Most investors are, and always will be, confused about stock investing because stock investing is and always will be confusing to most investors.
The Market Price Inherently Suggests That Every Stock is a Hold
Investors want to buy stocks that will rise and sell stocks that are about to fall. But every investor and analyst that looks closely at a stock tends to have a different view of whether the stock will rise or fall. For any given stock at any given time a large group of people own the stock and are not selling because they think the price will go higher. At the same time the vast majority of investors do not own that particular stock and are not buying – because they don’t think it will necessarily rise in price very soon. On any given day for every single share that is bought – because someone thinks it is a good investment, that same share was sold by someone who did not think that stock was the best investment at that point in time and preferred to cash out.
In this way the market is always in theoretical equilibrium and the average opinion is that each stock is neither a buy nor a sell. If the majority of investors believed that a particular stock was a buy (sell), the price would quickly rise (fall) to bring it back into equilibrium.
The market price is inherently neutral and therefore provides precisely zero information on whether any given stock is a buy or a sell at any point in time. It will therefore always be hard to identify winning stocks in the market.
Furthermore, investors are confused because they are bombarded with contradictory information. Most sources of investment advice are inherently biased and have a conflict of interest. Most investment advisors are really salespeople and most frankly don’t know what they are talking about. They often have little business and finance education. Clearly there are exceptions, but the model is that they usually get paid to sell things, not to give good advice as such. A successful investment advisor must be a good salesperson but true fundamental knowledge about the market is probably more of a hindrance than a help to a typical investment salesperson. After all, a truly intelligent salesperson would probably have trouble flogging stocks in an over-heated bubble market, since they would know that poor returns are likely. The less intelligent salesperson would have an easier time to keep on selling.
Frankly, I have always thought that a very high academic type of intelligence would be a big hindrance in selling most products. It’s far more effective to thoughtlessly and flawlessly pitch the company line, then to start thinking about whether the company’s products are really any better than the competitors. I suspect that top salespeople are highly intelligent but not likely in a traditional academic sense (with some exceptions of course). They probably are highly intelligent in terms of human motivations and emotions. Count on an investment salesman to make you feel good about your investment, but don’t count on him to really understand what he is selling or what the return is really likely to be.
Stock Analysts Are Taught Completely Contradictory Theories
According to the efficient market hypothesis, every stock is essentially always already at an efficient price. The most efficient portfolio, according to the theory, is to hold an index fund of the market portfolio. Furthermore the theory states the only efficient way to beat the market index (over the long term) is to add leverage by borrowing money. This theory suggests that a stock portfolio selected by an expert is no better, on average, than a portfolio picked by the proverbial dart-throwing monkey.
Stock analysts are taught this efficient market theory. But paradoxically they are also taught about picking stocks based on momentum strategies, chart analysis, fundamental analysis and so on. A Charted Financial Analyst is required by the code of ethics to have a “reasonable basis” for recommending that any stock be bought or sold. But if the efficient market hypothesis is true then this is nonsense – every stock is a hold and none are buys or sells, so any stock could be bought or sold with impunity – no reasonable basis would ever be needed.
Stock analysts are also taught that under the Capital Asset Pricing Model, the only thing that matters is how a stock tends to move with the broader market. They are taught that all company-specific risk and events should be diversified away in a broad portfolio. But paradoxically these same analysts are also taught to analyst company-specific items. Almost every stock analysts spends their life acting as if the Capital Asset Pricing Model is completely false.
Many stock analysts end up being confused by the contradictory theories that they have been taught and end up just as confused as the average investor. And most individual investors are in no way equipped to do their own analysis. Therefore confusion reigns supreme.
Lots of Noise – Little Signal
Many investors are aware that the long term trend of the market is up. Buy-and-hold should work in the long run. However, consider that the average annual increase in the DOW Jones Industrial Average Since 1929 has been 11.3%, but the standard deviation, of the annual returns, has been 20%. This means that in 2 years out of three, the return has been between about negative 11% and plus 31%. And in the third year it was either lower than negative 11% or higher than 31%.
What this means is that, although there has been an overall rising trend in the market of 11.3%, there has been one heck of a screaming lot of noise around that average. This creates confusion.
The market also exhibits two contradictory trends. First it does tend to have some momentum, if stocks went up last month there is generally a greater than 50% chance that they will go up this month. However, in the long run, the market tends to return back to its long run average growth of say 11%. This means that if we get a series of fat years with very high returns, it is absolutely inevitable that this will be followed by some lean years with low returns so that the long-run average can come back to say 11%. The long-term return on stocks is fundamentally tied to the real rate of growth in the economy plus the dividend yield. The problem is that no one can predict how many fat years we will have before the lean years inevitably return. It’s a bit like a world where night inevitably follows day – except that the length of the days and the nights are completely random and unpredictable. In this world we know that the days will average say 11% longer than the nights but with a huge amount of variation. In this way the underlying tend of stock market growth is almost obscured by random noise. In engineering, this is termed a high noise-to-signal ratio. Again, confusion reigns.
To make matters even more confusing, the long run return of say 11% tends to change slowly over time and is dependent on inflation rates and technology improvements in the economy. Today, many observers believe that the long-run average return is lower than 11% due to low inflation and a slowing rate of real growth in the economy.
Conclusion
For the reasons stated above and for many other reasons, the movements in stock prices are inherently confusing.
The bottom line is that investors are confused because investing is inherently confusing. It always has been and always will be.
Solution:
There are some education sources , including this site, that are intelligent and independent. Investors need to seek out advice that is grounded in logic. Strategies that focus on analyzing underlying businesses rather than on reading chart patterns are likely to be more successful in the long run. Warren Buffett’s success is the best example of that. By focusing on fundamentals and mostly ignoring the day-to-day movements in the market, a lot of the confusion can be avoided.
Shawn Allen, CFA, CMA, MBA, P.Eng.
President
investorsfriend inc. July 12, 2003