Picking Stocks

January 6, 2006

My friend Drew insisted that I read The Millionaire Next Door, a book that shows how being frugal in the long term can make you wealthy. Well I’m already about as frugal as I can be, but the book did emphasize how important it is to take your finances seriously, so I finally made it a goal to do so in 2006.

The first step is deciding whether to take the active approach of choosing individual stocks, or the passive approach of putting money in mutual or index funds and walking away for 40 years. In principle the former takes more effort but gets you greater returns. After thinking about this for a while, I’m not sure that it does give you greater returns.

Here are three ways of thinking about the problem.

1. Squeezing out profits

Let’s say that putting your money into an index fund will get you 10% per year on average, and it takes no effort. It doesn’t matter what the real number is, we just need something to compare to. I’m not going to invest in a stock if it’s going to get me less than 10%, since it’s not worth it, an index fund is less effort.

Let’s also say that some company, we’ll say XYZ, is currently selling for $50 per share. They put out a press release about some new product, and everyone thinks, “Wow, in one year XYZ shares will be worth $110. I can buy them for $50 now, so I should do that and more than double my money.” But of course buying shares is a bidding process, and someone else thinks, “I’ll outbid the first guy by offering $51 and still more than double my money.” This continues upwards, with everyone outbidding each other in a race to buy these promising shares. Where does it stop?

It stops at $100. Because if you buy a share at $100 and sell it in a year at $110 (your assumption), you stand to make 10%, and at that point you’re indifferent between buying XYZ or an index fund. (In practice you expect more from a stock because it’s higher risk, so it would stop below $100.)

So you can’t make any more money from XYZ than you can from an index fund. The bidding process will squeeze out every bit of profit before you can have a chance to actually buy anything. Once information becomes public, it’s too late. The only way to make money here is to already own the $50 shares that you then sell for $100, but to do that you must have guessed at this press release.

You could argue that people don’t literally think, “XYZ will be $110 in a year.” That’s true, but I think whatever thought process they do go through has a similar result. The science of economics has shown repeatedly that people in aggregate do the equivalent of performing very sophisticated math, even though no individual actually does that math.

You could argue that maybe you could buy a share when it’s on its way from $50 to $100. But one paper¹ showed that it takes about 30 seconds for that to happen, so in practice you won’t have time.

Now it turns out there is a way to make money here. If you guess that XYZ will be more than $110 in a year, then you can outbid the $100 guys, buy the shares for $101, and sell them a year from now for $115 (or whatever) and make more than 10%. Similarly, if you think that they’ll sell for $95, you can sell them short and make money. But in order for that to work you need two things to be true: (a) you need to disagree with everyone else; and (b) you need to be right. I don’t feel like I (or most people) can do this, especially when “everyone else” includes people who do nothing else all day but observe the industry and the stock market.

2. The bell curve

For any given stock, there’s going to be a spectrum of people from pessimistic to optimistic about the stock’s future price, and this plotted as a histogram would probably look like a bell curve:

People who are more optimistic are willing to pay more. Since it’s a bidding system, they’ll be the ones who own the shares. So basically all the shares are owned by the people in the shaded area on the right. (Those who are shorting are in the equivalent area on the left.)

If you own a share of a company, you’re in that green area. You’re more optimistic than just about everyone else. All those people in the middle don’t think quite so highly of this stock, and they think that you’ve overpaid. If the correct outcome is roughly the average of all opinions (this is an assumption, but it’s reasonable), then you have overpaid and you’ll get less than 10% (the point at which everyone else stopped bidding) on your shares.

(The counter-argument here is that when you sell your shares, you’ll sell them to similarly-optimistic people and it will all cancel out.)

3. The skepticism

I think that anyone who can consistently beat the market isn’t writing newsletters or managing mutual funds. They’re borrowing massive amounts of money from the bank and investing it all, making a quiet killing. So that implies that newsletter writers and fund managers cannot beat the market.

