Sunday, December 1, 2013

Why I don't trade stocks and (probably) neither should you.

This post is a more thought out version of my response to friends asking what stocks they should buy. The short answer is: none. Unless you have a sophisticated investment strategy (in which case you aren't turning to me for advice) you should invest the bulk of your funds in low-cost index funds.

This statement is neither profound nor new, yet lots of smart people I know trade at least occasionally. To begin, let's define the criteria under which this behavior is sensible:

Stock picking only makes sense if we expect to consistently outperform the market averages (approximated by broad index funds). Not only do we have to beat the average, we must do it by a wide enough margin to cover higher trading costs along with the opportunity cost of our time. In other words, the answer to "do we believe that our stock selection ability is significantly above average?" has to be a resounding, objectively justified "yes." 

This is where most of us should stop, because we have no reason to make this claim. This is where I personally stop. Despite a decade of working in capital markets, holding the CFA designation and being half-way through the MBA program at Stern, I know that, short of insider information, I have no reason to expect to outperform the market. Chances are, nether do you. 

But chances also are you aren't exactly convinced, so let's dive in.

"It's going to go up!" (unless it doesn't)
We buy an asset because we expect its price to increase. We might decide this based on gut instinct or research. We might evaluate the company's products and management and claim its prospects to be good. One way or another, we decide the stock must rise.

Imagine Yves buys the stock today. His purchase raises the price up a bit (supply and demand) so the next buyer will pay a bit more. The buyer after that trades a bit higher still, etc. Eventually, the price rises higher than is "reasonable" even given the company's rosy prospects. Cecil, who buys at this price, should expect to lose money.

The problem: how do we tell if we are Yves or Cecil?  There's no way. In fact, current prices reflect consensus, so the very act of buying is more aggressive than average and therefore likely to be a mistake. Unless we see something no one else does (and have good reason to believe that no one else sees it), there's no reason to expect any asset to go up. It's already "up." And unfortunately, unless we are  trading on insider information, everyone has already seen what we see.

So again, we should really stop here because there's no reason to expect a stock to rise. But you probably still aren't convinced. So let's look at 3 common justifications for trading.

"The stock is cheap now because everyone's over-reacting" (unless they aren't)
A common one is "buying the dip." Negative news comes out and the stock price tumbles. We decide that everyone's overly freaked out and the company's prospects are really not impacted. So we buy and wait for the stock to recover.

Unfortunately, even if we are right, there's no mechanism for forcing the price back to its previous level. Or maybe it was overpriced and the bad news sent it back to a realistic valuation. Or maybe its still overpriced. Or perhaps the news is that bad. We just can't tell.

Here's the price chart for Citi Group from 2007 to today. Lots of dips. Trading them would have been disastrous - though lots of people did just that. Any of those dips looked, at the time, like the bottom. Only the ones in early 2009 and 2011 were, but alas we can only recognize that in hindsight.

Did anything really change at Citi since 2007? It's in the same lines of business, going after the same set of customers. If anything, it's probably leaner and more efficient than it was back then. You can say the business environment changed, but we could have anticipated that. Citi faces the same prospects at $52 as it did at $520. And at 97 cents. If the same basic company can trade at exponentially different prices, does it make sense to bank on dip correction?

IPOs always go up (except when they don't)
If we can't rely on dips, can we trust the conventional wisdom that getting in on an IPO is a sure way to make money? Sometimes that's true, sometimes not. Many stocks go up on IPO and then crash. Many stocks don't go up on IPO but rise later. Which way the will next IPO go? 

We don't know, but we can guess based on how and why IPOs happen. Originally IPOs were meant to raise capital, but Google, LinkedIn, Facebook, etc. didn't IPO out of desperation for money. They sold shares as a way for founders and early investors to cash out. Put yourself in the shoes of a pre-IPO investor going through a "pop": your stock IPOs at $10, and closes at $20. That's great for everyone who's not you, since you sold your shares for half of what someone was willing to pay. You'd never intentionally let that happen. IPOs are priced by people with the most insider information and an interest in getting a high IPO price at the start. So why would we expect a "pop?"

It's a good company (yeah, but might be a crappy stock)
If we cannot speculate on IPOs, why not invest in stable companies? A popular version of this is the practical grandma who invested only in firms whose products she used. We like a company. We love its products. We see no way for it to go down in flames and we expect others feel the same way (ie no chance of a panicked sell-off.) Why wouldn't we buy this stock?

It goes back to pricing. Everyone else likes the company too. Chances are its stock is already bid up high. Also, our imagination for seeing a company crash and burn (or die a slow death) is, empirically, pretty bad. GM was a stable company that sold lots of products. Then one day, the same GM was viewed as saddled with labor costs and unable to design a reliable or efficient car. So we aren't safe investing in "good" companies. And if we were safe, there'd be no money in it.

Bottom Line
There are many versions of the story investors tell to justify their trades: the stock must go up because the company is good, or the news is overblown, or it's an IPO guaranteed to pop. Unfortunately, it's not enough for us to be right (even if we are). Everyone else needs to be wrong in order for us to profit.

So I am leaving you with this: every time we trade, someone trades the other side. Are we smarter than them? What if they are right and we are wrong? Personally, I like to visualize my counterparty as Goldman Sachs. If Goldman's as eager to sell a stock as I am to buy it, shouldn't I just not trade?

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