Wednesday, 15 August 2012

How to pick successful stocks

By the time you've stumbled upon this blog, you must have read at least a dozen pages of commentary about the inner secrets of stock trading, suggesting various techniques to make your investments as profitable as possible. So here, we share the secret, the answer to the question of all time – how can I pick successful stocks? And the answer is:
You can't pick successful stocks.
And if you read further, we'll explain why, and what can be done instead. 



What? 

To the lucky few, this shouldn't come as a surprise. I expect however that the majority of our readers are flabbergasted by this statement – but in fact, there are hundreds of pages of research supporting it, by very influential thinkers. Among these people are Benjamin Graham – author of the book The Intelligent Investor, a legendary fund manager and a mentor of Warren Buffett –, and the other is Daniel Kahneman – along with his lifetime associate Amos Tversky –, who won the Nobel Prize of Economics in 2002 – as a psychologist(!). So how does a psychologist and a businessman can explain the futility of stock-picking efforts? See below.

But how? 


 The basic concept of investment, advertised by multiple 'insider' books is that a stock's price includes all the available knowledge about the value of the company in question, and the available predictions about the future prices of that stock. Hence theoretically everyone has the ability to make profits – or suffer losses if they fail to recognise the 'signs'. We know however that this is not the case. There are many investors who are actually losing consistently, an achievement not even a dart-throwing chimpanzee (a popular analogy of picking stocks at random) could match. The statistics of this unsuccess were first published by a Berkley finance professor, named Terry Odean. Odean studied the records of around 10,000 individual brokerage accounts from 1991 to 1996, and he analysed 163,000 individual trades. This allowed him to study every situation where a broker sold one stock, and he immediately bought another. The justification for this stock change is, naturally, the expectation that the new stocks will do better than the old ones. So did they? Simply put: no. Odean found, that the sold stocks on average did 3.2 percent better than the newly bought ones – meaning, that every stock replacement actually decreased profitability instead of increasing it. The more you trade, the more you loose. 


Why?


The answer is illusion of skill. The process of selecting stocks for investment at hedge funds and investing firms is a very complex one – it involves reading economic forecasts, examining income statements, reading balance sheets, management evaluations and many more high-level intellectual processes. Unfortunately, evaluating business prospects and trading in their stocks is not the same thing – and despite claims to the contrary, stock analysts, quite simply lack the skills in order to assess whether a particular information is or isn't already incorporated in a stock's price. However, involving such an incredible intellectual effort in anything – however ineffective it actually may be – will inevitably lead to the conclusion that the effort was effective. Daniel Kahneman, the renowned psychologist – and as mentioned, Nobel Prize winner – calls this a 'System 1' reaction – the section of the mind which includes our instinctive, automatised reactions to the world around us. (For further enquiry, read more here about dual process theory or read Kahneman's bestseller, Thinking, Fast and Slow)

But what about the real experts? 


You might still wonder that there must be at least a few experts who have the know-how of stock-picking – not merely guessing, but bringing in decisive results year after year. The sad truth is, that there are no such persons – according to Kahneman's research, analysing the investment incomes of 25 top-notch wealth advisers, the correlation between any two consecutive financial years' year-and bonus (a general indicative of business performance in investment circles) was 0.01. In other words, zero. Even the best wealth advisers were guessing – and you can't hope to do much better.

What now?


 You can rightfully ask – can stocks serve as a viable investment option at all, considering their individual unpredictability? The answer is, yes – the key word is individual. You can't hope to pick out the most successful stocks, but if you buy diverse enough stocks to disperse your losses (in fact, buy index funds), you could achieve the market average – and don't forget that even the returns of the market average generally outshine those of alternative investment options, for example bank deposits or some government bonds. If you'd like to read more – and there is a lot to be read -, I recommend Benjamin Graham's book on value-based investment, and most importantly – Daniel Kahneman's aforementioned book on the basic emotional and logical fallacies the human mind so easily falls for.

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