Why I can’t pick winning stocks, and you can’t either

Don’t feel bad.  Most pros can’t either.

 Indexing vs. active management is always a fascinating debate; at least for us stock geeks with nothing better to do.  Over the decades I’ve been on both sides of it at various times. For a very long time I laughed –ha, ha, ha, ha — at the indexers.  I made all of the arguments, and then some.

 After all, if you just avoided the obvious dogs you’d do better than average, right?  Who would be stupid enough to own GM a couple of years ago?  Or Ford?  Opps.  Better forget about Ford.  Hindsight is a beautiful and perfect thing.

Convinced I could win this game, after all I’d just bought a stock that tripled, I even took a major pay cut to join an investment research firm mid-career.  http://jlcollinsnh.wordpress.com/about/ There I was, surrounded by exceedingly bright people.  Each focused on one, maybe two industries and perhaps 6-10 stocks.  More than one had been honored in the trade press as “Analyst of the Year” for their work.

They knew each of these companies inside and out.  They knew the top executives.    They knew the middle-managers and the front line people.  They knew the customers.  They knew the suppliers.  They knew the cute receptionists.  They spoke to them all weekly.  Sometimes daily. 

They still didn’t get info before anyone else (that’s insider trading, fool proof and, ah, illegal).  But they did know exactly when and how the info would be released.  Of course, so did every other competent analyst around the world.  Any new information was reflected in the stock price within minutes. 

They issued reports our institutional investor clients paid dearly for.  And yet, predicting stock performance remained frustratingly elusive. 

If you’ve worked in a major corporation it is not hard to see why.  The CEO and CFO work with internal forecasts from their teams.  The process looks something like this:

 Salespeople are required to forecast what their customers will spend.  Since these buys are rarely locked in far in advance, and can be cancelled anytime, nothing is certain.  Add to this all the pending business that may or may not come to fruition and basically you are asking the field salesperson to predict the future.  Typically they are not clairvoyant.  So, of course, they take a guess.

These guesses get passed on to their managers, who are also not clairvoyant, and who now have their own forecasts and decisions to make.  Do I take these sales forecasts at face value?  Do I adjust them based on knowing Suzy is an optimist and Harry always sees dark clouds?  So, of course, they take a guess and pass it on to the next layer of management.

So it goes until all these guesses on the inherently unknowable future are consolidated into the nicely packaged budget/forecast binders presented to top management.  More often than not, after one look, they’ll say:  “This is unacceptable.  We can’t present this forecast to Wall Street.  Go back and revise these numbers.”  Back down the chain it goes.  Maybe multiple times, and each time the numbers get a bit further from reality.

Now predicting the future is a dicey proposition for even the most gifted psychics; and they are not burdened with this process.

Suddenly my enormous stock picking hubris was clear.  Somehow reading a few books and 10ks was going to give me an edge?  Over not only the professional analysts who lived a breathed this stuff all day every day, but also the executives who run the companies in question?  I could succeed where they could not?

Suddenly I realized why even rock star fund managers find it almost impossible to best the simple index over time.

There is a reason names like Buffet and Lynch are so revered and well known.  There are also reasons more fortunes have been made brokering trades than making them.

That’s why I’m now an indexer.  If you choose to try to best the averages, God Bless and God Speed.  You may well be smarter and more talented than I.  You are most certainly likely to be better looking.  I’ll look for your name along with Warren and Peter’s in the not too distant future.

I extend the same to all those folks I’ve met in Vegas who assure me they have bested the house.  I listen, gaze up at the billion dollar casinos and reflect on how many smarter, more talented and better looking people there are than me.

Oh, and that stock that tripled?  Well, even a blind squirrel……

Care to comment?  Just click on the circle on the top right of the post.

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11 Comments

  1. Posted January 2, 2012 at 10:19 pm | Permalink

    Yep, those glittering Vegas palaces were all funded by people who thought they could beat the house. Of course if you head over to the Poker room, you’ll find people who can win consistently with skill, because they have found ways to invest their money in situations where they have a statistical advantage.

