Now before we jump into #2, let me give a brief background on an important underlying and controversial theory (that is, it’s controversial in the finance world – we’re a boring bunch) that will come into play in this post: the Efficient Market Hypothesis (EMH). Simply put, the theory suggests that the financial markets are “efficient” based on the information exchange available in the markets. For example, the price you pay for a stock reflects all current information available in the markets for that particular stock, company, industry, and economy. The price you pay reflects the current / updated value of that stock. Three versions / degrees exist of EMH (stick with me, this may help clarify some more). The weak form of EMH says that pricing in the markets already reflects common information publicly available (historical prices, dividends paid, financial reports, analyst reports, etc.). The semi-strong form says that pricing in the markets reflects all common public information AND instantly changes to reflect new information (the word “instantly” is key here). The strong version of EMH affirms all of the others and also says that pricing takes into account “insider” information; i.e., information that is not made public.
There is debate on both sides of the table as to whether or not EMH has legs to stand on. For example, “if markets are efficient, how come we get ‘bubbles’?” An efficient market would never have “bubble” events if everything is always at an optimal point, right? At the same time, technology has opened up a whole new world for the flow of information and the speed at which market prices are updated. Traders (and computer programmed traders) can execute trades much faster. On the whole, it would appear that the market pricing reflects value much faster and more “up-to-date” – so we have reason to believe that markets operate much more efficiently with technology than without. There’s plenty more from both sides of the debate, but I won’t bore you here (if not already!).
Myself, I tend to believe some elements of EMH exist in the markets, but there is evidence that markets are not entirely efficient. So I take a little of both…
If you grasp the above theory a little bit, then these concepts will help you understand the following…
Now - on to #2 of the “Top 5 Things An Investor Should Know”.
#2: You Can’t Beat Wall Street at Making a Quick Buck
Make no mistake: the financial firms on Wall Street are some of the most sophisticated, smartest, and most motivated institutions on the planet. Big money is made daily. Financial firms of all kinds have thousands of Ph.D.s, CFAs (Certified Financial Analysts), mathematicians, and computer science whizzes on staff all concentrated on studying the daily movements of the markets, the minutia of company financials and industries, and the economy at large. They have some of the fastest and most technological sophisticated computers available with computer algorithms programmed to take advantage of mispricing in the markets within fractions of a second (ever heard of high frequency trading?). They also have tons of money available at their disposal in which to invest based on their conclusions. They have war chests solely for lobbying politicians and getting favorable legislation. They have former employees in government positions and they have former government employees on staff.
So, do you think you and I stand a chance of making a fortune by buying a stock that was mentioned in the Wall Street Journal, or on CNBC by the sensationalist talking heads, by a recommendation from a stock broker (who is probably recommending it to all of his clients), or even by buying one of those infomercial computer software trading packages you see on TV? PUULLLLEEZZZZ.
Odds are, if you are looking to flip a stock quickly and make a pile of money, you will lose.
Why? Elements of the efficient market hypothesis (EMH) would suggest that such a large number of professionals engaged in investing activities would move prices to an optimal level – and fast. If there are a ton of people engaged daily, hourly, minutely, in exploiting mis-pricings then prices in the markets are corrected quickly. Thus, the profit available in a stock has already been picked clean by the Wall Street vultures before you and I even get wind of the stock, not-to-mention buy the stock and hope to sell it quickly for a large profit. Understanding this, will save you time, energy, and money.
The age old investment advice you hear is: “buy low and sell high.” Even though it’s such a common thing to hear, it hardly rings true for the average investor. Most investors “buy high and sell low” because they hold out too long. Most of us buy a stock due to hype or a “hot tip”, see it go up, and then try to wring out just a few more pennies of profit before selling for a gain. However, it never happens. Instead we find ourselves holding on for just a few more pennies whereupon the stock crashes before it can be sold. Now we are too emotionally involved in the stock and hang onto it…hoping that it will go back up. Then the stock tanks further. Finally we sell defeated. Ironically, days later after selling, it recovers in a rally. Oh the irony. Oh the painful sting. The sickness in the gut. This happens over and over to people daily. Sound familiar to any of you?
Did you know that most common investors don’t even beat the average market returns?
Why?
Fear, Emotions, Anxiety, Greed, Herd mentality, Lack of long-term vision - all factors that typically contribute to selling low and buying high. Much of this is studied by those in “behavioral finance.” I won’t pretend to know much about behavioral finance, but what I can say is that there is a HUGE difference between you and I as investors and those on Wall Street making investment decisions. We operate on emotions and impulse; Wall Street operates on calculated planning and objective factors in their investing.
So what should the average investor do?
1) Don’t try and beat Wall Street at their game of fast money. Don’t think you can make a quick buck. For one, financial institutions have millions of dollars in the coffers to fall back on if a trade doesn’t pan out. You and I don’t have that luxury. A big loss can hurt us big and set us back. Trying to get rich quick, or build back your nest egg that was lost in the last two years in one shot increases your exposure to risk and losing even more. Understand that building wealth takes time. Trying to get rich quick will more than likely burn you…
2) It’s important to have a financial plan and stick to it for the long-term rather than let fear and greed work its way in. As I’ve mentioned before, turning off the TV sensationalist talking heads will help decrease your anxiety levels as well. Keeping an eye on a longer horizon will help decrease anxiety and allow you to make more objective decisions. Plus it will help you weather the storms that come along by allowing you to focus on the long-term goal.
3) Diversification is still one of the best ways to protect yourself and your investments. For example, holding a small handful of stocks only is a bad way to diversify. Better to hold some mutual funds or index funds across asset classes to diversify the risk.
I’ll go more in depth on some of these things in future posts. For now, suffice to say, don’t get caught up in trying to make a quick buck!
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