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Stocks and Stockbrokers
Copyright © 2008, P. Lutus

Updated 06/2008

How Equities Markets Work | The Virtual Market Simulator | Equities Mythology | Equities Advice | Further Reading

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How Equities Markets Work
Tia Laverne Roberts, five-year-old stock genius
In a recent university experiment, three people were given a chance to show their stock picking expertise.  They were:

  • A professional stock analyst
  • An astrologer
  • A five-year-old girl (right)

The experiment, devised by Richard Wiseman of the University of Hertfordshire in England, set up three imaginary portfolios, each with stakes of £5,000. The participants chose their stocks, a year went by, and the picks were compared.

  • The professional stock analyst used all his expertise and computer power to make his choices. The man on the street would choose this person if he wanted his money to grow.

  • The astrologer used the position of the planets to guide her choices. Common sense says this shouldn't work very well, compared to a roomful of computers.

  • The five-year-old girl just made random picks. She could be expected to perform about as well as the average, untutored investor relying on instinct.

The results?

  • The professional analyst's picks went down 46.2%.
  • The astrologer's portfolio went down 6.2%.
  • The five-year-old girl came out ahead, with a growth of 5.8%.

How is this possible? Isn't stock picking a science? Can't professional portfolio managers perform better than ordinary, uneducated people? Is our trust in stockbrokers misplaced?

Well, contrary to what you may have been told,  fair, open stock markets are not predictable — not by anyone. Not in principle, not in fact.

If this were not true, if stock markets could be predicted, those markets would be neither fair nor open. In fact, the unpredictability of stock markets is proof of their overall fairness.

Hold on a minute. Did you hear me right? Yes, I'll say it again, for emphasis:

The unpredictability of stock markets is proof of their overall fairness.

Why is this true? Why are markets unpredictable by definition? Why can't there be a consistent "winning system," a "sure-fire stock picking strategy," as is so often claimed in articles and books?

Well, there are many reasons. Here are two:
  1. If someone came up with a stock-picking strategy that worked for a time, someone else would surely notice the strategy. That person wouldn't be able to resist telling his relatives, then the stocks targeted by the strategy would go up in price (because of increased demand), thus wiping out the strategy's advantage.

  2. The market is not a bunch of stocks sitting in a warehouse. It is a living organism — people, companies, all competing with each other to maximize their gain. These people are not acting in any predictable way, because predictable people, predictable actions, invariably result in loss. This is true because someone, somewhere inevitably anticipates, and acts on, any predictable behavior. Just like in nature.

There is only one method to gain a real advantage in the stock market, and that method is illegal: insider information. Example? At the same time top Enron executives were telling the public the company was doing fine, they were liquidating their own portfolios. That is how insider trading works — the trader knows something the general public doesn't. And that is why it is illegal.

Here is a very important secret of the stockbroker's trade, a secret stockbrokers pray you don't find out — there is no legal stock picking strategy that can outperform the average, long-term market. This is true logically, scientifically, and it is proven by history.

Why don't the professionals want you to find this out? Because their existence depends on your ignorance — if you found out this dirty secret, you would fire your broker, pick a broad, varied portfolio of stocks, and sit on them. This strategy is called "buy and hold," and it is the approach recommended by most market commentators who are willing to tell the truth.

In many studies performed over decades, the "buy and hold" strategy, as boring as it sounds, is proven to outperform all other (legal) strategies. And there is no reason a "buy and hold" portfolio should perform better than a portfolio overseen by a professional manager, except for two crucial facts:
  • The expense of brokerage fees.
  • The risk that the manager will gamble with your money by putting too much of it into too small a market segment, and lose that gamble.

Given that regularly buying and selling stocks is a bad strategy, you may wonder how people make any money in the stock market at all. Well, the reason is simple — the average market increases in value over time. This means if you bought a wide, diverse portfolio and waited twenty years, chances are your portfolio would have increased about as much as a typical market indicator like the Dow-Jones average (a portfolio of typical stocks used to measure market performance).

Which leads to this description of the two primary kinds of investment (and investor):

  • "Buy and hold" portfolio:
    • Steady, predictable performance.
    • Maximum gain in the long term.
  • Managed portfolio:
    • Occasionally very exciting.
    • Wild swings in value compared to the average market.
    • Added cost of brokerage fees.
    • Less long-term gain than buy and hold.

The Virtual Market Simulator
I have designed a computer market simulation (right) that will help you understand equities markets.

It is a Java applet (and if you cannot see it, complain to Bill Gates).

The simulator works this way:

  • It models a very simple market, composed of two stocks.
  • Each month, the two stocks randomly fluctuate up and down in value relative to each other (by the "Stock price fluctuation delta").
  • Over time, the average market value (the combined value of both stocks) increases in a predictable way (the "Annual change in market par").
  • Each month, by a virtual flip of a coin, traders randomly sell their existing holdings and buy one of the two stocks. Sometimes the random trade is a good choice, sometimes not.
  • At the end of the trading time period, the outcome is displayed.
    • The best performance.
    • The worst.
    • The outcome for the average trader.
    • The outcome for a boring "buy and hold" investor.