    Most Poker players also lose, admittedly. But some win – year in, year out.

    • Posted January 2, 2012 at 11:11 pm | Permalink

      The key to poker in Vegas is that, unlike any other game, you aren’t playing against the house.

      as I describe here: http://jlcollinsnh.wordpress.com/2011/07/01/johnny-wins-the-lotto-and-heads-to-paris/

      I used to play in a regular game in Chicago and made a pretty good dime or two in the process. It is the only “gambling” I’ve ever enjoyed because:

      1. It is a game of skill. Statistically, every player will receive the same number of winning and losing hands over time. The guys who walk out with the money are the guys who know which is which and how to play them.

      2. I didn’t have to be the best player at the table to make money. This was important as I was rarely the best player. In poker the top two or even three players take home the cash.

      I remember playing in a high stakes game in Vegas for the 1st time. It became clear quickly that four of the eight seats were occupied by pros. They spent the night cleaning out the tourists who’d sit down for the 20 minutes or so it took them to bust out.

      The pros hated me. I wasn’t good enough to win but I was good enough that it took them all night to clean me out. That made for a far less productive seat.

  2. Posted July 7, 2012 at 6:45 am | Permalink

    I’m coming back and reading through your blog Jim. This is such a great post. I really like the clipart, complete with watermark, of the “cute receptionist.”

    • Posted August 15, 2012 at 1:23 pm | Permalink

      Thanks, KO…..

      great to have you over here!

      I liked that pic, too!

  3. VK
    Posted March 15, 2014 at 11:39 pm | Permalink

    Hello Jim,
    I love your articles and agree with most of them. I’m on the fence on this particular one.
    I’m currently following AAII’s model shadow stock portfolio which has worked great for me since I started following it in the past couple of years.
    I’m young and have been investing only a few years in the market and I’ve been seeking the answer to this question – should I invest in individual stocks or index funds.
    AAII’s shadow stock portfolio’s return since inception in 1995 has been 17.9% vs S&P 500′s 9.43% for the same period. It seems to me that their model certainly seems to be working. I would like to know your thoughts as well. Do you still believe it’s better to invest in VTSAX vs just shadowing AAII’s model stock portfolio?

    • jlcollinsnh
      Posted April 10, 2014 at 10:07 am | Permalink

      Hi VK…

      Glad you love what you are finding here and hope you continue to read more.

      This post is really at the core of what I believe and discuss here. It is not just my opinion, but the conclusion of an ever increasing body of research. Even Warren Buffett, perhaps the best stock picker of all time, is on board with the concept of indexing.

      I am unfamiliar with the AAII model you mention, but there are countless investments out there striving to out perform the market. Some do for some periods of time, and they are endlessly creative in presenting their track records in the most favorable light.

      But every prospectus carries this warning: “Past performance is not a guarantee of future results.”

      The are both the truest words in these documents and the most ignored.

      It is easy to look back and find the funds and portfolios that have outperformed in the past. It is impossible to predict which will do so in the future.

      That said, it is great AAII has worked well for you so far and I completely understand the temptation to continue. It just seems so reasonable. It took me years to accept how vanishingly difficult it is to outperform the market and how rare and fleeting those that seem to are.

      For more, check out my story of CGMFX at the end of this post: http://jlcollinsnh.com/2011/06/14/what-we-own-and-why-we-own-it/

      Good luck!

  4. Posted July 8, 2014 at 7:21 am | Permalink

    Hi Jim,

    I’ve been reading your blog for a number of years but this is my first comment. Thanks for all your efforts.

    This is a great topic and rarely discussed. I have a few personal theories that others may or may not share. I would agree that the external stock price is almost completely unpredictable as it depends on the market participants and their level of the analysis of the company. For example, if they have done a great deal of analysis you would expect closer tracking between the quoted stock price and internal earnings than if the market participants just rely on staring at meaningless charts and momentum following. I also think that if the company pays a sizable proportion of it’s profits out as a dividend you would expect a stronger coupling between what’s happening internally on the financial statements and the external stock price.

