying T-bills (it's rather less these days, but that's not the point). So, you would have to be a fool to buy a business, which has risks, for, say a 5% return. You are going to demand some extra profit for that risk - and, the more the risk, the more the profit.

So, traders are just bidding on various companies. I have 100 shares of IBM, and am willing to sell them for $37.50. If another person considers that a good risk/reward proposition, they will buy it. If not, no one will buy it and my shares will linger. Of course, there is somebody else out there with IBM stock looking to sell, and maybe they ask $37.25. Etc., and so on. The market is just an auction. The prices adjust to reflect the risks of the company, and the amount of return the company offers, always measured against the risk free returns of T-bills.

So, professionals, being professionals, supposedly have a grasp of what things are worth, who is a risk, etc, and they also have the deep pockets. So, more or less (there are huge caveats I'm not going into for this simple model) the market reflects their views.

-------

Okay, so now Bogle. If you throw a dart randomly at the financial pages and buy whatever it hits, you are basically agreeing to trade at whatever price the professionals think is fair. Suppose IBM is worth somewhere around $35 in the opinion of the pros, but idiots are offering it for $20. The pros would rush in, start trying to buy it, and either exhaust the supply at $20 or cause those idiots to recognize they are sitting on a gold mine. Either way, the price would rise. So, on average, you will get a fair deal on whatever you buy if you buy randomly. The company that is making no profits will be at a low price to compensate for that, etc.

So, Bogle's argument is that pros are already setting the market prices.If you then go out and hire a pro (a mutual fund manager, say), he skims some off the top in fees. You are paying him twice. Necessarily, on average, you will do worse than the market (since the market's performance will mirror the summed average of all pros). So, instead of hiring a pro (a mutual fun), just buy index funds. Index funds just buy all the stocks in a specific index (usually the S&P 500), and the transaction costs are extremely small. You get the knowledge of the pros for free.

There are other arguments relating to taxes et., al., but I won't go into them.

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Okay, so, finally, to your "simplistic" question. To beat the market you are arguing that you can beat the thinking of the worlds professionals. Good luck on that (I think it is possible, but hard). What are the chances that some public list of stocks is going to beat the pros, do you think? And, remember we are talking about averages. Any individual stock can fail. Just having 2-3 of those in a 10 stock portfolio can spell real disaster. Are you really going to trust your financial well being to some random list on the web, a list readable by the pros setting the prices in the first case? I suggest not.

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So, the standard advice these days for the non-serious student (at least 99% of people) is to just invest in index funds. You will get the gathered knowledge of the world's pros for free.

Alternatively (and I admit bias here), your only realistic hope is to start reading Benjamin & Graham. Google it. Warren Buffet, and many other decades long market over-performers use this technique. Malkiel, mentioned by Dr. Kitten above, considers it the only intellectually defensible investment strategy other than index funds (full disclosure - he feels there is not enough data yet to prove it works - I disagree with him, but that is another thread).

So, to sum it all up, go buy one of Bogle's books, or better yet borrow from the library, and do what he says. Or prepare to use the same level of study and intellect the best of the best (Buffett, et al) use to beat the pros at their game.

As an aside, I don't think it is as hard to beat them as the above makes it out to be. Pros are not intellectually pure - they have pressures that cause them to make substandard decisions. Have a bad quarter? Lose 5% of your mutual fund holders, and thus lose your job. Or, if you are buying for the house, you swing for the fences - losses get swept under the rug, but if you connect you get a bonus that makes you and all your family wealthy. Etc. Lots of behavior goes on that skews the pricing scheme I described in that rational auction system I described earlier.

Finally, you have non-realistic hopes of creating, say, an algorithmic trading system that beats the market. There are various claims about efficacy; and I remain highly dubious. But realistically, you don't have supercomputers and squads of PhDs to devise the algorithms, and Wall Street does. What are your chances at competing with them in this way, head to head? (also, let's point out how companies using these techniques have blown up spectacularly, almost taking out our entire country with it - there are strong arguments that they have not adequately measured risk - another thread topic)

So, Bogle or Graham are your intellectually defensible choices. Go forth and prosper!

