Investing advice: Just enough information to be dangerous

by Pop on November 12, 2010

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You’re never going to learn to invest in individual stocks from reading this blog.

Says the beginning of a Wall Street Journal story today: “Forget ‘buy and hold.’ It’s time to time the market.”

Awesome. That’s the kind of provocative, yet easy to knock down, straw man that blog writers salivate over. I could pull up dozens of market-timing studies that show how much investors suck at it. I could make my oft-repeated argument that even though value investing should work, in practice, we’re too emotional to make it work.

This time I want to tackle something different, that is, the actual strategies people use to pick stocks and sectors. The WSJ story talks about a few common ones, such as picking companies with high dividend yields and low price-to-earnings ratios. They’re easily to calculate—but hey, why bother? Just look them up on Google or Yahoo Finance.

The truth is, they’re not a bad place to start. But how would you actually do by following any of these strategies?

Good investment or bad investment?

Let’s play a game. I’m going to describe a company stock from a few years ago using some favorite investor metrics, and you guess “good investment” or “bad investment” over the next three years.

Company A has a P/E ratio of 8. That means you could buy a share of its stock, and get a whopping 12.5% earnings yield. It also has a 2.4% dividend yield. The stock just lost a huge $30 billion in market capitalization, which means investors are running for the hills. But as Warren Buffett says, we’ve got to be greedy when others are fearful, right?

Company B has a P/E ratio of 23. It has no dividend yield. The stock’s risen 22% in the last four months. Pulling from the second part of that Buffett quote, you’ve got to be fearful when others are greedy, right? One of its main lines of business, insurance, has benefited from a spat of very good weather, keeping its profit margins high. But that hurricane’s got to come sometime.


Company A was Merrill Lynch. You bought at about $60 per share. If you held on until it was sold to Bank of America, you would have gotten out at about $29 per share for a 50% loss. Honestly, you would have been lucky. That deal, which was a 70% premium to its market price, left a lot of investors scratching their heads. Had Bank of America not stepped in, Merrill might have ceased to exist in a few days.

Company B was Berkshire Hathaway. You bought at about $99 per share (split adjusted for the B shares). If you’re still holding on, it’s worth about $80 per share now. It’s a 20% loss (hard to find a company that hasn’t lost money since 2007), but not nearly as bad as what you would have experienced with Merrill.

The other thing the companies had in common was that they were picked as two “Best Stocks for 2008” in Fortune Magazine. I don’t mean to pick on that reporter. Pretty much the only way he would have been right was if he wrote “None of them!” in big, capital letters.

Knowing just enough to hurt yourself

Based on traditional rules of thumb about dividend yields and P/E ratios, Merrill should have been the better buy. Alas, it was not. Is that really all that surprising?

Say your brother came to you and asked you to invest in his business. He said the business was making $10,000 per year, and he was willing to sell you a piece for $100,000. He’ll pay out $5,000 per year to you and other investors. That’s a P/E of 10 and dividend yield of 5% for your $10,000 investment.

OMG, give me a million shares, right? RIGHT?!

Well, no, actually. You want to know more about the business. Who are the competing stores nearby? Does he owe the bank any money? Are sales growing? Falling? Who else is running this business with your brother? Do they have good character? And on, and on.

Investing that much money based on a simple investing strategy in your brother’s business seems crazy. However for some reason, we don’t blanche when just a couple simple metrics are used to determine investments in the tiny pieces of companies that we call stocks.

That WSJ article from the beginning of this story? Its given “strategies” include to buy stocks that have boosted dividends lately and to buy the 10 largest technology companies by market capitalization. Those are easy to package and write about. But an investment strategy? That’s taking it a little far.

The real problem with learning about investing

Which leads us to the real problem that a little information creates: Overconfidence. Before you started reading Pop Economics and the Wall Street Journal and SmartMoney and all those other sources that teach you just a little bit about investing, you didn’t know anything about stocks, and were willing to cede control to index funds or a financial advisor.