Monkeys

Everyone can point to certain people who consistently were able to outperform the market using individual stocks. But you could take 1000 monkeys and have them invest in individual stocks and after 10 years maybe one of them would outperform the market too. The trick is to pick that monkey ahead of time, and that’s what you can’t do. It’s too easy in retrospect to point to the winner and ignore the 999 losers. And it’s no help to find someone who’s done well in the past and copy them, since that’s basically equivalent to copying the winning monkey. He may not be the winner from now on! In fact if enough people copy him, then his stocks will definitely get overbid and will perform less well.

So I’m sticking with index funds. I don’t think I can beat the market, not even with a great deal of research and insight or with help from the Motley Fool dudes. In fact, I don’t even think that mutual fund managers can beat the market, especially with the fees that eat into the gains. Some fund managers can, but I don’t think it’s possible to know which ahead of time.

Q & A

Q: Aren’t you just focussing on the short-term behavior of stocks? Long-term behavior is related to the financial success of the company, and that’s predictable based on things like cash, profits, debt, and owner-operators.

A: You could take the argument in section 1 above and replace “one year” with “five years” and “press release” with “information about cash, profits, debt, and owner-operators” and the argument would still be valid. It’s all public information, which means that other investors will bid up the price now in anticipation of its high price in five years.

Q: But maybe stock prices don’t work like that. Maybe a profitable company’s stock will go up 20% regardless of its starting price, which means that it’s okay if its price is bid up initially.

A: If that were true then all stocks would get bid up infinitely. You’d always be willing to pay more for a stock since you’d be confident that it would go up by 20% after that. But they don’t get bid up infinitely. At some point people stop bidding because they feel the stock is overpriced. Overpriced compare to what? To the price they expect it to be in one or five years.

Q: I subscribe to a newsletter that tells me about little-known companies that the market hasn’t noticed yet.

A: It only takes a few competing bidders to drive the price up. (And how many people are receiving this newsletter?) You should also ask yourself whether the newsletter writer owns the stock he’s pushing. If he does, then he’s benefitting from telling others to buy it (since that drives the price up), so maybe he’s not being ethical. If he doesn’t (for ethical reasons), then that implies that he can make more money writing the newsletter than investing in this stock. Remember: those who made money in the Gold Rush weren’t digging for gold, they were selling shovels. Newsletter writers sell shovels.

Q: When you buy an index fund, aren’t you also entirely in the green shaded section?

A: Yes, I simplified above by making it look like people would stop bidding when their expected return was 10%. But in fact they’ll stop before that because they expect better returns from individual stocks, maybe 15%. So the middle part of the curve will stop at 15% and you, in the green, will stop at 10%. So really you will match (on average) an index fund, but you’ll carry greater risk.

Q: My small-cap stocks have exceeded the S&P 500 for the last 2.5 years. (See The 5 Investment Must-Haves.)

A: And they probably were beaten by the S&P 500 for the 2.5 years before that. Be careful of only looking at your gains. You should expect small-cap stocks to have that kinds of standard deviation. Compare instead your small-cap stocks with, say, the S&P SmallCap 600, and use a 20-year window.

Q: What about using stock trading to get complementary stocks?

A: Good point, I’m assuming above that the goal of picking individual stocks is to find those that will go up the most. But there’s another strategy, which is to pick complementary stocks (stocks whose changes in value are inversely correlated). This has the effect of averaging the return but lowering the risk. It’s difficult but possible to do, and I assume that sooner or later someone will come up with an index fund that has such a set of stocks. Or you could buy two index funds that are complementary. In any case that’s not what most people do when they pick a stock; instead they expect the stock to go up significantly, and that’s really what I’m addressing here.

Q: But picking and watching stocks is fun!

A: Another good point! And the price you pay for that fun is lower returns. I don’t mean that in a negative way. It’s genuinely okay for people to pay money to play the stock market game, just like it’s okay for them to pay money for the fun of playing in a casino.

¹“Minute by Minute: Efficiency, Normality, and Randomness in Intra-Daily Asset Prices”, Lauren J. Feinstone, Journal of Applied Econometrics, Vol. 2, No. 3 (July 1987), pp. 193–214.

Thanks to Drew Olbrich, Jennifer Alden, Adrianne Yamaki, and Chad Cunha for reviewing a draft of this essay.