OK, here are the two most common investment mistakes that people make when investing:
Mistake #1: Using technical analysis as an investment strategy
Mistake #2: Buying an index fund (i.e. relying on the efficient market hypothesis) as your investment strategy.
The worst part? You could be making one of these mistakes even if you don't know what either of these two strategies are or what they mean. On top of that, they could end up costing you a ridiculous amount of money in the long run. Let me explain...
The field of technical analysis creates stock prices based on something they call "market psychology" and historical returns. Stock prices, according to the theory, cannot have anything to do with reality and are basically created out of the thoughts, feelings, and whims of investors. Technical analysis is based on three assumptions:
1. The Market Discounts Everything
Technical analysis assumes that investors (and the market) are inherently irrational. It also believes that all relevant information about a stock is reflected in the price of the stock. This makes the financial markets incredibly efficient. This only leaves the analysis of price movement. Technical analysts believe that the supply and demand for a particular stock in the market forms the basis of good investing.
2. Price Moves in Trends
The technical analyst believes that stock prices move in or follow various trends. This means that after a trend has been established in the financial markets, the future price of that stock is more likely to continue moving in the same direction that it has been moving and is less likely to break the trend and move in the opposite direction.
3. History Tends To Repeat Itself
A very important idea in technical analysis is that history tends to repeat itself, and that stock price movements can largely be determined by historical movements (called "trends" or "patterns"). The repetitive nature of the stock market is explained by something technical analysts call "market psychology".
Their explanation is that investors tend to provide a consistent reaction to similar market stimuli over time. Technical analysts use charts that contain a vast amount of historical market data to attempt to predict future price movements. While many of these charts have been used for over 100 years, they are still thought to be valid because technical analysis believes that historical returns can be used to predict future price movements in the stock market.
As investors, all we need to do is find the “right” pattern and trade on that pattern. The underlying premise, which is often unspoken, is that the returns in financial markets are already there, and will be there in the future (hence the idea that we can trade on a specific pattern or patterns). All we need to do is capitalize on them.
The Problem With Technical Analysis
There is no way to consistently trade on long-term patterns in the stock market and be profitable. The reason for this is that long-term patterns don't exist.
Every form of traditional technical analysis that uses data mining and historical returns to predict future price movements ignores cause and effect to the extent that it advocates trading on long-term patterns and a mushy or subjective idea of market psychology. No business, no company, exists in a vacuum or arbitrarily, and neither does the pricing of its stock. Technical analysts believe that each individual investor somehow comes up with their own price.
How do they do this? No answer is ever given. Whatever investors think the price of the stock should be is the "right" price - is what the stock is worth. This is what makes technical analysis subjective. Stock prices become an arbitrary creation of investors' minds. Whatever they want the price to be is what it is, and the most consistent practitioners of technical analysis will readily admit this. How the heck do you invest on this premise?
In theory you are supposed to find a "good looking" stock, buy it, and then hold that stock until it returns the kind of profits that you want. In practice, you are just buying what everyone else is buying. It's more or less like a dog chasing his own tail.
How do you make money? Simple. By buying what everyone else is buying you follow (and become part of) a trend. If the trend is up, you make money, if the trend is down, you lose money. In actuality, you are doing little more than guessing. You might make money, or you might lose money, but you are basically tossing a coin and hoping for the best. If enough people get together to buy the same stock and they are all guessing the same thing, does this make their pick "valid" or "right?" No, it does not.
Fifty million Frenchmen can be wrong. Reality is not subjective, and neither is investing. It doesn't matter how many people buy into a particular stock. The subjective feelings of 2 investors or 2 million investors does not determine the price of a stock. This kind of technical analysis encourages investors to trade on fictitious long-term patterns. But no such long-term patterns exist because historical returns are not predictive of future returns.
If technical analysis could be followed consistently, there would be no risk in financial markets and thus no risk in investing. But, what about technical analysts that seem to make a lot of money? The only valid form of technical analysis relies on observing phenomena in the financial markets but does not base its trading on long-term historical results or data mining.
For example: a savvy analyst may pick up on a very short-term pattern developing after discovering that many individuals get paid on Friday. This is more or less a behavioral phenomenon. The rational explanation for this is simple: people get paid at the end of the week and buy into the stock market through weekly contributions.
This happens via 401K plans or through direct stock or bond purchases. A savvy trader picks up on this idea because he notices that all of this buying causes a temporary rise in stock prices at the end of the week. The trader sees this, and then exploits it by selling off his positions or finding short-selling opportunities to correct the temporary distortion in the financial markets. By doing this, the phenomenon disappears which prevents any true patterns from ever forming. The reason for eliminating patterns is simple: the profit motive.
Traders make an incredible amount of money by finding and exploiting phenomenon before they ever become true patterns. When the phenomenon disappears, the monetary incentive to short-sell or sell off positions also disappears. Some alleged patterns are just a matter of clever data mining and reconstruction. The human mind can create order out of what seems to be random data.
Think about how an individual will often see images in clouds, the "man in the moon," or any number of other creative illusions formed from subjective thinking. With enough data mining and enough graphs, a "story" can be created out of the statistical data to make practically everything sound legitimate. All of this is an attempt to make sense of what is, in actuality, just a random set of circumstances, facts, and numbers.
This technical analysis - the "story" - can then be passed on to the lay person as a legitimate reason to buy a particular stock or mutual fund. When you try to apply this idea in real life, you are left with a completely nonsensical, and arbitrary, method of investing and trading. This “method” of trading gives you absolutely no answers, only questions which cannot be answered because they are unanswerable. Not because you are not intelligent enough to understand the reasoning behind it, but because there is no reasoning behind it.