 

[lomiller]

I look at it this way. The market assesses the available information to arrive at a price. These analysts are simultaneously working off that same information and indeed form a part of the information the market is using. It’s only natural that they should track with the market on average.

If you want to beat the market you need to be calling on information that isn’t widely disseminated for some reason. This can be due to the analysts getting it wrong, because it’s slipping under the radar and not getting reported on or even because there is some other reason why objective reporting would be ignored. (For the last one I’m thinking about companies that people love/hate for reasons outside of their value. I.E. Apple who’se fans love them regardless could well be overvalued while BP whom people hate at the moment could be undervalued.)

In all the above cases, however, you need to understand the business and industry very well to really have a chance at spotting stocks that really are undervalued. If you don’t you will essentially be guessing.

 

[drkitten]

I'd like to expand on this excellent post, if I may...

So, professionals, being professionals, supposedly have a grasp of what things are worth, who is a risk, etc, and they also have the deep pockets. So, more or less (there are huge caveats I'm not going into for this simple model) the market reflects their views.

I've highlighted a key assumption there, and one that explains a lot of the experiments done by Bogle and Malkiel.

The assumption is that the analysts control enough dollars in the market for any particular stock to set the price to a fair value.

This was less true thirty years ago than it is today. Analysts, who generally aren't in it for their health, tend to concentrate on analyzing stocks that will make them a profit to analyze (which is different than stocks that will make them a profit to buy). In 1970, for example, most analysts concentrated on specific large-cap stocks (e.g. part of the S&P 500) and left the smaller, thinly-traded stocks alone, because one couldn't buy enough of a microcap to make it worth an insurance company's while to buy the report.

The price of IBM or Boeing is thus much more likely to be fair than the price of Stewart's Transmissions.

So one reason that the four-year-old girl outperformed the professionals is that the four year old girl could and would "buy" any of the stocks in the market, including the small-cap stocks that no one bothered to look at.

Okay, so now Bogle. If you throw a dart randomly at the financial pages and buy whatever it hits, you are basically agreeing to trade at whatever price the professionals think is fair.

... but in the case of a small or thinly-traded stock, they haven't actually given this particular price much thought.

And here's where Graham, Dodd, and Buffett can come in. Because they're willing to look at Stewart's Transmissions and figure out if the price really is fair, and Buffett is willing to buy the entire company if he likes it (which is something the insurance company can't do, legally).

Okay, so, finally, to your "simplistic" question. To beat the market you are arguing that you can beat the thinking of the worlds professionals.

Pretty good if you find the right area that the pros have overlooked.

.... and now we get to today.

The problem is that now, computers have gotten so good that I can do a cursory "look" at every stock in the market overnight. And the pros do. Which means its much harder to be a true diamond in the rough for very long.

Ben Graham found his diamonds in the rough because there were companies out there that had more cash on hand then they had market capitalization, because no one was able/willing to check all the companies. No one finds those anymore, but it's trivial to set up a program to scan the financial reports "just in case." But precisely because it's so trivial, people have done it, and those kind of opportunities don't pop up any more.

Peter Lynch found his diamonds in the rough by calculating PEG ratios (price divided by earnings divided by growth). Again, most people didn't or wouldn't scan the expected growth rate for every company on the market, so he found some gems. Today my broker has that kind of screen on its web page -- of the 9000 or so stocks it knows about, exactly 539 have a PEG ratio suitable for Lynch to buy. In a second, I did a month's worth of Lynch's preliminary screening.

 

[roger]

So one reason that the four-year-old girl outperformed the professionals is that the four year old girl could and would "buy" any of the stocks in the market, including the small-cap stocks that no one bothered to look at.

Do you have a cite for this?

I'm not disagreeing - if I was to show you my purchases you'll just how often I buy from the sheets, and basically the rest are under $1B in capitalization. However, there is the argument that transaction costs on these smaller companies eat the profit. I haven't really bought that argument - certainly I've seen some pretty big gouging on the pink sheet quotes, but then I'm buying things at what I consider to be a fraction on the dollar - I can afford the gouge. I could believe that on average the gouge equals the profit potential - I try to avoid being average.

