Faculty Column: Does anyone know how to pick stocks?

Courtesy: www.thunderbird.edu
Courtesy: www.thunderbird.edu

By Professor Lena Booth

As a finance professor, students and friends often ask me if I have any stock tips. My typical response is “If I do, I would be out there making big bucks, sipping Margaritas on the beach, and not work another day”.  Well, without illegally using privileged insider information, does anyone really have any “stock tips”? Having been in the finance profession for over 2 decades, I sometimes come across these so-called “stock tips” from professional money managers, investment advisors, or experts in the field. I noticed that some of the tips do produce great short-run returns, while others lead to flops or simply “do nothing”. Not knowing in advance which are the “reliable” ones, stock tips to me are just as good as using a blindfolded monkey throwing darts to pick stocks.

Does this mean we should just throw all the traditional investment theories out the window? Well, it depends on each investor’s perspective – John Bogel, founder of the Vanguard Group, would likely say ‘yes’ while Warren Buffett would like say ‘no’. To understand this further, let’s look at the common approaches to stock selection. For decades, many equity analysts use technical and fundamental analyses to decide what and when to buy or sell, in hopes of making abnormal returns.  Technical analysis engages in charting market activities such as past price and volume patterns of the stock, counting on previous patterns repeating themselves in the future. Fundamental analysis involves studying everything that could affect the fundamental business of the company, such as its management/employees, products, customers, industry growth, competitive and regulatory environments, market share, plus quantitative measures such as revenue, earnings, cash flows, price earnings (PE) ratios, etc. In other words, everything that makes economic and financial sense.

If one conducts both technical and fundamental analyses thoroughly, would he/she be able to identify which stocks to buy or sell and beat the market?  Investment advisors and money managers certainly hope so; that’s how they convince investors to invest with them.  However, many of us know how unpredictable stock price of a company is, especially in the short term. Look at the company Apple Inc.  Apple is a highly admired company with very handsome profits, lots of cash on its balance sheet, wonderful products, even though some say it lacks innovation and faces intense competition, especially after Steve Jobs died. Its stock price has been moving up and down in an unpredictable manner in the last 2 years, hitting a high of $702 and a low of $390.  It was affected not only by the company’s fundamentals, but also by an array of behavioral factors such as market momentum, investors’ sentiment, and irrational exuberance.  Often times these factors play a much bigger role in driving the stock price of a company than the company’s fundamentals.

If it is that difficult to know how a single stock will behave, shall investors resort to investing in the whole stock market instead? Market-wide exchange traded funds such as SPY and QQQ that mimic the S&P and Nasdaq 100 indices respectively are some ways to invest in the stock market.  Others such as Dimensional Fund Advisors invest in various segments of the stock market as they believe the market is efficient and do not attempt to pick individual stocks. (Dimensional was co-founded by David Booth, whom my husband dreamingly likes to consider as his long lost brother. The fund did very well with this strategy. In 2008, David Booth donated $300 million to University of Chicago Graduate School of Business, which was subsequently named Chicago Booth.)  Given the success of Dimensional, does it mean we should all invest in the stock market or adopt a strategy like that of Dimensional?  Are we able to predict the general stock market better than we could with individual stocks? Again, it depends on how long the investment horizon is and over what time frame.  For example, if you had invested in the U.S. stock market (S&P) from 2001 to 2010, you would have earned less than the T-bill rate, about 1% annualized return during the 10-year period – famously known as the “lost decade”.  On the other hand, the 10-year annualized return from 2004-2013 was 7.3%. For a shorter investment horizon, the stock market return is even less predictable, as evidenced from the daily big swings on the Dow and Nasdaq indices.  They are affected not only by factors related to the countries’ fundamentals such as interest rates, inflation, job creation, government quantitative easing (QE) measures, but also by the political and economic instability in other countries such as the Euro debt crisis or the recent Ukraine incident, and the most unpredictable of all – the investors’ impulse and irrational behavior.

Studies by Brad Barber and Terrance Odean suggest that investors’ behavior plays a big role in the success of investing.  Investors who trade often tend to do worse than those who trade less frequently. Frequent trading often results in selling the winners and buying the losers – commonly known as the “disposition effect”. They document that men, who tend to be overconfident, trade 45% more than women, hence perform worse than women when come to investing. The difference in trading pattern, and hence returns, is especially profound between single men and single women. They also document that individual investors do worse when they hold undiversified portfolios, base their purchase decisions on limited attention and past return performance, repeat past behaviors that are pleasurable and avoid those that generate pain. As a whole, individual investors perform worse than the standard benchmarks such as index funds.

So, what does all that tell us about investing? My two cents: investors should try to adopt a buy and hold strategy and avoid frequent impulse trading.  If they want to pick stocks, they should do a more systematic search instead of gravitating towards those that receive high media attention. They should invest in more diversified portfolios, or better still, hold low cost index funds for the long-term. Or perhaps, very simply, men should just learn from the women!

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