Updated February 2021
STOCK TRADING
Abstract: Professional money managers and mutual fund managers with large research teams, expensive computing power, and extensive experience cannot, in the aggregate, outperform the market and those managers who will beat the market cannot be identified in advance. Trading strategies are always changing. Risk parity trading did very well until 2016 then fell behind other strategies. Trading on price momentum has been popular for decades though research indicates that trading costs offset returns. High frequency trading with supercomputers running nanosecond fast data purchased from exchanges dominate the markets in 2021, often holding positions in milliseconds. It is very unlikely retail investors will beat the market trading stocks.
Few investment activities are as exhilarating as researching a stock, buying it, watching its price double in a few months, and taking your profits. A huge industry exists to feed this desire. The financial media constantly provide ideas and strategies that might make money, particularly fast money, trading stocks. Unfortunately, stock trading is a form of gambling and has the same outcome. Eventually, if not immediately, traders are very likely to underperform the market or lose money. Just what are the facts on trading stocks?:
PROFESSIONAL MONEY MANAGERS CANNOT, IN THE AGGREGATE, OUTPERFORM THE MARKETS. Full-time professional money managers and mutual fund managers control trillions of stock market dollars. Despite very low trading costs, teams of research analysts with advanced degrees, inside connections, and sophisticated mathematical and computer models, they do not consistently beat the average "chance" returns given by markets. We discuss this elsewhere on our website in "Active versus Passive Management". It's folly for an individual investor to believe he'll beat the professionals or the markets, particularly if he gets his ideas from the mainstream financial media. And, the research evidence is clear. By the time the retail investor gets a stock idea from CNBC, the WSJ or Barron's, the proprietary accounts at big brokerage firms and investment banks and mutual funds already own them. A retail investor is very unlikely to beat the Street which is itself unlikely to beat the indexes. Retail investors often believe that have special knowledge during bull markets leading to an old Wall Street saying, "Don't mistake a bull market for brains". That statement has particular meaning after a record 350% gain in the S&P 500 from January 2009 through Fall 2018.
PAST PERFORMANCE OF PROFESSIONAL MANAGERS DOESN'T PREDICT THEIR FUTURE PERFORMANCE. While active professional traders are quick to point to the minority of managers and mutual funds which outperform the market as evidence of their skill, those who will beat the market cannot be selected in advance because past performance doesn't predict future performance. A mountain of evidence from numerous studies supports this view. EAM sometimes talks with individual retail investors who claim they have outperformed the markets through timing or trading strategies. While this is often the result of selective memory even those who have beaten the market cannot be sure they will do so in the future. In fact, the Dalbar studies referenced elsewhere on this site show that retail stock investors are likely to produce CD like returns for 20 year periods.
THE MAJORITY OF COMMON STOCKS WITH DIVIDENDS INCLUDED DON'T OUTPERFORM ONE MONTH TREASURY BILLS FOR THE TOTAL TIME THEY ARE LISTED ON EXCHANGES. Academic research (Carey, W. U. Arizona, 2017 draft) on historical returns in common stocks indicates that knowing which equities will outperform the market in advance is impossible. When they examined the total data base for all stock prices in the CRSP data base for all common stock returns from their first appearance on an exchange through their delisting during the 1929 to 2016 period, 88 years, only 42.6% of stocks gave a buy and hold return that exceed the return on one month Treasury bills over the same time horizon. Individual publically traded stocks tend to have rather short lives with a median listed time on exchanges of only 7.5 years. The single most common listed return for all publically traded stock returns rounded to the nearest 5% was a complete loss of 100%. A total of 25,300 companies issued stocks appearing in the CRSP common stock database between 1926 and 2016. Of these, the 1,092 top-performing companies, slightly more than 4% of the total, accounted for all of the "wealth creation" in common stocks since 1926. Thus, the odds of choosing a wealth creating individual equity or selected group of equities are rather slim, 1 out of 25. Wall Street would not be happy if this probability was widely quoted. Passive equity asset class portfolios or indexes with large samples are highly likely to outperform stock pickers. Of course, there will always be a small minority of stock pickers who beat the markets for some period of time but there is little chance we can know who they will be in advance, there is little chance their outperformance will persist over long time frames, and their outperformance may simply be due to chance. We know very little with certainty about the future.