    For an investor that is concerned primarily with receiving growing dividends (I don’t see the point in stocks that don’t pay me), the unpredictable stock price growth can become an irrelevance as long as earnings are growing internally and cash flow is fine. It is possible to geometrically predict (The rarely discussed “T-model”) the growth of both the internal earnings and external dividend to an extent if a certain amount of stability can be assumed in the financial statements. For example, a P/E of 10 and a 50% payout ratio should lead to a 5% dividend payout and 5% growth in equity, and hence 5% growth of the dividend (assuming further re-investment in the business does not hit diminishing returns) each year as a rough estimate. Obviously the next year may not be exactly the same, but concentrating on how much earnings you are buying and the dividends rather than the stock price behavior is a much more predictable animal. I like to have a reasonably stable “base” income from dividends whilst still allowing to reap additional (though completely unpredictable) capital gains for further rewards if the stock gets bid up beyond reason. I only sell then if I think I can buy more earnings and dividend payout with an alternative issue.

    • jlcollinsnh
      Posted July 8, 2014 at 9:56 am | Permalink

      Hi e2f…

      and welcome. I’m honored to hear you’ve been a reader for the past few years – hard to believe I’ve been doing this for over three years now! – and I’m glad you’ve chosen to comment.

      If you’re interested, here’s my take on DGI: http://jlcollinsnh.com/2011/12/27/dividend-growth-investing/

      Are you planning to attend FinCon this year? If so, maybe we’ll have a chance to meet.

      • Posted July 9, 2014 at 4:43 am | Permalink

        Hi Jim,

        Thanks for the other link. I also like the Dividend Mantra blog. Not sure I can make FinCon as I am in Japan and have an old house to restore this year. But would be good to share more ideas. Sorry for the long post, but here are some further thoughts on your “Dividend Growth Investing” article:

        Point 1. With vanishingly rare exception Index Investing bests all other methods.

        I think that the pros can’t do active investing because of both the size disadvantage and career risk. Whilst it is not common, I believe active investing possible from what I have read and from my own experience. See “The Superinvestors of Graham and Doddsville”. This was Buffets excellent rebuttal of efficient market theory. It’s an amusing (and short) read talking about how all the Graham students did well beyond the odds.

        It is possible to find very good returns in the market but easier when small cap companies are considered. This rules out the big guns and massive funds as they have too much scale to invest in those small companies. I also think most studies on the subject recommending ETFs have only concentrated on professional funds, whos size may still be too large. The financial industry would also have a vested interest to push “passive investing” and they fund all of the university professors! The only Economists I believe are not frauds are from the “Austrian School” which was the economic thought before the Keynesians took over around the 1960′s.

        For mass market, where the majority of society needs to invest, I agree the only possible way is with index funds. Active investing is not possible if your scale is too large and moves the market for particular stock. This must be true by definition, because the mass market is basically all of the investors, but if you succeed in purchasing under-valued securities then those must have been sold by others at too low a price. It’s a zero-sum game and there unfortunately must be winners and losers. The winners have done the most homework. If everyone has to invest, then it must be sub-optimal as they will have to buy an index containing both overpriced and underpriced companies.

        Point 2. Taxable event. This is of course OK if you are already retired. But very difficult if you are working at the same time in UK, US or Japan where taxes can hit over 40%. Some other more economically free countries (Hong Kong or Singapore) do not tax dividends. As a result companies in those countries tend to have higher dividend payouts. In those countries dividends of up to 8% are quite common even for large REITs as of 2014. The financial press in those countries is entirely less useless than in the west.

        I think the trend towards high taxes on dividends in the western countries has resulted in a great decoupling between the stock price and financial statements due to the loss or reduction of dividends for the most part over the last 50 years. Books in the 1940′s emphasized dividends a lot as “proof” of real profits not suspect to accounting shenanigans. For example Graham and Dodd’s “Security Analysis” is an easy read and makes a lot of sense rather than modern books mentioning the “efficient markets” mumbo jumbo that seemed to arrive around 1950.