But now, you know something about stocks. It’s like a teenager learning to drive. When he was 3, he didn’t know how to turn on the car. Now that he’s 17 and behind the wheel taking lessons, is that car more or less dangerous to him?

So anyway, all that’s to say, read PopEc at your own risk. I hope you come away from most of my posts with a new understanding of how much you don’t know. I know that’s how I feel after writing them. Heck, I don’t even remember what this post was about.


{ 3 comments… read them below or add one }

Rob Bennett November 13, 2010 at 10:12 am

I agree with you 100 percent on your essential point, Pop. The humility you express in this piece is wonderful. And it is not only nice to hear. It is right. You really do not know it all. And of course neither do I. And of course neither do any of the “experts” quoted in the Wall Street Journal and many other places.

There’s a problem though. We must invest our money in something. We must make choices. We cannot wait until some genius figures it all out. Sand is running through the retirement planning hourglass. What to do, what to do?

What has happened is that in the past 30 years one group of “experts” has not followed your great example of humility but has pretended to know things with great confidence. This group is the Buy-and-Holders. They claim that “You can’t time the market!” and that “There’s no such thing as a free lunch!” and that “Stocks are always best for the long run!” and they have directed hundreds of millions of dollars in marketing money to persuading people that these claims have something to them. Many of us have fallen for this stuff, to our great financial misfortune.

This is what has to change. We need a national debate on what works in stock investing. There are thousands of people, experts and ordinary people alike, who have some very exciting ideas to put forward. But we are not going to be able to hear them until things reach a point at which the Buy-and-Holders are able to acknowledge that they acted for a time like they knew a whole big bunch more than they really do know.

You’re humble. I’m humble. Lots of good and smart people are humble. But the Buy-and-Holders ain’t even a tiny bit humble. And the Buy-and-Holders have hundreds of millions of dollars of marketing money behind them. Until we find a way to get the message being delivered by those without the hundreds of millions behind them heard, things are going to continue in a downward spiral. You and me and the others who offer humble takes are not the problem!


Jan November 13, 2010 at 12:05 pm

Some of my things are buy and hold ( that means I will probably hold them for five or more years), some are quicker profits. I never really know which ones will be which.
Let’s take Ford and GM. When the market price of both of them went to Around $2 you could have bought 150 shares each. GM left the market and you lose $300. At this point you have made $2100 on Ford. You then buy a 1000 at $7. That gives us $9,000 profit if you sold today.
The Ford at $2 should probably always be in the portfolio. That makes it a buy and hold on that stock. If you sell the $7 Ford around $28.(my bet after the GM IPO) and gain around $21,000(Which would be a eighteen month year turn around) that is a timing thing. Both are stock picking.
I do Cramer’s buy and homework. We only sell long (unless we see something crazy happen and have to sell short or lose everything). We investigate our companies- management, sales, outlook for the future. It is daily work. The reason I refuse to do mutual funds of any kind is that they are so buy and hold- they fall flat when they should have gotten out. If you buy something with the idea that it will not be a good stock in two years- it was not worth putting your money in to begin with. Portfolio is up 15% this year (not counting November figures- I do my books monthly).

I am -coining a phrase- “getting rich slowly”. Diversify- house, stocks, savings and thinking of SS as the bonds:>)

PS- The Berkshire really took a hit when they bought BNI rail- THAT is what the dip was about- not the actual market.
In the long run- they hold assets and Merrill holds other people’s money. I will never hold a bank or a money holding company.

Robert @ The College Investor November 14, 2010 at 6:39 pm

I agree with you 100% as well. I think the one aspect that people miss most is asking themselves if they know “why?”.

Take the P/E ratio you mentioned above. The P/E ratio can be a useful metric for evaluating a stock, but you need to know the why’s behind it. It the P/E ratio low because of short-term negative news, or is it because the company is really foretasted to have bad earnings, or a declining business?

Take this into consideration whenever making an investment!

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