How to invest in stocks

imagesI’ve been investing in stocks for several decades. Here’s what I’ve learned.

In 2000, during the dot-com bubble, I owned AOL stock, going up and up and up. I thought it was crazy, but held on for the ride. Then came AOL’s buyout of Time-Warner. My rule of thumb is that mergers are bad for the acquiring company; the touted benefits rarely materialize. So I told my broker I wanted to sell my AOL stock. He tried to dissuade me, calling this merger the greatest thing ever.

UnknownIt was one of the greatest disasters ever. Turned out the AOL honchos knew their stock was way over-valued, and they were cashing in by using it to buy Time-Warner. The stock then collapsed.

Am I relating this to show how smart I was? Nope; I heeded my broker’s advice and didn’t sell. What is the lesson? I wasn’t so smart. My broker wasn’t either. Neither was Time-Warner. You can’t expect to outsmart the market or beat the market.

Everybody aims to pick stocks that will do better than average. Thousands of people are paid a lot of money for that. But the very fact that so many very smart people are trying is what makes it unachievable – they all cancel each other out.* Since they’re all so smart, with so many analytic tools at their disposal, so much information, computer programs and models, etc., no one can truly outperform the rest – except by mere luck.

Unknown-1That may be a bit overstated. It does happen. A good example is the housing bubble collapse that triggered the 2008 crisis. Most of the Wall Street herd didn’t see it coming, and continued drinking the Kool Aid right to the end. However, a few did see the true situation, and profited thereby. But that was a special case. More normally, if you’re smart enough to see something, a lot of others will be smart enough to see it too.

Now, since YOU surely aren’t smart enough to beat all that firepower in picking stocks, it might instead seem sensible to buy into a mutual fund, which employs hot-shots to do it for you. There are thousands of funds. Which to choose? Well, you can look at their track records and see which has performed best.

But here’s the thing about track records. Suppose all those mutual funds picked stocks by a random dartboard method. The results would form a standard bell-shaped curve – most performances would be middling, a few much above or below the average. If you choose the one that came top — what are the chances it will again be the best next year?

Unknown-2Of course mutual funds don’t use a dartboard method. They use, again, sophisticated analysis, computer models, etc. And because they all do, the results are the same – mostly bunched in the middle, some better, some worse. And remember, you can’t expect to beat the market, at least not consistently. So a mutual fund’s track record is not necessarily more predictive of future results than if they did shoot at dartboards.

Economists call this “reversion to the mean.” In a given year, out of a thousand mutual funds, inevitably one will clock the best performance. Does that indicate its guys are actually smarter than all the other very smart guys at all the other funds? Not likely! More likely it’s just natural random fluctuation around the mean (average) performance. So next year, its results will fall back to the average – “reversion to the mean.”**

Then too there’s “efficient market” theory. This says every piece of information relevant to valuing a stock is already folded into its price. You can’t really know something about a stock, affecting its future prospects, that the market doesn’t know (unless it’s “insider information,” illegal to trade on). Thus again it’s not normally possible to profit from trading stocks by being smarter than the market.

So you’d expect the entire universe of mutual funds to produce a return simply matching the market average. But actually it doesn’t. All that frenetic activity costs money, and they charge investors a percentage for their services, which makes the net return less than the market average.

imagesI recently read Nate Silver’s book, The Signal and the Noise, concerning all the problems of predictions. Wall Street is a major focus. Silver too notes that a lot of people are highly paid to try, and at the end of the day inevitably fail, to beat the market. Seems crazy. They all know about efficient market theory and that they can’t beat the market; or should know. But if they all actually followed the logical implications, no stock trading would occur at all. Yet having a functioning market serves a quite valuable purpose in the overall economy. The trillions worth of trades dwarfs the amounts “earned” by the investment industry (to essentially achieve nothing) – a small price to pay for having a financial market.

Every prospectus warns, “future results may not replicate the past.” Otherwise investing would be a snap and everyone would be a millionaire. The caveat is true on the largest scale. You’ve been told that in the long run, stocks do such-and-such; the market returns X%. And that may indeed be accurate concerning a very long past time span. But future results may not replicate the past. In fact, the future is quintessentially uncertain. The only certainty is that it will differ from the past.

Nevertheless, over the long term, stocks should provide a return for a simple reason. Their values are ultimately grounded in company earnings. And the typical company typically does earn profits. ***

Unknown-3If you ask people whether it’s a good time to buy stocks when they’ve been going up a lot, they’ll likely answer “yes;” and “no” when stocks have been falling. Those answers are – of course – wrong. In fact, this is really the most common investing mistake. When the market is high, stocks may well be over-valued; in a slump, they may be cheap. But optimism and pessimism are contagious. Many people plow in when stocks are up, while becoming demoralized and sell when they’re down.

A key consideration is the ratio between a company’s stock price and earnings. This P/E ratio for the whole market has, over the long term, averaged around 15 or perhaps somewhat more. If the market’s average P/E is much higher, stocks may be over-valued; and vice versa. Today’s P/E is above trend, at about 25.

If you want to just capture the market’s long-run tendency to produce a return through earnings, there’s a simple option: index funds that just track the performance of an index like the S&P 500. Since there’s no need for hot-shot analysis, fees to investors are typically quite low.

images-1So, how’ve I done, overall? Not bad. But I’ve had quite a few real disasters like AOL along the way. I’ve finally pretty much given up trying to be smart. That’s a sucker’s game.

* Remember that in general, whenever a share of stock is sold, somebody else is buying it.

** This was explained well in Leonard Mlodinow’s book, The Drunkard’s Walk.

 *** “Return” is the sum of dividends plus stock price appreciation. Earnings not paid out as dividends accumulate within the company and increase its net worth.

 

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2 Responses to “How to invest in stocks”

  1. BLA Says:

    Well done, well written. Thank you.

  2. Lee Says:

    I agree with you 99%. However, sometimes research, research, research (compare to real estate) can make picking an individual stock worth it. If you are an aficionado of some type of product you might actually be in a better situation to appraise it than those financial guys in the fancy suits. If your product appraisal and your research, research, research into company P/E ratios, etc. indicates it then a buy and hold of the company stock could pay off.

    But if you aren’t an expert, or if you skip the research step, or if you are buying merely because the stock is rising (or was rising, or is/was falling or whatever), or if you hold less than a year,* or if you invest too much** then save yourself the heartache and just stick with the index mutual fund.

    *Holding less than year will likely kill any advantage once the transaction costs, bid-ask spreads, etc. are factored in.

    **Any advantage you might have does not merit overruling the commandment “thou shalt diversify.”

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