This simulation differs from reality in a couple of ways:

  • No brokerage fees are assessed on the trades, which makes this constant buying and selling strategy look better than it actually is.
  • Traders are allowed to go in the hole and continue to trade. In reality and in most cases, nature steps in and prevents this perversity. But it accurately shows the dramatic downside of constant buying and selling.

Now press "Run market" to see what happens. The market will run for the chosen number of months, some investors will get ahead and some will fall behind, making random trades. And you can experiment — change any of the white numbers at the top of the display and run the simulation again (if you choose a large number of traders, they won't be graphed, but the simulation will still run correctly).

On some simulations, the average investor does better than the "buy and hold" investor, and sometimes worse. Over time, on average, the two outcomes are the same (because no brokerage fees are charged in the simulation). In reality and on average, the managed portfolio does worse than the buy and hold portfolio because of brokerage fees.

You might object and say, "Well, yes, but this simulation is based on random trades, they aren't the trades that a professional would make." But yes — they are. Unless they are based on illegal insider information, all trades are random trades.  All are trades based on no more wisdom than a five-year-old girl possesses.

You might object to this bleak assessment, thinking of all those glossy quarterly reports that corporations produce, reports that stockbrokers read and rely on for guidance, reports that end up changing your portfolio. My reply? Here's Enron CEO Kenneth Lay's report, two months before Enron collapsed:

"Our performance has never been stronger; our business model has never been more robust. ... We have the finest organization in American business today."

Equities Mythology
The idea that regularly buying and selling stocks can put you ahead of the average market is a myth — it is false. It is not just false sometimes, or for some people, in the long term it is always false. Given enough time, a buy and hold portfolio outperforms any other strategy — always.

This doesn't dissuade millions of investors with managed portfolios — managed by professionals whose primary purpose in life is to make as many trades as possible.

It also doesn't dissuade hundreds of thousands of day traders (people who buy and sell their own stocks on a daily basis), some of whom go berserk when things don't work out:

"Mark Barton, who reportedly lost $100,000 day trading in the stock market recently, opened fire yesterday afternoon in two Atlanta brokerage firms, killing nine people and injuring 12 others. Police later discovered the bodies of his wife and two children, whom they say Barton had killed earlier this week. Barton, 44, shot and killed himself after being stopped by police at a gas station." — from The Motley Fool, www.fool.com

In study after study, day trading has consistently been shown to be a fool's paradise. Day trader portfolios perform much worse than the more traditional managed portfolio, which in turn performs worse than the classic, boring, geriatric "buy and hold" portfolio. What's going on here? Are these people crazy?

No, they are gamblers. Did Las Vegas go out of business when people found out they would lose more money on average than they would win? No, because gambling is not about making money, it's about excitement, mystery, risk. This is also what drives most stock trades.

Therefore you need to ask yourself why you are an investor. If you want to maximize your chance to make money on equities, then buy a wide, diverse portfolio and sit on it. If instead you actually prefer to gamble, hire a portfolio manager or become a day trader.

And when you see an advertisement for a sure-fire, guaranteed stock picking strategy, article, book, seminar, or whatever — please think! If the method works, why is the author selling it? If the strategy had merit, the author would make more money practicing the strategy than by selling a book about it. And more, by revealing the strategy, the author is ruining any effectiveness it might have had, because widely practiced strategies always fail.

Equities Advice

We all hear advice about equities — from friends, strangers, online, in magazines, and from Wall Street "experts." Most of this advice is completely worthless, or worse, it may be meant to fleece you in one fashion or another. Here's an example — a friend tells you about Company X, and provides this information:

  1. "The stock of Company X has doubled in value over the past 12 months."
  2. "An important Wall Street Analyst has given Company X a 'buy' recommendation."
  3. "To prove that I am sincere, I have personally invested in Company X's stock."

Well! Doesn't that look like a good recommendation? No, not at all — in fact, each of the points in the list above represents a clear warning sign to avoid that stock. Here's why:

  1. If a stock has just substantially increased in value, it is statistically less likely to continue climbing in the future, in fact, there is a good chance that it is headed for a "correction," e.g. a drop to a price more in keeping with the true value of the company. Never rely only on past performance when considering an investment.
  2. By the time a Wall Street analyst publishes a "buy" recommendation for a particular stock, it's too late to take the advice — that train has already left the station. It's possible that millions of investors have already taken the advice, and the stock's price may already be peaked or even dropping. This leads to a Wall Street saying: "Buy on the rumor, sell on the news."
  3. If your advisor has a position in the stock he is recommending, this is a reason to avoid the recommendation. Why? Because he has a conflict of interest — if he can get you to invest, he stands to benefit personally, because the stock increases in value with each new investor. In the worst case, it could be a case of "pump and dump" — a scheme in which a person acquires a position in a stock, recommends it to everyone he knows, then sells to reap the advantage of the resulting price gain.
We close with this typical scene. On late-night TV there's a guy selling his sure-fire stock picking book. The author says he made millions without leaving the house. Use your head   — If his claims are true, why in God's name is he yelling about his book on TV at 3 AM, asking for $19.95? That makes just as much sense as hiring a manager to oversee your portfolio, a person who only makes money if he buys and sells your stocks, at your expense.
Further reading
The links below show the acceptance of these ideas among equities professionals who are willing to tell the truth.


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