And here's where Graham, Dodd, and Buffett can come in. Because they're willing to look at Stewart's Transmissions and figure out if the price really is fair, and Buffett is willing to buy the entire company if he likes it (which is something the insurance company can't do, legally).

Buffett agrees - I recall seeing him on a CNBC interview where he agreed that the big stocks are mostly efficient - he ends up looking at the big boys because he has so much friggin cash and existing investments that it takes Billions in purchases to make the needle move.

The problem is that now, computers have gotten so good that I can do a cursory "look" at every stock in the market overnight. And the pros do. Which means its much harder to be a true diamond in the rough for very long.

Ya, which is why I don't do much screening. I do some - I won't buy under roughly %10ROA, I won't buy if they have massive debt, etc. For awhile I subscribed to ValueLine - over a year or so you get an education on just about every business that trades in America (okay, not the pink sheets, but you get the idea). But I didn't use the tables of numbers to make buy decisions, it was more education (who is every major to medium company that makes bearings for jet engines? Has any of them reduced the risk that fluctuation in steel and energy prices represent?).

I'm saying this because it is in line with what Buffett recommends. When he learned the market he sat down with Moodys and started reading from the A's. There is really no other way*, especially with all of the computerized screening now available.

* with a caveat. It's seeming more and more the real way is just keep a bunch of cash around, and then buy in these major crashes. At these times everything is on sale, and cash is king. I've made 7x on my investments in the crash, but I was only able to put a small amount of cash to work because I was largely all in already. So long as you didn't buy a company caught up in the mess, it was pretty hard to not make major money.
-------------

All of this may seem kind of out there based on the information presented in this thread. Suffice it to say that people like Buffett believe that they can put a price on some businesses, independent of what the market is asking. Coke sells X cans every year, grows by 2% every year, and raises prices by 3% a year. That's pretty easy to price. When you have a market crash, or temporary bad news (oh no, coke recalled 1MM bottles, costing them $3MM!!!) the stock plummets, and people like Buffett jump in and buy at bargain basement rates. The idea is to buy at 50% or less of the actual value of the business (which was easy back in the depression when Graham was writing, not very easy today), so even if you are quite wrong about the prospects you are likely to make money or at least not get hurt much. As I understand it these days Buffett has a hurdle rate more like 15%.

So, you look for good profits, great management, low debt (so the company doesn't go bankrupt during financial crises like 2008), and then wait for the price to become artificially low. What the dr and I are discussing is that these artificially low prices are harder to come by because there are so many computers and other 'eyes' looking at the entire universe of stocks that people are quicker to pick up on anomalies. Back in the day you could flip through Moodys or such and find ripe pickings. Buffett has departed from Graham in respects because of this change in access to information.

 

[drkitten]

Do you have a cite for this?

Lynch, Beating the Street, and I think it's also in Malkiel's Random Walk. Having neither book in my pocket, I can't give you page numbers, I'm afraid.

I'm not disagreeing - if I was to show you my purchases you'll just how often I buy from the sheets, and basically the rest are under $1B in capitalization. However, there is the argument that transaction costs on these smaller companies eat the profit. I haven't really bought that argument - certainly I've seen some pretty big gouging on the pink sheet quotes, but then I'm buying things at what I consider to be a fraction on the dollar - I can afford the gouge.

Yes, that's the standard argument and counterargument. As you point out, if you're buying at five cents on the dollar, it doesn't matter if you pay another penny in transaction costs (even though that would be a whopping 20% commission). The trick is to find someone willing to sell at five cents on the dollar before the rest of the world does. And, perhaps obviously, the best way to do that is to look where no one else is looking.

 

[skepticalbeliever]

It seems like everybody breaks even or loses money at stocks. In order to actually make any money, you must hold on to 1 stock that will outperform for the decade. Diversifying just causes you to underperform the index. Indexing causes you to break even because you can't time it. So have nerves of iron and bet big on the stock that will outperform for the next 10 years.