INVESTMENT FIRMS AND ADVISORS NEVER GUARANTEE FUTURE RETURNS BECAUSE THEY KNOW THAT THEY DON'T KNOW HOW WELL THEY WILL DO. No active professional traders are so sure of their stock trading skills that they will guarantee investors they'll beat market averages or compensate investors if they fail to do so. Public optimism about professional investment skills and offerings is, however, always optimistic and always high. If the professionals are unlikely to beat passive and index returns individual investors shouldn't be confident they can either. Several studies of self-traded accounts at discount brokerages indicate that the average amateur investor does about as well as the average professional if he's a light trader and the more he trades the poorer his returns. Trading frequently increases expenses and destroys profits.
PROFESSIONAL TRADING SYSTEMS ARE ALWAYS CHANGING. Traders are forever hoping to find "hot" stocks, or better still, a system for selecting stocks that will consistently yield profits. Perhaps, the all-time, most popular stock trading system is Value Line, a widely distributed proprietary stock selection manual found in many public libraries. It boasts impressive theoretical results, soundly beating the market. Yet, of the three mutual funds run by Value Line, none managed to beat the S & P 500 index, let alone capture the remarkable theoretical returns it claims. As of 2021, high frequency trading (HFT) with supercomputers dominates the market and accounts for 50% to 95% of all daily trading on the major exchanges. HFT computer trading began in 2004 and took over the markets by 2009. HFT computers are colocated a few feet from exchanges and purchase exchange data and, most importantly, receive quotes a few nanoseconds before non-HFT traders and can "front run" prices. HFT computers can place trades thousands of times per second with strategies like quote stuffing and cascading and in various ways front run and manipulate prices. Such trading has nothing to do with company fundamentals, traditional technical trading, or macroeconomic based trading models. The individual retail investor is a pawn in this predatory game. The HFT industry, of course, claims it adds liquidity and value to markets. As of Spring 2019 some calls for banning or slowing down HFT computers were showing up in the financial press. As of February 2021 nothing has been done.
WALL STREET AND THE FINANCIAL MEDIA PROVIDE RETAIL INVESTORS WITH A CONTINUOUS STREAM OF TEMPTING INVESTMENT IDEAS. Pundits, fund managers, financial experts of all stripes, books, newsletters and seminars stimulate the desires of the stock trading public. One of the more popular books is William O'Neill's, "How to Make Money in Stocks." He was the founder of "Investors Business Daily" and publishes a widely circulated daily investment newspaper, offers books, and conducts seminars, claiming big profits from his stock selection system. Like Value Line, there appears to be a substantial gap between theory and performance. O'Neill's mutual fund failed to outperform the S & P 500 and was finally sold to another fund company.
Hundreds of newsletters are published monthly to assist stock traders in choosing profitable stocks and timing markets. They don't work. Only one newsletter of 29 "survivors" from 1993 through 2007 beat the market. From 2002 to 2007, only two newsletterss out of 105 beat the market. Most newsletters don't last long enough to create long-term track records and chance alone should have produced far more market beating newsletters.
"Fundamental" traders do thorough research on the financial statements of companies, their management, and the industries they compete in. They then choose stocks they believe to be "undervalued" by some set of criteria. For example, earnings per share growth rates are sometimes considered a very important determinant of future stock prices and are announced and commented on constantly by the financial press. Research indicates earnings growth is a weak predictor of future company growth and share price growth and often far off the mark. Worse still, the majority of professional and retail investors today have short holding periods while investing based on company fundamentals assumes that time, measured in years, will be required to realize the value in a company's stock.
"Technical" traders pay close attention to stock prices, volume, and chart patterns, analyzing them with statistical techniques and intuition. Predictions are made about what stocks or industries or asset classes will go up or down. Unfortunately, research on stock price behavior has found that only a tiny and insignificant fraction of future stock prices, 3% to 4%, can be explained by historical price data. Many studies have found that typical technical formulas fall apart under rigorous statistical examination though all systems work at least occasionally. These random successes are similar to those that occur in gambling casinos.
