Stock Picking Fails

Humans, and there creations, fail dearly when it comes to picking individual stocks. Nature created us for survival and as such we are emotional and worst of all, overconfident. We tend to remember events that where pleasurable, such as winning in a trade, and forgetting all of the times where we lost. This is the reason why humans love to gamble and why picking stocks is so appealing to investors.

When investors pick individual stocks they are attempting to beat the averages. If you where to interview every stock trader on the planet a great majority of them would say they have beaten, and will continue to beat the market averages. Just like the average person rates themselves as a good driver the average trader will rate themselves as a good stock picker. After all, if they are not beating the averages then why are they trading stocks?

Unfortunately for the trader and the drivers it is mathematically impossible for everyone to be above average. In order for an average to exist there must be those that fail to meet the middle point and those that exceed it. No matter the trading system you are employing there are others on the other side of trade. One of you is going to come out ahead and the other is going to be the loser.

Many investors fall into the trap of attempting to find some magic formula that will help them beat the market. These investors will invent trading systems that rely on P/E ratios, P/B ratios, dividends, technical analysis, or some other combination. Other traders will rely on news letters, CNBC, or online chat rooms. Then there are the professional managers that have access to equipment and supercomputers that we can only dream of. For every one of these traders mathematical law still applies; some of them will be above average and some will be below average.

Imagine for a moment that a trader beat the averages and did well in any given year or perhaps a few years. What are the odds of them continuing to beat the averages? Does this stock picker have some underlying strategy that the millions of other traders don’t? Perhaps they have found some mystical holy grail and it will make them rich. This does not seem very likely to me.

There are always going to be some individuals who manage to beat the averages-- at least for awhile. Just like you may win in Vegas eventually the house is going to catch up with you. While you are winning you are going to get to pay a special tax to Uncle Sam. It’s called the short term trading tax and it’s based on your marginal tax rate. You also get to pay any trading costs, spreads, ext. Hopefully you are beating the market by a big enough percentage to cover these extra costs or you are simply wasting your time.

As time presses on and a trader picks more and more stocks they will inadvertently get closer and closer to average. Just like when flipping a coin you may actually flip 50 heads in a row. However, over the course of a few thousand flips the average is going to get closer and closer to 50 / 50. Unfortunately, as the stock picker gets closer to average they end up under performing as they had all those extra expenses to pay. This is why stock picking fails. The only way to invest is to simply use index funds and forget about it.