How does one pick stocks?

April 25, 2006 4:40 PM

I'm seeking advice on and a short term investment strategy that won't offend Grandad.

My Grandad has offered me some money to invest over a 12 month period. I can keep what I make in excess of interest. He's made it implicit that this venture carries no financial risks for me (I trust him fully). It's clear he mainly wants this to be a teaching and bonding experience for us.

So far, so good: this is a generous offer, I'm keen to have this experience with him, and the last thing I want to do is appear ungrateful. However, he has in mind that I should pick a few stocks and sink the money into them exclusively.

I plan on going along with him on this in spite of what I think I know of the market. I'm pretty sure I understand random walk theory, that short-term stock picking generally comes down to luck, but I know he believes and behaves otherwise. He's a restless investor, always going into this and out of that.

I don't plan on arguing with him over this after he's been so generous, so a sensible mix of funds/indices/bonds is out. With this limitation in place, how can I best promote my own gains and protect him from any loss?

How does a complete beginner pick a stock? He seemed to imply that he'd just give me the money and I should set up an account with a broker or something. Is that a sensible way to go about it?

I would be in the US, while he's in Belgium. Any implications from being in different markets?

posted by godawful to work & money (41 answers total)

For a 12 month investment, you really do just want to buy and hold, unless the wheels fall off. Specifically, you want to hold for 366 days.

Reason being, you're going to be taxed 20% of gains if you sell at one year or less, or 15% if it's a day longer than that. (If you're very low income, change those numbers to 10% and 5%.)

Another reason to go for a buy and hold strategy, every time you make a trade you pay several fees. The obvious fees are the transaction charges on the purchase and the sale. The hidden fee is the bid/ask spread that silently sucks a tiny of value from your investment.

I'll leave stock picking to somebody else. The Motley Fool has a ton of info on basic technical analysis and what not, but given that everybody knows how to do basic technical analysis, I wouldn't expect to get far riding that train.

I'd also suggest that if he's giving you a large sum, that you take it in installments, and try to study investing, and try to make one good pick at a time, instead of trying to pick six different quality investments all starting from day one.
posted by I Love Tacos at 5:12 PM on April 25, 2006 [1 favorite]

Oh, and if you want to invest in alternate markets from the US, the easiest way to do this is via ADRs.
posted by I Love Tacos at 5:13 PM on April 25, 2006

So, do you have to sell at the end of 12 months? Suggest to your Grandad that you should keep the difference between the rate of return on your investments and short-term interest rates for the life of the investment.

If you have to exit the investment at the end of 12 months, well, I don't have any prudent advice. So all the following information should be consider irresponsible activity...

Maybe you can get a cheapo online brokerage account and gamble on bankrupt OTC stocks. They're mostly illiquid, but you can luck out and buy something at $0.50 and see it go $2.00 the next week (or the opposite, of course). But I think most of the people driving the activity in these markets are trying to do exactly this. Perhaps going up market and buy exchange traded stocks after bad news hits the wires - the hope is that the initial negative reaction is an overreaction and the stock rebounds quickly. Or try to buy shares just before a quarterly-earnings announcement with hopes that the earnings are better than expected - you'll get a quick bump in price.

You probably don't have the option, but you'd increase your potential returns if you had a margin account and could leverage your investments. You could also short sell - a lucrative strategy could be short-selling stocks after a merger announcement if you don't think the transaction will close. The stock will trade up near the purchase premium, but if the merger fails it will fall back down. You could make the merger arbitrage the other way too - the stock won't trade up all the way to the premium, so if the merger closes you will get the extra bump, but this is less risky and therefore less lucrative.

You can do all sorts of risky shit with options and futures. But you'll have to figure out how to get an account (the NASD is supposed to make broker-dealers verify that you are a knowledgeable investor before allowing you to trade options or take on leverage).

Hmm...what else? Can you buy tax liens from your local tax office?
posted by mullacc at 5:21 PM on April 25, 2006

The number of stocks you need to actually effectively hedge your risk is pretty low, on the order of 10 or so (if they're well diversified and such). If it's a large enough lump of money, buying, say, 10 random mid-caps might not be a bad idea. (If the lump of money is smaller, brokerage fees will eat you alive.)
posted by raf at 5:25 PM on April 25, 2006

how can I best promote my own gains and protect him from any loss?

