Stock Market Recommendation — an Oxymoron
Stock picking is big business all over the world. But is it possible to pick stocks? Let’s do a thought experiment. Suppose you find a great stock picker who recommends a stock for you to buy. Let’s assume that the stock picker has no insider information (in which case it will be illegal) and reached her conclusion based on publicly available information. If we can’t identify a mechanism by which such a pick generates performance, such advice will have no value. And we have not found any such mechanism, yet.
So, why does this industry exist? There are three reasons:
1. The performance of stock pickers is not analyzed systematically and over time. If one randomly picks a stock, there is approximately a 50:50 chance that the stock goes up or down within the horizon considered. There is a slight upward bias as in the long run stock markets tend to go up. So, anybody who picks a stock, even a monkey who employs a dart throwing process, has an equal chance of being right or wrong. And it is quite possible that a random stock picker had a series of correct calls, akin to a coin flip returning heads sequentially in a series of throws. The person who has such a lucky stream of succusses ends up advertising her “capabilities,” and unfortunately, we will not hear from those who had bad luck. More importantly, the “lucky streak,” will end and so it is important to analyze performance over long-time horizons.
2. Making money on a stock pick is not sufficient to assess performance. As there is a slight upward bias in a random stock going up as stock markets in general go up over long-time horizons, anybody who picks a stock and holds it for a period is more likely to make money. However, buying a stock has risk associated with it. As the buyer of stock is holding risk, the return on that investment is expected to be commensurate with that risk. As such, to assess if there was any performance in the stock pick, one must look at risk adjusted excess returns (alpha). In other words, we must subtract the cost of risk from the actual return and only if there is a positive residual, we can conclude there is performance.
3. Finally, stock markets are noisy. Even though we can show that stock prices follow random walk, this does not preclude long excursions of prices in one direction of the other. Stock market calls that show persistent performance are, thus, based on luck when stock prices show correlated movement in one direction or the other.
Financial advisory services and stock recommendations are a trillion $ industry. There are very large number of “experts,” who seem to know where the stock market is heading, when it will change direction and even which specific stocks are going up or down. They show up on financial TV and press, showcasing their rare wisdom. But a quick analysis of all their advice using risk adjusted excess return will quickly show that such wisdom has no or negative value. This is even true of oracles of investment management who proclaim performance over extended periods of time. It is true that one will make money by investing and holding equity in companies. However, as mentioned before, performance can only be measured by subtracting the cost of risk from the total return shown.
Investors across the world rely on “expert,” stock pickers to make decisions. And others hire financial advisers to manage their portfolio. In either case, such advice is no better than the flip of a coin. If the public is aware of this, a very large industry that adds no value to investors or the economy will come to a screeching halt. Many media companies and investment banks have a lot riding on this, and they are not going to let the gravy train stop anytime soon.
There are three important questions one must ask in this regard:
1. If the adviser and stock picker have superpowers, why are they advising you? Would they have not made trillions of $ by applying their own advice?
2. When you buy or sell a stock, the counterparty in that transaction is the market. Assuming you know more than the market is fraught with danger. How can you know more than millions of investors who have equal access to publicly available information?
3. Luck and competence result in remarkably similar outcomes. If one demonstrates “performance,” how can you determine if it is not just random luck?
The academic prescription for over half a century for investment selection has been simple. Invest your money in an index, the performance of which is based on a large portfolio of stocks, bonds, and real assets such as real estate, education, and intellectual property. There is no value in selecting specific stocks, bonds, or any type of securitized assets. There is also no value in trying to time the market — the game of the stock pickers. Always assume that the stock market follows random walk and tomorrow’s prices will be based on new information that will arrive tomorrow. Till one can figure out a way to time travel into the future, there are no known ways to create risk adjusted excess returns by selecting specific securities.
Individual investors can substantially boost their returns by simply following four rules:
1. Invest only in Indexes (baskets of securities) so that all security specific risk is diversified away and the chance of positive return over long horizons is improved.
2. Construct a portfolio of indexes — stocks, bonds, and real assets. Real assets include investable securities such as real estate trusts as well as personal investments such as education and homes.
3. Keep the portfolio over long periods and rebalance as necessary.
4. Finally, turn off financial TV and stop reading financial press. This will allow you to avoid mistakes that could rob your portfolio’s value.