Stock Picking is a Gamble Even for the Best

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The stock market carries risk and so stock picking is a gamble even for the best. The future is unknown and nobody can predict the future. Picking individual stock out of thousands of others, to be the one that performs the best, is a gamble.

There are only a handful of people who have been or are good at picking stocks. The best of the best pick stocks based on their “proven” method. If this method was so good then they would only pick winning stocks all the time and have no bad performers. Yet when you look at their portfolio you find that some perform and some don’t. So that means that it must have been a gamble despite all the analysis and understanding of the company and market.

Picking a good business

Being successful means you have to choose a good business and buy it at the right share price. Researching the financials, operations and strategy gives you a good idea of the quality of the business. It’s still all based on past performance and future promise. But you should be able to find the good from the bad. But still you don’t know if that business will have problems in future like regulations, sector dynamics, competition, disruption etc

Company results are a lag that follow the strategy execution, probably a 3-5 year lag. So good results today are due to a strategy implemented 3-5 years ago. Similarly poor results today are due to poor strategy executed 3-5 years ago. Choosing a bad business with a good strategy is a gamble because you don’t know if this strategy will work.

Everybody says that you can’t use past history as future prediction. This is true because nobody can predict the future. But yet that is the fundamental analysis that everyone does. Hey look at these greet company financials, this must be a good buy because they are performing well.

Read any investment advice, it will tell you to understand your risk and diversify accordingly. Even the best of the best will tell you this. Why would they say this if their analysis was so good and they knew how to choose the good stocks? Maybe it is because picking an individual stock is a gamble.

Buying at the right price

The assumption then is that a good business will have an increasing share price

Problem is that company value and share price vary all the time. Fair value share price is a subjective measure depending on your point of view. Different people have different views on company valuations . Traditional stable markets were easier to estimate but in todays volatile market with new tech disruptors it is rewriting the rules for fair price.

Actual share price is random and determined by the market. There is no predictable correlation between a good company and increasing share price. There are theories that good companies will deliver value over time but there are so many factors that it is near impossible to predict reliably and consistently. Great companies have poor share price growth and new kids on the block making losses have incredible share price growth.

Picking a stock is a gamble but buying at the right price is and even bigger gamble. There are a couple of theories on how the market works that can help us.

Efficient Market Hypothesis

Basic finance at college- or university will teach you about the efficient market hypothesis (EMH). The EMH theory originated with Eugene Fama at the University of Chicago in the early 1960s. The theory is that the financial markets are mostly very efficient.

This means that everybody participating in the market are acting on the same available information.  Since everyone has the same access to that information, all the stocks are correctly priced at any point in time.

So this then brings into question how it is that you are able to find information that other people do not know and that is not already indicated in the price.  To do this consistently you would need inside information which is illegal. New information is spread in a matter of seconds these days thanks to the internet.

If you are a strong believer of this theory then you would say that picking individual stocks is no better than gambling. If you are a weak believer of EMH then you don’t believe that technical analysis of predicting stock price movements is possible. If you are somewhere in the middle then you don’t think that fundamental analysis is worthwhile.

In reality markets are full of inefficiencies but they are also unpredictable. Its this unpredictability that makes picking a stock a gamble

The Random Walk Theory

The random walk theory was presented in 1973 when author Burton Malkiel coined the term in his book “A Random Walk Down Wall Street.”

Random walk theory says that in order to outperform the market you need to take a gamble and take on risk. It believes that technical analysis is backward looking because it only sees a trend after it has happened. It also believes that fundamental analysis is not reliable because of poor quality of information and the ability to misinterpret it.

Malkiel said in his book that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” The conclusion was that picking an individual stock is a gamble and that investors are better off investing in passively managed well diversified funds. Hence the emergence of the index fund.

Why do people still pick a stock and take a gamble

People love to think that they can do better than the last person. It is a human trait that allows us to be innovative and improve. But when it comes to your money then maybe its no better than gambling.

There is also another view that Wall Street wants you to believe that you can pick stocks. That’s the thesis of Larry Swedroe and Andrew Berkin’s book, “The Incredible Shrinking Alpha,”

Stock picking is Wall Streets’ business model. They tell you that you need to pay an expert to pick and manage your stocks for you. The last thing they want is for you to do it yourself in a passive index fund. The financial press plays along with all their complex analysis and stock picking advice from the gurus.

The reality is that the gurus are no better than the market. Every year, S&P Dow Jones Indices does a study on active versus passive management. Last year, they found that after 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent are trailing the index.

The market gurus can’t get it right, how is the man in the street supposed to do it. What makes it worse is that individual investors like you and I are not professionally trained. The average person has very little financial education and understanding about investing, so it’s easy to prey on their ignorance.

One of the most successful investors of all time Warren Buffet has been saying that stock picking is a gamble for decades.

“I don’t think most people are in a position to pick single stocks,” he said during the Berkshire Hathaway annual shareholders meeting. A few [are], maybe, but on balance, I think people are much better off buying a cross-section of America and just forgetting about it.”