Whoops, I missed the second part of that sentence. Nevermind me.
posted by mullacc at 5:25 PM on April 25, 2006

I hear the best way to go about it is to buy when the price is low, and then sell when it's high. Some people prefer to buy high and sell higher, but whatever. Maybe look at some ETFs for a compromise between index funds and individual stock picking.
posted by sfenders at 5:27 PM on April 25, 2006

I really can't imagine recommending that he mess with futures and options, given that his current investment knowledge consists of the random walk theory.

Personally, I don't believe that theory holds outside of non-news days, and very short-term periods. One analyst changes his rating, and the next hour won't be random.

It might be a good educational experience if he tried doing one investment of a certain type each month, just to try to understand each one.

As for stock picking, you're trying to see into a companies future. If it was early 2004, and you really believed that SUV-based business plans were absurd, and that Toyota had a better set of automotive options than the american manufacturers, then maybe you'd buy a Toyota DR, and either short Ford and GM, or buy a put on them or something.

Sadly, it's not early 2004 so you can't do that one, but what do you see happening in 2006? Have some fun, and put your money where your mouth is.

Oh, and don't try to juggle more than a half-dozen investments. You won't be able to track 'em with any level of accuracy.
posted by I Love Tacos at 5:38 PM on April 25, 2006

I didn't recommend messing with futures/options. I said it would be irresponsible - but it would be a way to take on a ton of risk in hopes of getting lucky. I missed the part where he wanted to protect his Granddad's downside.
posted by mullacc at 5:49 PM on April 25, 2006

How to pick stocks, the easy way: find some solid company, with a low price compared to its growing earnings, with not too much debt, strong cash flow, and excellent management, in an industry that's currently out of favor but which you expect to do well in the next year. Study it for a while to see how it trades, and then buy some when the price is low. Then, wait until you get stopped out, and try again.
posted by sfenders at 5:51 PM on April 25, 2006

I plan on going along with him on this in spite of what I think I know of the market. I'm pretty sure I understand random walk theory, that short-term stock picking generally comes down to luck, but I know he believes and behaves otherwise. He's a restless investor, always going into this and out of that.

Talk, Talk, Talk! Spend as much time as you can talking to your grandfather and learning about his suggestions.

Your investing strategy depends a lot on your goals for the money. Older people are generally less interested in increasing their pile of money than they are in either generating enough interest or dividends to live off of, or just preserving their capital. Younger people who are employed can afford to take more risks. If their capital gets wiped out, they just work harder, save again, and repeat the investing cycle until they hit a good investment. Check with your gandfather to see what he thinks about age-related strategy. Does he think you should be taking large risks, or just making some interest?

If you are going to engage in a buy and hold strategy, as some people have suggested, then be sure to pick a stock that has low volatility. That is, a stock where the price doesn't change much from day to day but does tend to slowly move up.

If you look at a stock like MSFT, you will notice that it often makes larger up and down moves in a month than it does in a year. A buy and hold investor would want to avoid such a stock. A more aggressive momentum investor might try to buy MSFT on the dips and sell on the peaks. Experienced momentum players know that it is much safer to buy just after the dip, and sell just before the peak. There are charting techniques that can help you to do this. It isn't particularly difficult, but you have to carefully filter your stocks first.

Regardless of which strategy you prefer, spend some time at clearstation. They provide a small but very useful set of technical analysis tools. Their toolset should be more than sufficient for your project, and they won't confuse you with esoteric or just plain useless indicators.
posted by b1tr0t at 6:00 PM on April 25, 2006

how can I best promote my own gains and protect him from any loss?

Take on small positions, don't use any margin and learn about things like modern portfolio theory. I would normally recommend Fooled by Randomness, but that book is more about psychology and managing traders than it is about specific investment advice. The investment strategies Taleb does suggest are more appropriate for large funds than for individual investors.
posted by b1tr0t at 6:04 PM on April 25, 2006

mullacc: I didn't do a full-thread preview before I posted, so I didn't see your retraction. My first thought was "well that's great, if he wants to maximize his personal expectation at grandpa's expense..." :-)

b1tr0t's ideas for more complex trading concepts are great, though I'd suggest starting off simpler. Start off by putting a bit into a reasonable buy and hold, and then learn more about what the indicators actually mean, and learn how to evaluate them.