        Point 3. Dividends do cause a reduction in company value.

        This is true, however consider that:

        – It is necessary to have some income to live off. Selling when others are fearful is bad.
        – Dividends are more stable than stock prices.
        – Dividends paid in a time of turmoil allow you to re-invest at fire-sale prices.

        In some cases, it may not be possible for the business to expand easily (marginal return of further investment in the capital of the business is less than the existing return from the business) in this case it is better to pay out all the profit to the shareholders. I think this is referred to in the “Security Analysis” book. It discredits the “empire builders” who want to re-invest all of the profits back into the business on grand (but possibly unproven) schemes to grow the company. This might be better for their self aggrandizement but if it lowers the average ROE it was a poor decision for the shareholder. Some business should just stay the size they are.

        Dividend Mantra’s comment perfectly reflects my previous post thinking regarding using the T-model to predict returns: “The extreme gyrations do not affect my steadily rising dividend checks.”

        Regarding your comment: “The price you pay is lower potential growth.” That is true, however if the company that paid out that dividend still offers the best return for you, then you can still buy more of their stock with the dividend and create growth this way from all of the profit (paid out plus retained). You have a choice, unlike if all of the profit is retained.

        As I understand and agree, the issue of dividends getting taxed at a punitive rate of income tax is an enormous problem if you are working as an employee, and don’t live in Hong Kong or Singapore. In this case I do understand the argument against dividends. Unless you can ship all your capital to Bermuda using a yacht full of gold bars :) Most of the elites in the US have probably taken such measures.

        I think given two companies of otherwise identical financial ratios, the one with the larger proportion of profit paid out as a dividend should have a better correlation between what the financial statements say and what the stock price does. The one without a dividend will have a looser “coupling”. But in the end even a company with no dividend should have the stock price converge eventually due to other events such as corporate takeover, which should force the true worth to appear in the stock price as highly numerate individuals are involved in those deals. It’s just that it will be more of a wild ride and could take many years. And during that time you can’t collect any benefit if the market goes the wrong way, even if internally everything is good with the company. So if you have already retired switching from non dividend paying to dividend paying stocks seems like a good proposition.

  5. Posted August 12, 2014 at 5:39 pm | Permalink

    Great Post Jim. I think you’re right for the most part. You either have to be fully diversified and hope that the market goes your way. If you are going to invest actively, you must spend quite a bit of time doing it and just make really good investments.

    I’ve done a fairly good job over the years but I wouldn’t call myself a market sage. Often times I’ll go years between investments where its sitting in cash or liquid bonds. I think the key is to make a few good investments and watch those investments very closely. Warren Buffet has said something to that effect, I think. So I’ve found that its best to invest in what you know in and with as much as a margin for error as possible so that when you’re wrong you’re THAT wrong. Keep in mind that I spent 4 years in college learning about investments then preceded to work in the Investment banking business for 2 years after college. So for the average Joe, you’re probably right.

    It seems like as time goes forward that there are fewer and fewer gems in the public market. The market for private equity seems to be gaining momentum and due to regulatory restrictions a lot of companies don’t see the benefit in going public. I’ve found that most of the good investments in public markets now come from special situations with overzealous selling in the market with a short time horizon outlook.

    There’s still hope for getting decent returns in the Public Stock Market, it just might not be as “easy” as it was in the past with less asymmetries of information(proliferation and speed of information spread through the internet) and the rise of private equity markets.

    That being said, I love your blog and found it through a manifesto quote you posted on Mr. Money Moustache. Thanks for all the insight, love your writing.

2 Trackbacks

  • […] They give you the best returns with, using an index fund like VTSAX, the lowest effort and cost.  Never try to pick individual stocks unless you turn pro.  Even then you likely will underperform the index.  Most pros […]

  • By Picking Winning Stocks on July 10, 2014 at 11:40 pm

    […] Why I can’t pick winning stocks […]

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