It was after a statement like this that he made a million dollar bet to prove that you can’t pick winning stocks consistently.

The Warren Buffet Bet

In 2005 Warren Buffet said that rank amateurs invested in index funds would outperform active professionals picking stocks. His argument was that the massive fees levied by “helpers” would leave the clients worse off than amateurs in an unmanaged low-cost index fund.

He publicly offered $500 000 that no investment pro with actively managed hedge funds could  beat an unmanaged S&P fund. Buffet suggested a  10 year bet and named a low-cost Vanguard S&P fund as his contender. He announced the bet publicly and waited for a response.

Only one man , Ted Seides was brave enough to take the bet. Ted was a co-manager of Protégé Partners. He picked 5 funds-of-funds to be averaged and compared against the Vanguard S&P index fund. These five were invested in more than 100 hedge funds. So overall performance would not be distorted by a single manager

The winner of the proceeds of the bet would be a charity of your choice. Buffet chose the Girls Inc. of Omaha. This was the charitable beneficiary he had designated to get any bet winnings that he earned.

Bear in mind that the five funds-of-funds managers were incentivized to select the best hedge-funds. The fund managers were entitled to performance fees based on the results of the underlying fund. Those fund managers in turn were incentivized to perform as well.

The Winner is …..

The best was on. Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017 they tracked the returns of the 5 funds and the S&P 500. The performance measurement was on a basis net of fees, costs and expenses. After 9 years it was evident that there was a winner

After 9 years the winner was the Index fund Compounded annual increase was

Index fund:  7.1%
Five funds of funds:  2.2%

That means $1 million invested in 2008 would have been worth

Index fund – $ 1 854 000
Hedge funds – $ 1 220 000

The scary part of the fees was that hedge fund managers would have received

2% annual fixed fee even when losses are huge
20% of profits with no clawback in good years

Fund of fund managers usually get a 1% of assets fee. Despite the por performing years and terrible overall record they still got bonusses. In the good  years they got performance payments estimated at 60% of all gains over the 9 years. So that is where the lower performance went.

Buffet concluded: “A number of smart people are involved in running hedge funds. Their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund.”

If you are an investor then you will be taking a long term view with a slow and steady process. You would be investing in a well diversified portfolio on a regular and consistent basis. You will reinvest the dividends and be looking for a steady investment return. The reliance will be less on individual events or stocks but rather on an overall improvement and creation of value.

11 Warning Signs that you are gambling and not investing

Dr. Paul Good, a clinical psychologist in San Francisco, identified 11 signs that an investor might be a gambler in disguise. If you exhibit just 5 of these you could be gambling not investing:

  1. High-volume trading where the action of trade is more compelling than the objective of the trade.
  2. Preoccupation with your investments that interfere with work or social life, or constant calls to a broker.
  3. Needing to increase the amount of money you have in the market by borrowing money from brokerage firms, using options and futures contracts to feel excited.
  4. Repeated failed attempts to stop or control your trading activity.
  5. Restlessness when cutting down market activity, or when cash is sitting in your account “uninvested.”
  6. Using market activity to make yourself feel better
  7. After taking losses, continuing to take positions or increasing a position as a way to break even.
  8. Lying to family members and friends to conceal the extent of your market involvement.
  9. Committing illegal acts, such as forgery, fraud, theft or embezzlement to finance market activity.
  10. Jeopardizing relationships, your job, or career opportunities because of excess time spent playing the market.
  11. Relying on others to provide money to relieve a desperate financial situation caused by gambling in the markets.

Dr. Carlos Blanco, a psychiatrist who heads the Gambling Disorders Clinic at Columbia University sees a lot of Wall Street patients. He says there is one major difference between compulsive investors and chronic gamblers. The difference is the age of the disease, chronic gamblers are typically in their late teens and early 20s, while those who immerse themselves in the stock market to the point of excess are typically in their 30s and 40s.

The difference between gambling and investing

It’s a proven fact that investing is the route to creating wealth. Make no mistake that despite stock picking being a gamble people build fortunes through investing. So clearly the concept of investing is not a gamble. Its all about what you invest in and how you do it. The higher the reward the higher the risk. The higher your risk tolerance the bigger your gamble will be.

So it comes down to your willingness to accept risk. There will always be an element of risk investing but if you are taking significantly more risk then you are gambling. If you rather take a 50/50 chance of doubling your $1000 then you are a gambler. When you are picking hot stocks and want to double your money quickly you are taking a gamble.

It is risky to you put all your money into a handful of individual stocks. Don’t be surprised if you lose and don’t think you are clever if you win. With all that said don’t be put off picking individual stocks but see it for what it is, a bit of a gamble. What has your experience been and how do you approach stock picking.

5 tips to invest without gambling

  1. Invest for the long term
  2. Understand your risk tolerance
  3. Limit your stock picking exposure
  4. Buy the whole market and stop speculating
  5. What you buy is more importent than when you buy