An example of an indicator that could confuse a novice: Priceline's P/E ratio is currently 5.79.
posted by I Love Tacos at 6:08 PM on April 25, 2006

The equity slices of Spanish residential mortgage backed securities (RMBS) - levered say 20x. Just call your friendly Goldman Sachs sales guys and ask to speak to "Prime Brokerage." Lever your capital on your own first before you call him. You can't go wrong. Actually hold that - is there a chinese ABS market yet? do it there. Just think about it if you earn 10% on your total capital you too can be up 400% if you borrow enough money.

In all seriousness 1 year is luck no matter what. You could bet on what worked last quarter working for the next 12 months so just buy anything that's up a lot. The more risk the better. Alternative energy, oil related steel. Literally anything with lots of price momentum. Don't worry about business models or valuation. Just believe.

You might get smoked, or you might make a ton of money. Pretty much a coin flip though no matter what.
posted by JPD at 6:19 PM on April 25, 2006

To be serious for a moment:

"If you look at a stock like MSFT, you will notice that it often makes larger up and down moves in a month than it does in a year. A buy and hold investor would want to avoid such a stock. A more aggressive momentum investor might try to buy MSFT on the dips and sell on the peaks."

This is wrong in so many ways. One of the central tenets of serious value investing is that price volatility /=/ risk
posted by JPD at 6:26 PM on April 25, 2006

One of the central tenets of serious value investing is that price volatility /=/ risk

Either "value investing" is just a dumb idea, or you misunderstood that volatility over a month is not a useful proxy for volatiliy over a year. Of course there is a relationship between volatility and risk, you just have to choose the appropriate time period(s) for your study.
posted by b1tr0t at 6:30 PM on April 25, 2006

I don't understand why you think a stock that moves around a lot in a month is a bad investment for a buy and hold investor?

If you have a multi-year horizon why does how much a stock moves around over any time period shorter then your investment horizon matter?

The riskiness of a stock is a function of the uncertainty of its future cash flows. Not of the volatility of its returns.
posted by JPD at 6:38 PM on April 25, 2006

If you plan to hold a stock for one year, and it moves more over the course of a month than it does over the course of a year, then you could very easily be buying and selling at the midpoint of the monthly volatility or worse. In the worst case, you buy at a local maxima and sell at a local minima. Because the monthly volatility is greater than the annual volatility, the gain over the year does nothing to erase your accidental poor timing.

If you try to time the market, then you are adding a momentum component to your buy-and-hold strategy. If you want to avoid timing entirely, then you need to know that ignoring timing won't adversely impact your strategy. When the short term volatility is much lower than the long term volatility, then you can safely ignore market timing. Stocks with such properties make great buy and hold investments and terrible momentum investments.

I suspect that some of the confusion comes from proponents of "value investing" quoting statistics over the period from the 1929 crash to the present. Over such a long period of time, the survivor's bias kills off the hypervolatile stocks, so it looks like everything goes up in the long term. Unfortunately, there are plenty of companies that were listed in that period but have since gone under. Such companies are typically not present in discussions of value investing.

Since we can't look ahead to 2106 and see what stocks will still be around, the next best thing for a buy and hold investor is to cull out stocks that show high short term volatility. Those are the stocks that are most likely to die off (volatility cuts both ways). Of course, outlier events like the crashes of '29 and '87 as well as the downturn of '02 tend to hurt everyone.
posted by b1tr0t at 6:51 PM on April 25, 2006

It's risky for one year, but if you can get your grandfather to give you the money for 3-5 years, you might check out Magic Formula Investing. Look to see if your local library has Joel Greenblatt's book in which he explains this style of investing ("The Little Book that Beats the Market"). Greenblatt claims average annual returns of over 30% with this method, albeit with the occasional down year.

Depending on how much he's giving you, pick 10-25 stocks to reduce volatility. Generally you don't want the transaction cost to be more than 1% of your capital so assuming you use a deep-discount broker like Scottrade ($7 a trade) you will want to put no less than $700 in each stock.

