For the individual investor, doing extensive research, making a trade and having it pay off can be intoxicating- and dangerous in my opinion.
Why? Because based on my seven years of experience as a “Wall Street” stock analyst, I believe an individual’s winning trade on a stock could foster a false sense of confidence that will ultimately cost the investor in the long run. In my current role as an independent and fee-only financial advisor, I believe individuals and families should not attempt to pick stocks but instead are best served by diversifying their investment assets using low cost, tax efficient funds or ETFs- usually index funds or ETFs. I will dig deeper into this topic in a later post but for now, I want to only provide a general sense of who you are up against when you make a trade on an individual stock.
In the simplest terms, when you make a “trade” you are essentially making a bet with someone who has spent a lot of time and money to be better informed than you. Remember, in a case like buying an individual stock, someone else is selling that stock and you are basically in disagreement with that party on the value of the stock. Whether you realize it or not, most of the time that “someone else” is an institutional trader that is leveraging both extensive (and expensive) research and/or complicated mathematical algorithms to set their price to sell.
As a former sell-side equity analyst, I was one of those people paid to inform those buyers and sellers as I was on the front lines of trying to provide real-time equity valuation analysis on a small subset of mid-cap industrial companies. Basically, my job was to advise my institutional clients (managers of mutual funds and hedge funds) as to which of my covered companies’ stock was going to go up (BUY rating), down (SELL rating) or stay flat (HOLD rating).
Sell-side equity analysts work long hours and do extensive research in order to formulate an educated opinion on a stock’s valuation. Like most analysts, every day I poured over every SEC filing (10-Q, 10-K, 8-K, etc.), spoke directly with senior management as often as possible, participated on conference calls with the CEO and the CFO, attended one-on-one meetings with investors and management and hosted conference meetings (side note: at no time did I ever witness any of my companies’ management team provide “insider information” as they were always very careful with the rules around Full Disclosure). In addition to all this, I would also attempt to correlate economic metrics and even survey suppliers and customers of my companies in order to come up with an “edge” that my clients could use to “beat the market”. Finally, I had access to technology that helped keep a sharp eye on the news wires around the clock for any market moving news such as SEC investigations of a company, a win or loss of an important contract, rapid changes in currency or a departure of a CEO or CFO. If something like this did happen (no matter what the hour of the day or night), I would immediately analyze, write up and publish an assessment on the change so that my institutional clients could read my research note or talk with me first thing in the morning. This means they could take advantage of the new information and have their trade ready to go before the markets opened.
How did that work? Even with all the long hours and research, it was exceedingly difficult to consistently pick winners and losers.
Is it possible for individuals to “beat the market”? Sure – it’s possible but the key word is possible. Because as the aggregated numbers prove out for even professional investors, beating the market is not probable.
If any of my clients want to try to pick individual stocks, I say go ahead. Let’s portion off a small percentage (i.e. less than 5% of investible assets) to play with and to scratch that trader’s itch. However, when we’re formulating a strategy around a family’s life savings and potential wealth preservation for future generations, I will not recommend picking stocks knowing what I know about who is on the other side of that trade.