Investing advice: Just enough information to be dangerous

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.

Answers

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.

Tagged as: Investing, stock market