Of course this won't get you much bonding with your grandpa, since you're going to use a computer program to pick stocks, and then hold them for around a year (hold your losers 364 days, hold your winners 366 days, for tax reasons), and then you're going to do it all over again. The idea of bonding suggests to me that he probably wants you to take a somewhat more active role. Which can be risky, of course. In that case I suggest paying for a basic Motley Fool membership and start reading their articles and posting questions in their forums.... you will learn a lot in a hurry.
posted by kindall at 7:12 PM on April 25, 2006

If a stock is cheap a stock is cheap. I don't care if its at the top of it monthly range or the bottom of its monthly range.
Expressly I am not trying to time the market. I just don't really care that much if I am buying on a huge margin of safety.

Are you really trying to argue that buying cheap stocks does not work? I am sort of flabbergasted by that argument. It has been proven time and time again that its the only way to make money in the long-term. You are arguing that returns are cooked by survivor bias? really? Like the Fama-French studies are flawed? That the long-term track records of Graham and his acolytes are tainted?

I am really pretty confident "Everything goes up in the long-term" is not part of the thesis behind buying stocks at a discount to intrinsic value leads to superior returns.
posted by JPD at 7:15 PM on April 25, 2006

If (1) a stock's monthly range is greater than its yearly range, (2) you buy at the top of the monthly range at the beginning of the year and (3) you sell at the bottom of the monthly range at the end of the year then (4) you will lose money.
posted by b1tr0t at 7:42 PM on April 25, 2006

I think you guys are talking past one another. As JPD says, if you assume you can buy a stock at a valuation below its intrinsic value, you're circumventing a lot of the issues you'd have to deal with if you assume you're buying at fair market value. In theory, a portion of your return will be affect by volatility due to the unavoidable realities of ignoring market timing at the eventual time of sale, but the larger portion of your expected return is the gap between purchase price and the intrinsic value at the time of purchase. If you're not "value-investing", but simply going long on a particular equity at FMV, volatility and risk play a much more important role. An increase in volatility and risk over a given investment horizon will increase that company's implied cost of equity (or, implied return to equity holders). My assumption is that most stocks are valued according to their long-term volatility versus their short-term volatility. I'm having a difficult timing making sense of a stock that has high short-term volatilty, but low long-term volatility - can a stock maintain this difference for very long with creating an arbitrade opportunity in the options market?
posted by mullacc at 7:50 PM on April 25, 2006

whoops - arbitrade should be arbitrage
posted by mullacc at 7:51 PM on April 25, 2006

Actually that whole last sentence was garbled, I'll try again: "I'm having a difficult time making sense of a stock that has high short-term volatilty, but low long-term volatility - can a stock maintain this difference for very long without creating an arbitrage opportunity in the options market?"
posted by mullacc at 7:54 PM on April 25, 2006

mullacc: You almost piqued my interest enough to talk to one of the computational finance guys, and ask how exactly they measure volatility for options pricing.

This short-term high, long-term low claim seems very counter-intuitive to me, since it implies a grossly inefficient market.
posted by I Love Tacos at 8:49 PM on April 25, 2006

(and as much as I love grossly inefficient markets, I'm immediately skeptical that a stock that's as thoroughly scrutinzed as MSFT could have such exploitable behaviours.)
posted by I Love Tacos at 8:52 PM on April 25, 2006

To make sense of the disputes above, invest a little of Granddad's money in some good reference books.

Benjamin Graham's The Intelligent Investor (get the new edition with commentary by Zweig) would be my top recommendation, followed by Value Investing: From Graham to Buffett and Beyond by Greenwald, Kahn, Sonkin, van Biema.

I would also get some basic college text that explains efficient market theory and modern portfolio theory. There is a school of thought (to which I belong) which says these are a load of arse, but it cannot hurt you to think these issues through for youself, and it will help you understand some of the issues being debated upthread.

To answer your question directly, here is how I pick stocks. Most people do not follow this method, and that is all to the good in my view; that is what creates the mispricing that I am trying to profit from.

I try to have around 10. This is the minimum number to significantly reduce risk, and the maximum number I can easily keep tabs on.

