A LOSER'S GAME

IF YOU ARE TRADING INDIVIDUAL STOCKS AND YOU ARE NOT ILLEGALLY INSIDER TRADING, YOU ARE A LOSER. 

HERE'S WHY .. 

“It’s a stock-picker’s market!” ..

How often have we heard this over the years? The implication of the statement is that, in the market conditions prevailing at the time, the way to go about making money is by ignoring the movements of markets as a whole and instead focus on the performance of a tiny sliver of the component parts of that market that you somehow magically know will perform better.

And, if you eavesdrop on conversations on the train in the mornings or in Manhattan bars in the evenings, you might even be swayed that the statement has some validity. “So, I bought Tesla back in 2013 and got out in 2015, made a bundle ..”, “I’ve been in and out of Starbucks like ten times in the last year, I’ve done awesome!”.

And isn’t that how our parents and grandparents made money? Someone told them to buy GE, Eastman Kodak (!!), Coca-Cola and IBM and stick to playing around with those stocks and nothing else. And they all did great. Didn’t they?

Let me spell this out: in almost every case, if you are trading in and out of individual stocks and you are not illegally insider-trading, you are a loser. Statistically speaking, that is. Or if you are not yet a loser, the data shows that you are likely to become one very soon. And possibly a really, really bad loser. Using themed baskets often containing hundreds or even thousands of stocks called exchange traded funds (ETFs) is always a better idea. I can go into the advantages of ETFs in another post, but for the time being, lets begin to explain why using individual stocks is a such a poor idea. 

Well, we can start at the moment that you decide that you are going to buy 100 shares of XYZ stock, showing on your Yahoo Finance screen as currently trading at $50.00. Why have you come to this decision? It can be any number of reasons;

  • maybe, you saw a report that you thought was buried deep in the internet that XYZ’s sales of their widgets in Belgium last quarter was nearly 30% higher than it was forecast to be

  • maybe your kids and some of their friends were talking in glowing terms about an XYZ product in the basement while they were playing on the X-Box the other day, and you happened to overhear them

  • maybe the 200-day moving average and 50 day moving average lines just crossed

  • maybe Jim Cramer wasted no time yelling “Buy! Buy! Buy!” the last time XYZ stock came up on his show

  • maybe you saw three people on line in a store recently, waiting to pay for XYZ products, like on those disgraceful E-Trade commercials featuring Kevin Spacey.

There are, of course a million other reasons you may have decided to buy, some are smarter than those listed above and some are even dumber than those and appeal even more to useless anecdotal and recency bias. Remember, “data” is not the plural of “anecdote”.

But let’s assume that, whatever your rationale, the decision is made. XYZ stock is going up and you want to buy some now, so that you can sell it higher at some future date.

So how do you go about this? Easy, you may say .. log on to your Schwab account, key in the ticker symbol, enter 100 shares and click on the “Buy” button. Bingo! You now own 100 shares of XYZ that you bought from some stranger.

Except this is what really happened. Who do you think sold you those 100 shares? Chances are it was not some other basement-dwelling, internet-trawling stock-picking individual like you, but professionals at Goldman Sachs. Or Merrill Lynch. Or UBS.

An organization that knows a thousand times more about XYZ as a company and a stock than you do and access to resources that dwarf yours. Unless, as I said, you are illegally acting on inside information, there is absolutely nothing relevant to this stock that you know that these firms don’t already know (I don’t classify your kids’ conversation in the basement as relevant, FYI) and a mountain of information that you don’t and never will.

And yet, armed with a thousand times more information than you can ever dream of, the firm has decided that if you are foolish enough to be willing to pay the price you did, they would happily sell you their shares in XYZ. If this wasn’t the case, they would not offer them at that price. The only price you can buy at is one at which a Merrill or a Goldman thinks you are silly to pay. Whatever information you think you may have found is already factored into the price of the stock before you have even finished reading it. Demand and supply 101.

So once the transaction is consummated, it essentially becomes a simple tug of war between you and whoever you bought from. One of you is going to be right and the other is going to be wrong. One of you will make money and the other will lose money. Who’s it gonna be? Here we need to bring in another factor. When you made that trade, you paid two costs.

Firstly, you probably paid a transaction fee of some kind to a Schwab, a Fidelity or whoever provided the platform on which you traded. Secondly, you paid a spread. There is a difference between the price at which you can buy a stock (the higher price) and the price at which you would be able to sell it (the lower price). That is the spread, and it means that even if the price does not move in either direction and you then sell what you bought, you will automatically lose money (you paid more to buy it than you receive to sell it).

So the moment you do the trade, you are down money right away. The price has to move higher by enough to cover the transaction fee and the spread before you even begin to move into positive territory.

