Why stock picking is really hard

When people pick stocks, they are often hoping that they will get rich quick; they’ll pick a few speculative stocks and with an initial investment of $5,000, to $10,000 in each and they’ll end up a millionaire. They often talk about stocks on the ASX like Fortescue Metals Group and Afterpay that have skyrocketed after their initial public offering (IPO).  Further to this, looking at all of the charts on finance websites often leads people to believe that repeatedly buying low and selling high is a simple recipe to make money off the markets.

Odds are stacked against
Let’s say you started with $100,000 and want to make $1 million. The simple maths means that you will need to grow your portfolio by a factor of 10. To do this, without leverage, you could:

• Invest in 1 stock that multiplies 10x
• Invest in several stocks that don’t have to grow as much (let’s say they grow by a factor of 2x) and once the growth is done, you move onto the next stock that grows 2x; re-invest all of your gains 4 times and you’ve achieved your goal.
• Take advantage of a multitude of small stock market moves, by buying low and selling high until you reach your goal

In all of the above scenarios, the odds are stacked vastly against any investor. For instance – of the circa 2000 stocks on the ASX, between 2007 and 2017 less than 10 of them have grown by a factor of 10 (including dividends) (King 2017). This represents a roughly 0.5% chance of choosing a stock that can satisfy this condition. To put this in perspective shuffling a deck of cards and pulling the ace of spades on the first draw has a probability that is almost 4 times as high as picking one of these ultra-successful stocks.

The following 2 scenarios, which involve buying low and selling high, are something that tends to be a strategy that makes sense when looking at graphs and investing with 20/20 hindsight. The issue with this is that not only do you need to pick stocks that rise, you will also need to avoid stocks that fall. The proportion of stocks that rise and fall in any given time period will vary depending on what the market is doing as a whole. If we assume a situation of symmetrical risk, then half the time you’ll be picking winners and the other half you’ll be picking losers, keeping in mind that a loss of x% will require a greater than x% gain to make up for it, this results in a net loss for the investor.

But you’re a smart guy…

What I’ve quoted above is just picking stocks at random; stock picking and market timing is about skill and analysis. Ok fair point, I can understand, you’re probably a smart guy that isn’t going to pick stocks at random. Two major hurdles that now present themselves are human decision-making biases and access to information. Here are some common cognitive and emotional biases that can lead to poor investment decision making.

Self-attribution
As humans, one of the ways that we learn is through trial and error, but the issue with this is that we have a tendency to attribute positive outcomes to our own skills and negative outcomes to external factors such as luck (Sathishkumar and Vijayalakshmi 2019). This can result in numerous negative consequences such as taking on higher levels of risk than appropriate which increases the probability of entering a loss-making positions; or trading too frequently which causes losses through transaction costs.

Oversimplification tendency
As humans, we have a tendency to want clear and simple explanations for complex things (Douglas 2019). However, in the field of investing and markets, there are such a huge number of factors that influence share prices that it is impossible for us to fully comprehend all of their effects. Oversimplifying the drivers of asset prices movements can lead to poor decision making. For example, this might lead to an investor believing that because a company has low debt and good return on equity that it’s share price will rise. However they may not have taken into account the future market demand for the company’s product as well as the effect of incumbent competitors as potentially destructive factors for the stock valuation.

Groupthink
This is often called herd mentality, which can result in speculative bubbles (Douglass 2019). An example of this is the late 1990’s where everyone was buying internet stocks based purely on the speculation that their stock prices would rise; or the example of a market crash where everyone dumps their stocks without consideration for how strong many companies actually are.

Loss-Aversion
Loss-aversion is a bias that causes investors to place more weight on bad news than good news. This is because losses hurt more than their equivalent gains (Hendricks 2018). Loss-aversion causes investors to hold on to their losses to avoid the pain of realizing the loss which reduces their opportunities to invest stocks that may appreciate (Parker 2019).

There are many other cognitive and emotional biases that work against investors. I will be the first to admit that in my own investing journey, I’ve fallen victim, on numerous occasions, to all of the above-mentioned biases and more. For you, as an investor, to is important to be aware of the effects of these cognitive and emotional biases so that you can work towards a more rational decision making process.

Access to information and market efficiency

The market is very efficient at compounding information into asset prices. Imagine a scenario where you have access to information that no one else knows and it allows you to deduce that an asset is worth $2 but you could buy it today for $0.50. You know that this information will be released next week in the press, what do you do to profit from this? Easy, you buy as much of the asset as possible at $0.50, wait until the news hits and promptly sell for $2.

Unfortunately, for retail investors this scenario is not too far from the truth, except they aren’t the ones with the information. The issue is that retail investors are unable to process asset price information as quickly or as effectively as professional investors. Even if you subscribe to google news and check your phone every millisecond, you will still need to process this information and determine its effect on the asset pricing. I’m willing to bet that you can’t do this as quickly, or as effectively as the teams of people working at investment banks or hedge funds. Something else to keep in mind is that while you’ve made a killer spreadsheet in excel during your lunch break, an investment team’s full-time job to use the best analytical tools at their disposal to digest the available information and execute trades to extract maximum value. To believe that as a part time retail investor you can outperform these teams consistently is likely to be a statement of overconfidence.

Concluding thoughts
As the title says, actively picking stocks with the intention of buying at low and selling high is very difficult. Market efficiency, access into information along with cognitive and emotional biases will all work against the retail investor. This means that out-performing a professional active investment manager or a passive index type fund is an incredibly difficult task. While this article may give off the vibe that I am against stock picking and active management, this is not true, I merely want people carefully consider the many factors that can lead to retail investor under-performance before choosing their own path.

Engineer your freedom

References
King, M, 2017, Top ten ASX200 stocks over the past decade, fool.com, viewed, 6/7/2020, <https://www.fool.com.au/2017/07/11/the-top-ten-asx-200-stocks-over-the-past-decade/>

Parker, T, 2019, Cognitive vs. Emotional Investing Bias: What’s the difference?, Investopedia, viewed 11/7/2020, <https://www.investopedia.com/articles/investing/051613/behavioral-bias-cognitive-vs-emotional-bias-investing.asp>

Douglass, H, 2019, 10 cognitive biases that can lead to investment mistakes, Magellan, viewed 11/7/2020, <https://www.magellangroup.com.au/insights/10-cognitive-biases-that-can-lead-to-investment-mistakes/>

Hendricks, K, 2018, What causes loss aversion?, kenthendricks.com, viewed 11/7/2020, <https://kenthendricks.com/loss-aversion/>

R, Sathishkumar and Vijayalakshmi, P, 2019, Influence of Cognitive Behaviour on Investment Decision of Individual Investors in Tirunelveli District – an Empirical Study. Suraj Punj Journal for Multidisciplinary Research, Vol. 9, No. 1, p. 130-139, viewed 11/7/2020 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3572502>