I use financial analysis methods only. I follow techniques that would be labelled "value investing".

I try and keep in mind Graham's dictum that an investment operation is one that offers safety of principal and the prospect of a satisfactory return. All else is speculation. Note that you can make great returns as a speculator, but very very few people consistently do so, while many wipe out. The Taleb book mentioned above will help you realise why.

Then I use various online services to screen companies that meet my criteria. These include low price to earnings ration, low debt levels, high return on invested capital, a track record of consistent earnings, blah bla... read the books I've suggested and you'll learn what these mean and why they are significant.

Having identified some candidate companies, I get their reports and I study them in detail. I look for what Graham calls the margin of safety. In essence, I look for an intrinsic value that is markedly above the current asking price. This should in theory a) limit my downside risk (because the price can't fall much further and in the event of liquidation I'll get my money back) and b) should produce a nice capital gain when everyone else cottons on.

"Intrinsic value" is a mixture of a conservative price for the company's assets if liquidated + a conservative value for estimated future earnings + a conservative value for any special advantage held by the company (strong brand like Coke, legislative monopoly like drilling rights, inability for consumers to easily move to another product like Windows). Some people believe that stocks are worth what the last buyer paid for them - I think those people are idiots. You will have to decide between them and me :-)

Lastly, I ask myself a few hard questions. For example: Would I recommend this to my Mum? Is this better than anything else I currently own? What is the worst thing that could happen to this company, and how likely do I think it is?

I keep a diary of my decisions and thinking so that I can review my older decisions dispassionately and see how they turned out. It is easy to discount and forget your past mistakes if you don't review them in a disciplined way.

This approach has been successful for me in the two years since I have adopted it. It has returned roughly 20% p/a in capital gain + dividends. This is only an average return for this period on the Australian Stock Exchange where I own most of my holdings, but again if you read the books above you will see that even average performance (that is, doing as well as the index) is quite hard. I have every hope of doing better in the future as my analysis skills improve.

The other approach, technical analysis, basically discards any notion of value and looks at price movements and the behaviour of market particpants to identify "trends" and hence buying and selling points. Many many people swear by this approach, but my understanding is that there is little evidence for it and quite a lot against it. (See Malkiel "A Random Walk Down Wall St" for an amusing discussion. Of course, he trashes my favoured approach too...) I'll leave it to someone who believes in it to provide an outline and pointers.
posted by i_am_joe's_spleen at 9:04 PM on April 25, 2006 [2 favorites]

"Those are the stocks that are most likely to die off (volatility cuts both ways). "

ooh, I can't resist this. What do you mean by "volatility?"

If you mean so-called beta, ie deviation from the market index, then there is a class of stocks for which it does not cut both ways. Ie, a successful company whose price increases above the index will show increased beta (volatility) but this is all upside. As the growing company matures - which takes years - its price will regress to the market - and beta will decline!
posted by i_am_joe's_spleen at 9:21 PM on April 25, 2006

By volatility, I mean variance.
posted by b1tr0t at 9:56 PM on April 25, 2006

This thread would be a lot more effective and valuable if people posting their various suggestions also revealed their investing track records at the same time -- as would almost any of the hundreds of people posting tips about how to "make money in stocks" online.
posted by Big Fat Tycoon at 12:48 AM on April 26, 2006

All the same, Big Fat Tycoon, I'd much rather hear from an unlucky expert than a lucky fool. If we are ready to admit that at least some it comes down to luck, that is.

Thanks to everyone for your answers. I think I'll have to return to the JPD-B1tr0t debate after going through these book recommendations.
posted by godawful at 2:36 AM on April 26, 2006

That luck aspect is very important. Taleb's book "Fooled by Randomness" has a great deal to say on that and I highly recommend that you read it. If nothing else, it should cure you of pride if your year goes well, or depression if it goes badly.
posted by i_am_joe's_spleen at 3:29 AM on April 26, 2006

And one of the things you will take away from it is that one year is absolutely too short a time span to judge the effectiveness of an investment strategy, or even a trading one.
posted by i_am_joe's_spleen at 3:30 AM on April 26, 2006

Using arcane methods*, I chose only from amongst the large caps that were well thought of by published analysts. I bought in blocks of around $1,000 worth, and expected to hold each block only long enough to earn x percent (5-7%, depending). My return was roughly 20%. IIRC (too lazy to check the ledger) I took a loss on only 2 blocks, one being a generic drug mfgr that hit some troubles (Andrex) and the other being some company which held a bit of nostalgia for myself.