Hold on to it through ups and downs. Don't even read the financial statements or reports. Many people try to game the market through this method and fail. Forget about analysts and pundants.

Now which stock you pick is up to you. I don't know what will outperform for the next 10 years.

 

[Dunstan]

It seems like everybody breaks even or loses money at stocks. In order to actually make any money, you must hold on to 1 stock that will outperform for the decade. Diversifying just causes you to underperform the index. Indexing causes you to break even because you can't time it. So have nerves of iron and bet big on the stock that will outperform for the next 10 years.

That's a lot of wrong statements to cram into one paragraph.

 

[timhau]

It seems like everybody breaks even or loses money at stocks. In order to actually make any money, you must hold on to 1 stock that will outperform for the decade.

What a great recipe for disaster. That's moronic, but not an uncommon opinion -- lots of people see the stock market as some sort of a shady gambling arena.

 

[stevea]

I'd like to expand on this excellent post, if I may...

It's hard to imagine that some overly simplistic pro's vs shmoes false dichotomy represents an excellent post,

I've highlighted a key assumption there, and one that explains a lot of the experiments done by Bogle and Malkiel.
[...]
The price of IBM or Boeing is thus much more likely to be fair than the price of Stewart's Transmissions.

So one reason that the four-year-old girl outperformed the professionals is that the four year old girl could and would "buy" any of the stocks in the market, including the small-cap stocks that no one bothered to look at.

That's an incompetent explanation and defies reason. The dart-thrower is certainly more likely to select under-analyzed and therefore inefficiently and perhaps under -priced stocks - but this doesn't explain success. The under-analyzed stocks may well continue to be to be ignored and underpriced and therefore under-perform. You'd have to additionally posit that under-analyzed stocks generally beat the averages - and that's not in evidence, and is in fact a crock. If it were so, then there would be a simple formulaic way to beat the market (which for obvious reasons cannot be sustained).

And here's where Graham, Dodd, and Buffett can come in. Because they're willing to look at Stewart's Transmissions and figure out if the price really is fair, and Buffett is willing to buy the entire company if he likes it (which is something the insurance company can't do, legally).

Well yes ,there are several dozen examples of individuals like Lynch, Buffet, Rogers, ... who have, over a period of decades, publicly, repeatedly beaten the market. Universally they analyze fundamentals, and also take account of long term trends. There are a few like Soros who have placed huge timely wagers when the long term trends they've tracked have come to a head. None are market timers; they aren't trying to read anything into market moves. They are looking towards the fundamental cause rather than the effect.

In any case the "pros" are often wrong and it's very possible to make a living betting against pro's in areas where there knowledge and analysis is too superficial - typically new or changing technology. Also they "drive herds" and contrarian positions can often be very advantageous. Ultimately the "pros" are just investors with enough backing to significantly change market pricing.

WRT to funds, there are now numerous papers and Lipper Analytics reports that a vast majority of managed funds fail to beat market averages, and some recent work that the underperformance is relatable to the cost of fund management. IOW actively managed funds actually do just as well as a monkeys throwing darts, if we discount the higher fees of the fund managers. The monkeys just work cheaper, not better.

Pretty good if you find the right area that the pros have overlooked.

Again this assumes that "overlooked by pros" means better than average return, but that's nonsense.

.... and now we get to today.

The problem is that now, computers have gotten so good that I can do a cursory "look" at every stock in the market overnight. And the pros do. Which means its much harder to be a true diamond in the rough for very long.

Ben Graham found his diamonds in the rough because there were companies out there that had more cash on hand then they had market capitalization, because no one was able/willing to check all the companies. No one finds those anymore, but it's trivial to set up a program to scan the financial reports "just in case." But precisely because it's so trivial, people have done it, and those kind of opportunities don't pop up any more.

Peter Lynch found ...

