The Big Myth About Stocks

I’m sure you’ve all heard fantastic stories of investors who made untold millions in the stock market and retired like kings. You are also being constantly reminded by the mainstream media of all those Wall Street traders who make more money per week than 75% of the average Canadian worker’s annual pay check. You’ve always wanted a piece of the action, but never knew enough to enter the equity markets, or was simply too nervous to do so. Hopefully, by the end of the next few posts, you will have a better understanding of the equity markets and the best ways of entering them.

Firstly, there are a couple of notable distinctions that have to be made. There is a difference between what is called a ‘trader’ and what is called an ‘investor’. A trader buys and sells stocks on a daily basis, looking for quick returns on their money. An investor buys stocks for the longer run, and trusts the mathematics of financial principles to attain long-term goals. There is a huge difference between the two. Traders mostly rely on heavy technical analysis, which involves complex statistical methodology to try and pinpoint current trends in the trading prices of equities. This is not an easy thing to do – it is extremely fast-paced, stressful, and requires a lot of skill, time and energy. Suffice it to say that trading equities should not be the average family man’s strategy – leave it to the experts with millions of dollars at their disposal, and very low transaction costs. I am going to be talking about investing for the long-run. The premise of the investor is that the overall average of stock returns is 11%/year – and that the actual choosing of individual stocks (often) doesn’t really matter – what matters is the allocation of stocks. In other words, what matters is the type of stocks do you buy, as opposed to which specific ones.

My goal here is not to give you advice about which stocks will be going up next week or month. Why? Because your guess is as good as mine. In fact, your guess is as good as most of the professional money managers heading the giant mutual and hedge funds, and who are getting paid millions to do so. This brings us to one of the most eye-opening and fascinating studies in the history of finance. In 1973, Princeton economist Bernard Malkiel published a book called ‘A Random Walk Down Wall Street’. In it, he described an (albeit thought) experiment, where he had monkeys throw darts at listings of stock securities on the market. What he found was that monkeys’ stock portfolio managed to out-perform the majority of the mutual funds on the market (??!!). Malkiel concluded that by owning a portfolio of random stocks, or more simply, by tracking the market index (to be explained later) and holding on to them for the long-run, you are more likely than not going to outperform the vast selection of actively managed mutual funds on the market.

The debate rages on even today, about whether there is any point to having traders and actively managed portfolios, as opposed to passive long-term investors (actively managed portfolios refers to people who are actively and continually trying to pick winning stocks; passively managed portfolios are portfolios made up of a selection of stocks and held for a long time without interference, or by tracking the returns of a market index, such as the TSX). The funny thing is that the whole conundrum is a catch-22: The reason why the monkeys can outperform money managers is because the stock markets are efficient – there are no discounts or good buys on stocks. All stocks are priced correctly, and therefore, you can’t make quick returns by being a trader. Traders therefore get outperformed by the average market index (or the monkey), because of increased transaction costs resulting from more frequent trading. But the reason why stocks are priced correctly in the first place is because the traders are constantly trading them! If all the traders in the world stopped trading, markets wouldn’t be as efficient, and then there would be more room for individual managers to beat the monkeys, by finding stocks that are underpriced. I hope I’m not confusing you!

Anyway, the point is that it is extremely hard (if not impossible) to consistently beat the average returns by picking winning stocks (over the average stock return). It’s simply a statistical game - exactly comparable to throwing dice. If you roll a die, there’s always a chance that you will roll a 6. But if you do, does that mean you’re a better dice roller than the average? Of course not! It means you got lucky; subsequently, your first dice roll has nothing to do with your second one. The next time you roll the dice, you are equally as likely to roll a 1! This is completely analogous to most mutual funds. If a mutual fund outperforms the average return in one year, it has almost no bearing on the fund’s return for the following year. In other words, it was all luck.
Therefore, if you heard about someone who managed to outperform the markets for years on end – chances are they are lying, or got extremely lucky. The probability that they could repeat their performance isn’t any better than you doing so.

So after contemplating what I just said you are probably wondering why there is such a massive financial industry. Well – it’s all about what you believe. Some people believe in Malkiel’s theory, and some don’t. Studies on the subject are mostly mixed and inconclusive, but one thing that I’m certain about is this: The overwhelming majority of Wall Street financial firms make their money off charging clients for their trading, rather than the trading itself. This is perhaps the biggest myth of finance dispelled. Mutual fund managers are paid millions not because they earn high returns, but because they charge a lot of money to handle your funds. I can assure you that the vast majority of mutual fund managers would not be able to earn money on their own (in the stock markets) – they manage other people’s money and charge them for doing so. The number of people who can actually consistently become rich via equity trading is as rare as moon dust. You may have heard of some of them – Warren Buffett, Peter Lynch, Bill Miller, etc. The funny thing is that supporters of Malkiel would argue that these investors didn’t do it on their own – they had access to resources that the average investor would never have. Otherwise, they wouldn’t do any better than you or me.

Does this mean that all actively managed mutual funds are bad? Not necessarily. Studies have shown that about 1 in 5 actively managed funds can beat the market index (market average) consistently over the long run. Does this disprove the theory that’s it’s impossible to choose winning stocks? It’s anyone’s guess! Mutual funds can still be of much value, just you cannot blindly throw your money at them because they supposedly have professional management. Most professional money managers do worse than the average, not better.

As well, some traders have found success using technical and fundamental analysis. I would not advise the average investor to start trading equities unless you really have a solid financial background, and that you understand what you’re getting into.

Whether you believe in Malkier or not, the takeout lesson is that there are no get-rich quick schemes in the stock market. Successful investing takes patience, strategising, commitment to principles, dedication, and above all, realistic expectations. Interestingly enough – of the 20% of funds that do manage to beat the market index, most of them are the ones who practice exactly the principles I just mentioned (dedication, patience, etc.). As soon as they get greedy and chase higher returns – they inherently accept more risk in their portfolio, and they end up getting burned over the long run.

The smart investor worries more about the allocation of stocks, rather than the choosing of stocks. The smart investor focuses just as much of his attention on how his/her returns are going to be taxed, as the returns themselves. The smart investor always considers the riskiness of his/her investments.

And lastly, perhaps most importantly, the smart investor does not pay attention to past returns of individual stocks. You may open the newspaper today and see that Apple or RIM stocks went up 10% yesterday. Remember, that although you may be tempted to now buy Apple or RIM, the fact that the stock went up yesterday has zero significance with today’s performance. Yesterday’s returns have absolutely no statistical bearing on today’s or tomorrow’s returns. This has been proved over and over, so never chase previous returns!

You need to develop a long-term strategy, and you need to stick to that plan. Obviously, the strategy can be amended at particular points in time, but the dedication to strategy remains essential. Next post I will discuss the principles of how to create an investing strategy, and then show you the nitty-gritty of how to purchase equities (i.e., where to purchase stocks, how to research stocks, day to day portfolio monitoring, etc.).