All you have to do is look at the 95+ percent failure rate of technical forex traders and the non-existent profits of day traders to see that there's something very wrong with this investment strategy. My guess is that only a very small percentage of investors understand how to find and exploit emerging trends in the marketplace, and this makes perfect sense. If patterns were wide-spread, or easy to find, then the paradox would be that there would be no money in exploiting them. Almost by definition, an extreme minority are the only ones that can capitalize on this type of investment strategy making consistent profits for most people impossible.
The Efficient Market Theory or "Just Buy An Index Fund"
The efficient market hypothesis (EMH) says that no matter what you do, there is no way to beat the passive returns of the stock market. The theory holds that there is no money to be made by actively trading in the market. Less militant versions of this hypothesis simply say that it is so difficult to beat the passive returns of the stock market that it is impractical to even try...and that if you somehow do outperform the passive returns of the stock market, then it was a matter of chance or luck and not skill or ability.
That's why advisers who believe in the EMH tell you to just buy a low cost index fund. An index fund merely tracks the performance of a stock market index and doesn't try to do any kind of analysis. Low cost? What could be wrong with that? Read on dear visitor...
The efficient market hypothesis is an idea that is largely harbored in academic circles and it is based on one fundamental idea:
1. Stocks Reflect All Available Information In The Marketplace
The underlying premise of the efficient market hypothesis is that the value of the stock is somehow "in the stock", that stocks have "intrinsic value", a 'true" value, or one "correct" value which is determined instantaneously as new information becomes available to the market. Because of this, there is really no way for investors to outpace the returns of the broad, underlying, index that that stock belongs to. So, for example, if you were investing in a stock that was listed on the S&P500, you would be better off just investing in the broad index (through an index fund, for example) because you will never outperform the collective stock market.
This view promotes the idea that the stock market is always right, and that's why you cannot "beat the market".
The Problem With The Efficient Market Theory
The efficient market hypothesis is correct in assuming that stock prices are sensitive to information. They are. Stocks (and all other investments) are affected by information relevant to the investment. But, just as with technical analysis, the efficient market theory is also arbitrary in the pricing of stocks. The reason for the automatically correct and instantaneously self-correcting stock market is unknown and unknowable. It apparently "just happens."
There are three false assumptions being made in the idea that markets "automatically" or "instantaneously" adjust to new information:
- The outright assumption that stocks are somehow priced instantaneously, leaving no room for profit from active trading. False. There is always a time delay between when information comes to the market and when information can be acted on. Buildings are not built instantaneously, iPhones are not created instantaneously, and research-particularly stock research-does not happen instantaneously.
- The idea that markets reflect all information. False. Stocks do not reflect all available information. Why? This is partially due to the illegality of insider trading, and various Government regulations. For example: If Warren Buffet traded on inside information about Berkshire Hathaway, he would be promptly arrested. Since insider trading comes with severe civil penalties of 3 times the amount of money gained or loss avoided, fear keeps many CEOs and insiders from investing on their information. And, this inside information does not get reflected in the price of a stock-at least not immediately. In other words, the stock market does not reflect the most informed traders. The most informed traders are kept from investing on their information which effectively prevents their information from being traded on by other investors.
- The idea that people like Warren Buffet are just lucky, and have no influence on the passive returns that other investors receive. False. Someone must be actively trading for those index mutual funds to work properly. There must be someone there to make the market efficient because markets don't exist without investors and traders. If someone is selling stock for $23 and someone buys it for $23, then the price is made at $23. If a seller offers stock for $23, but negotiates with a buyer and sells for $20, then the real price of the stock is $20, not $23, because the stock actually sold for $20, and reality is what it is regardless of anyone's thoughts, wishes, or desires. The seller may have originally wanted to sell for a higher price, but did not. The seller, however, wasn't forced to sell his stock lower. He agreed to do it-voluntarily. It was the two participants that came together and agreed voluntarily on the price that made the price what it is. And this principle of trade (the trader principle) is what makes the stock market efficient.
It is the people exploiting the small developing patterns, the individuals acting on new information as it comes to the market, it is the savvy investors who are willing and able to buy and sell stock based on that information that creates the efficient market. In short, the reason the market is efficient is because there is money to be made, not because there is not.
If the efficient market theory were valid, then there would be no incentive for anyone to buy any stock because there would be no opportunity for profit. Additionally, if there was no profit to be made by selling, there would be no incentive for an individual to sell their stock. There would be no reason to invest in the stock market, and quite possibly no way to do it-not even in an index mutual fund which would be holding stocks in a stock market where no one would be willing to sell because there would be no incentive to do so.
There would be no functional stock market. Incidentally, the efficient market hypothesis encourages its practitioners to "buy and hold" stocks perpetually since the theory holds that active investing is fruitless. But, because of active traders making the market efficient, and because of natural (and also often unnatural) business cycles, this has also led many adherents of the efficient market hypothesis to have their investment portfolios wiped out during a market correction.
As a somewhat recent example of this, witness the amount of money index fund investors lost during the stock market crash of 2008. Investors had literally 10 years worth of investment returns completely erased because of this investment philosophy.
Where Do You Go From Here?
Investing is tough but it's not impossible. Getting a good education in this area is pretty much required if you have any kind of long-term savings goals. Fortunately, some very good stuff has been written, tried, tested, and proved. Two awesome books on how to invest are: Common Stocks and Uncommon Profits and The Intelligent Investor. Even if you do decide to go the index fund route, these books will go a long way to help you time the market so that you can actually enjoy the money you've earned (and avoid a 2008-like disaster in the future).
I know this was a long one, but I hope it was helpful. Hit me up in the comments and let me know if you've read these books, how they changed your view of investing, or whether you're struggling and still trying to find your bearings._________________________
This entry was posted on July 9th, 2012 by David. Edits may have been made to keep this entry current. · · No CommentsInvesting