Right, more stocks have actionable analysis today. All that means is a paradigm change in investing. If (neary) everyone is investing according to a Graham and Dodd value analysis, then stock prices will (imperfectly but closely) reflect that value analysis. This means that you can no longer make better than market average returns with the methode ordinaire analysis.

That is not the same as saying you can't beat the market when everyone is using competent value investing; it's just that you can't beat a valuation market by investing with the same valuation style analysis everyone is using. Instead you must always exploit inefficiencies in the "current regime" to beat it. The stock market is, ignoring dividends, mostly a zero sum game and the point is to beat other investors except to the extent you think dividends provide return. If we all used exactly the same valuation, then there would be very little trading - the difference of opinion makes for the bet.

All investment theories necessarily assume that the market does not reflect the very same theory being universally applied. This is easy to see for a more formal theory like MPT, and DrKitty makes the case for Value investing.

It's a rather complex game with some similarity to rock-paper-scissors where each choice has it own weakness and it's own advantages. There can be no formulaic "win". Or perhaps more like evolution ...

 

[lomiller]

It seems like everybody breaks even or loses money at stocks. In order to actually make any money, you must hold on to 1 stock that will outperform for the decade. Diversifying just causes you to underperform the index. Indexing causes you to break even because you can't time it. So have nerves of iron and bet big on the stock that will outperform for the next 10 years.

Stocks that perform with the market sill make money. Sometimes they make a lot of money. Even stocks that have underperformed the market for the last 18 months have made a lot of money.

 

[drkitten]

Indeed, this is a lot of wrong to pack into one post.

In order to actually make any money, you must hold on to 1 stock that will outperform for the decade.

Must I hold on to one stock for the full ten years, or can I make money with a holding time of only nine years and 360 days?

If I can make money holding stocks for a ten year period, I can make money holding stocks for a five year period, too. The problem is simply that trading more frequently causes you to pay more commissions, which reduces your return.

Diversifying just causes you to underperform the index.

Again, not at all. If I can pick one stock that's likely to outperform the indices, I can pick two.... or I can pick one, and a friend picks one, and we swap recommendations. (That's why stock clubs exist.) Diversification across a well-chosen set of stocks increases your return and lowers your risk, as long as you've got a better than 50% chance of picking a stock that will beat the returns.

And if you can't do that, then you shouldn't pick a stock and hold it, either, because you're more likely to lose money to win (by assumption).

 

[The Central Scrutinizer]

It seems like everybody breaks even or loses money at stocks. In order to actually make any money, you must hold on to 1 stock that will outperform for the decade. Diversifying just causes you to underperform the index. Indexing causes you to break even because you can't time it. So have nerves of iron and bet big on the stock that will outperform for the next 10 years.

Hold on to it through ups and downs. Don't even read the financial statements or reports. Many people try to game the market through this method and fail. Forget about analysts and pundants.

Now which stock you pick is up to you. I don't know what will outperform for the next 10 years.

Ummmm....what?

 

[drkitten]

That's an incompetent explanation and defies reason. The dart-thrower is certainly more likely to select under-analyzed and therefore inefficiently and perhaps under -priced stocks - but this doesn't explain success.

Actually, it does.

The underanalyzed stocks are less liquid for that reason, which means it's harder and more expensive to get out of a position; this reduces the value to a trader (less so to a buy-and-hold investor, as the dart throwing girl is generally assumed to be).

If it were so, then there would be a simple formulaic way to beat the market (which for obvious reasons cannot be sustained).

And indeed there is. Throw darts at the WSJ on New Year's day. The dart-throwing girl has an advantage over the professionals, as Malkiel's studies have shown. And, in fact, the long-term return on small cap stocks is better than the long-term return on large-cap stocks.

 

[Modified]

There are plenty of micro-caps where trying to buy $10,000 worth in one day could move the ask up 30%, and trying to sell $10,000 worth in one day could drive the bid down 30%. I don't think they are considering that when analyzing dart-girl's results.

 

[skepticalbeliever]

You would probably do fine with value stocks. I just looked at the portfolio and there are some intresting ones I admit.