"Macroeconomic" traders are forever trying to appraise the condition and direction of the economy from the continuous flow of government statistics. Usually, predictions are also made as to what the Federal Reserve will do and many economists and financial pundits try to interpret the Fed's ambiguous and optimistic language in its public pronouncements. This "macroeconomic" approach is then used to predict which market sectors and stocks will do well. Unfortunately, macroeconmic data from government statistical agencies is of questionable quality, constantly revised, and spun in the most optimistic manner possible by the financial press. Research indicates that economists and economic experts have no greater skill than chance guessing in predicting future economic events. We examine this elsewhere on our website in "Economists and Economics".
DISHONESTY IS ENDEMIC IN THE INVESTMENT BUSINESS. Just like the gambling business, the stock trading advisory and publishing business has its share of dishonest practitioners. Investment guru Wade Cook promised that for up to $8000 for a three day seminar he'd teach investors how to double their money every three months in the stock market. More than 400,000 people attended his seminars in 1997 netting his company $100 million. In 1997, his publically traded corporation lost 13% trading its own account while the market went up 23%. Promises and future performance frequently diverge in the world of stock trading advice. Bernie Madoff's long-running and hugely profitable Ponzi scheme fooled even professional investors and major investment firms. Bernie Madoof said that he was surprised he hadn't been found out years earlier. Investors are impressed by investment experts and claims of outstanding performance.
EVEN EXPERTS CAN'T PICK STOCKS WELL. A WSJ article (1-15-11), "Why You Shouldn't Trust Wall Street's Top Stocks for 2011", examined the price performance of 10 stocks analysts rated most highly as "buys" and 10 stocks analysts expected to do the worst. In 2008 and 2009 analyst's top rated stocks trailed the S&P by 9% and 4% respectively while their sell rated stocks beat the S&P by an incredible 44% in 2009. In 2010, their top rated stocks beat the S&P by 11% but their sell rated stock picks beat the S&P by 19%. Numerous studies confirm these findings. There's little if any evidence that trained professionals can pick stocks any better than random chance or guessing.
INVESTMENT CLUBS MAY BE COMFORTING BUT ARE UNLIKELY TO PROVIDE INVESTORS WITH ABOVE MARKET RETURNS. Investment clubs, of which there were some 13,000 plus in the U.S. as of 2005, often get financial media coverage when a particular club produces exceptional returns. For many years, the Beardstown Ladies stock club, frequently mentioned in the WSJ, boasted an average return of 23%+ annually and sold millions of copies of books full of stock trading tips. Unfortunately, in 1997 it was discovered that their record keeping was inadequate and their real returns were under 10%, below those given by market indexes. Other studies have found that investment clubs, in the aggregate, underperform the markets.
JIM CRAMER ON CNBC DOESN'T BEAT THE MARKET. The folly of trading hot stock ideas is dramatically illustrated by Jim Cramer's popular CNBC show "Mad Money", still on the air as of 2021. A former hedge fund manager and allegedly hot stock picker, Barron's lead article on August 20, 2007 reported that over the prior two years Cramer's stocks were up about 12% while the Dow rose 22% and the S&P 16%. Diversified equally weighted DFA equity portfolios returned around 40%. Of over more than 100 stocks he recommended in 2007, Cramer trailed the S&P return by 2.2%. Barron's found that selling Cramer's recommendations short offered an opportunity to make 5% to 30% per year. Worse still, Barron's revealed some of Cramer's hedge fund strategies. They are not atypical for Wall Street and also are not illegal. Cramer's firm would build a position in a stock which had petered out, then hunt up some bullish news on the company and feed it to sellside analysts and financial reporters and retail investors. On the subsequent price increase, Cramer and company would profit by selling out their position. "Buzz merchandizing" is what Cramer calls it. Most investors today do not realize that stock selling and trading were regarded as a highly unreputable business full of gamblers and con artists until the 1920's, and didn't reachieve public acceptance after the 1929 crash until well after WWII. Decades of advertising, lobbying and political contributions by brokerage firms and huge public relations campaigns paid off. Stock trading and equity investing is at boom levels as of early 2021.
CONCLUSION: Since there is little evidence that retail investors or professionals can consistently beat average market returns and a great deal of evidence that no one can predict where the market or individual stocks are going investors should avoid trading stocks or listening to experts on the topic. Investors should particularly avoid listening to hot stock ideas or following trading systems promoted by the financial industry. EAM recommends that money allocated to stocks should be invested in a diversified portfolio of passive asset class and index funds for time frames of ten years or longer. It may be boring but it's simple to do and returns are likely to be substantially better than the other options.