If you are trading individual stocks and you are not illegally insider trading, you are a loser.
“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 focusing on the performance of a tiny sliver of the component parts of that market that you somehow magically know will perform better.
Let me spell this out: 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.
Where to begin explaining this? (For related reading, see: How to Make Decisions About Your Stock Options.)
The Dangers of Buying
Let’s start at the moment you decide that you are going to buy 100 shares of XYZ stock, which is currently trading at $50.00 on your Yahoo Finance screen. 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 its widgets in Belgium last quarter were nearly 30% higher than forecasts said.
- 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 XBox the other day, and you happened to overhear them.
- Maybe the 200-day 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 E*Trade commercials featuring actor 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 and appeal even more to useless anecdotal and recency bias. 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. How do you go about this? Easy. Log on to your Schwab account, key in the ticker symbol, enter "100 shares" and click on the market order “buy” button. Bingo! You now own 100 shares of XYZ that you bought from some stranger. (For related reading, see: Portfolio Returns: What's Reasonable to Expect?)
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 Group Inc. Or Merrill Lynch. Or UBS. Any organization that knows a thousand times more about XYZ as a company and a stock than you do and has 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 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. That's Supply and Demand 101.
Who Wins With Stock Picking?
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.
First, you more than likely paid a transaction fee to a Schwab or whomever provided the platform on which you traded. Second, 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 (because you paid more to buy it than you receive to sell it).
So the moment you do the trade, you are down money. 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. 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 100 shares you just bought for about $50 are not the first hundred in a million shares being dumped and that there’s not another 999,900 being sold right now to other unsuspecting victims.
What kind of win ratio do you need in these battles? 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 need to be getting it right around 60% to 70% of the time, depending what fee arrangement you have, what kind of stocks you trade and what size trades you execute. (For related reading, see: 5 Investment Mistakes You Might Be Making.)
So you are going to go head-to-head in a game with organizations that know a thousand times more than 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? 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 long-term investment, as a general rule? There is plenty of evidence that says no, it isn’t.
Probability of Winning With Individual Stocks
According to a report from JP Morgan Chase & Co., “when looking at how often a stock has what we call a ‘catastrophic decline’ [between 1980 and 2014]—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? Because stock-pickers love those more dangerous sectors. 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 under-performance of about 50%.”
Again, I strongly suggest that you re-read that a couple of times and truly 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%!
To summarize, stock picking and trading mean that you are automatically down money from the start. You're constantly taking on professional opponents who know far more than you and have way more firepower than you and yet you have a bar of needing to win six or seven 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, have about half the rate of return of the market as a whole. Lastly, even if by luck you happen to make money in the face of all this, you may have to hand over up to 40% of it to the government in taxes.
Why would you put yourself in this hole? It’s never a stock picker’s market. (For related reading, see: Don't Buy What You Don't Understand.)
For more you can listen to ANGLES: THE PODCAST Episode 1: "Stockpicking Is a Losers Game (October 4, 2016). A companion podcast to this article in which Simon discusses the futility of trading individual stocks and why it riled up so many day-traders on Facebook. (23m 01s). This article is from the Anglia Advisors blog and is subject to all disclaimers and disclosures found elsewhere on the website. Anglia Advisors is a New York Registered Investment Advisor.