Another thing, the Goldmans and Merrills of this world have the resources and the clout to move the market in XYZ stock. Not illegally, but if they decide to unload a million shares of the stock, it makes absolutely no difference what the fundamentals (or Jim Cramer) say about what “should” happen to the price. It’s going lower. And you had better hope that the 100 shares you just bought for about $50.00 are not the first hundred in a million share dumping down to, say, $42.00 and that there’s not another 999,900 being sold to other unsuspecting victims while you stare at your newly-minted purchase ticking incessantly lower on the screen.

Well, you may say, this is only the story of one trade. But I do multiple trades in individual stocks and this kind of thing isn’t going to happen every time. That’s true, but figure out what kind of success ratio you need. If you are going to make interesting money and cover the transaction costs and the spread each time you trade in and again on the way out (not to mention the capital gains tax you will have to pay on every profitable trade), you kind of need to be getting it right around 60–70 percent of the time, depending what fee arrangement you have, what kind of stocks you trade and what size trades you execute.

In 2000, researchers Brad Barber and Terrance Odean of the University of California conducted an interesting study*. Using data drawn from about 65,000 household brokerage accounts, they sorted them into quintiles based on their monthly turnover, almost all of it in individual stocks (i.e. the 20% most active in the top quintile and the 20% least active in the bottom quintile). 

The top most active quintile earned an average annual return net of trading costs of 11.4% over the period studied (1991–1996). The bottom quintile, the least active, earned an average annual return of 18.5% net of trading costs over the same period. That is more than 7% a year being foregone by active traders in return for what? An adrenaline rush? A chance to boast in loud voice in a bar that they trade stocks a lot?

Barber and Odean’s work has been replicated many times, the results always coming out the same. Active trading of individual stocks kills returns and that is not even taking higher taxes into account.

So you are going to go head-to-head in a game with organizations that know a thousand times more than you do, know about whatever sad little morsel of information you feel you have way before you do and have the ability to move the goalposts whenever they feel like it and you are going to come out on top seven times out of ten? Really?

Sorry, but I’m not backing you to achieve that over time.

But let’s even say that you somehow manage that and consistently out-think the world’s most powerful investment banks with an internet connection from your basement. Is it wise to hold individual stocks, even as a longer term investment, as a general rule? There is plenty of evidence that says no, it isn’t.

According to JP Morgan Chase & Co.**, from the universe of the Russell 3000 Index that “represents approximately 98% of the investable U.S. equity market” between 1980 and 2014, the risk of “catastrophic failure” among individual stocks is very high, and especially in those sectors that are favored by stock-pickers.

The report says; “When looking at how often a stock has what we call a ‘catastrophic decline’ — falling 70% or more and never recovering — we see that 40% of all stocks suffer this fate at some time in their history. And some sectors — like telecom, biotech and energy — saw higher-than-average loss rates,”. Read that again. And then again. Let it sink in. Are you going to avoid all those stocks? Or are you fishing in a very dangerous pool?

It gets worse. According to the report, “The data shows that two-thirds of all individual stocks underperform over their ‘lifetime,’ as compared to the Russell 3000. On average, the outcome for individual stocks was underperformance of about 50%.”. Again, I strongly suggest that you re-read that a couple of times and really absorb its meaning.

What that says is that, over time, two individual stocks out of three fail to match the return of the index of which they are a part. And the average amount by which they underperform that index (and, by the way, underperform the exchange-traded fund that tracks that index) is a whopping 50%!!! Are all the stocks you pick going to be in the one third that does not suffer this fate?

The report finishes by addressing the fact that concentrated holdings in individual stocks add huge amounts of risk to a portfolio by stating; “When computing the optimal risk-adjusted return for a concentrated holder, we find that 75% of concentrated stockholders would benefit from some degree of diversification.” Are you in the other 25%?

To summarize, stock picking and trading means that you are automatically down money from the start, constantly taking on professional “opponents” who know far more than you do or ever will, will know everything quicker than you do, have way more firepower than you and yet you have set yourself a bar of needing to win 6 or 7 out of 10 of your battles with them, you are investing in products that have at least a 40% catastrophic failure rate over time and which on, average, achieve about half the rate of return of the market as a whole and even if, by luck, you happen to make money in the face of all this, you may have to hand as much as 40% of it to the government in taxes.

Why would ever you put yourself in this hole?

It’s never a stock picker’s market.

A companion podcast to this post is available and can be found here

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* “The Behavior of Individual Investors”, Brad M. Barber and Terrance Odean .. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1872211

** “Eye On The Market” (Special Edition), September 2014, JP Morgan Chase & Co. .. https://www.jpmorgan.com/cm/BlobServer/Eye_on_the_Market_September_2014_-_Executive_Summary.pdf