Many of my purchases would have done me far better had I held them. However, I could not watch investments that sit there and don't change. The short-term nature of my strategy held my interest.

*I combined some traditional tech analysis with my own notions and wrote my own software to find what that for which I was looking. I have very low tolerance for loosing.
posted by Goofyy at 4:18 AM on April 26, 2006

I talked with a computational finance guy, who seemed to think that MSFT options arbitrage probably wouldn't pan out.

He said that volatility is implied from other formulas, and it's largely functional despite being an inexact science. As for one error in options pricing, he talked about the volatility smile that occurs because the models usually use geometric brownin motion with normal gaussian levels, but vol isn't actually normal in distribution... thus if you graph it versus the models expectations, you get a smile.

He noted that market friction makes most arb opportunities unprofitable, and noted that while the underlying assumption of market efficiency isn't there, but the transaction costs usually exceed the expected take.

He further noted that there are a few small low-risk funds that do things along this line.

Sorry, I didn't take notes, so I forgot everything that involved actual formulas.
posted by I Love Tacos at 6:32 AM on April 26, 2006

The problem with expertism is that it often leads to things like "technical analysis". Luck is definitely paramount, frankly.
posted by Big Fat Tycoon at 7:59 AM on April 26, 2006

Big Fat Tycoon writes "This thread would be a lot more effective and valuable if people posting their various suggestions also revealed their investing track records at the same time"

I think this would do the exact opposite. Less sophisticated investors are likely to be blinded by advice given by those with who have performed well - but we'd never know if that performance was due to luck, difference in risk-tolerance or myriad other reasons that we'd never be able to ascertain in the context of AskMe. For example, I have some problems with the strategy employed by Gooffy, yet he has demonstrated strong results. I wouldn't try to dissuade him from investing that way, but I'd never do it myself nor would I recommended it to any other retail investor (sorry, Gooffy, not trying to pick on you, this is just my personal opinion on the matter).

Ownership disclosure is good if someone is recommending a specific stock - it reduces the likelihood of pump & dump behavior. But I don't think it's good in the case of overall investment philosophy.
posted by mullacc at 8:46 AM on April 26, 2006

All the same, Big Fat Tycoon, I'd much rather hear from an unlucky expert than a lucky fool. If we are ready to admit that at least some it comes down to luck, that is.

Thanks to everyone for your answers. I think I'll have to return to the JPD-B1tr0t debate after going through these book recommendations.

Just about everything that has been said in this thread is worthy of further investigation. I may disagree with specific posters on specific topics, but what they suggest is probably largely correct for their investing perspective.
posted by b1tr0t at 9:55 AM on April 26, 2006

Just about everything that has been said in this thread is worthy of further investigation. I may disagree with specific posters on specific topics, but what they suggest is probably largely correct for their investing perspective.

The problem with that is that investing is essentially results-oriented. Theorizing about different investing methodologies is well and good but the implication of this thread is that there are empirical methods that can be applied to a system that is essentially driven by luck and psychology. Hmm, I guess if you could convincingly say that human nature was understood well enough to build investment methods on top of it, that would be okay.
posted by Big Fat Tycoon at 12:04 PM on April 26, 2006

I guess if you could convincingly say that human nature was understood well enough to build investment methods on top of it, that would be okay.

Some people win in the market.
Some people win at cards, too.

The losers (not saying you are one...) always put it down to luck.
posted by I Love Tacos at 12:43 PM on April 26, 2006

Just about everything that has been said in this thread is worthy of further investigation. I may disagree with specific posters on specific topics, but what they suggest is probably largely correct for their investing perspective.

Agreed. I'm always happy when I see mullacc and b1tr0t (among others) in financial discussions. At a minimum, I can expect a well-reasoned opinion.
posted by I Love Tacos at 12:45 PM on April 26, 2006

I Love Tacos, you basically underlined my point. Cards is a game where psychology can be mastered, since your opponents are playing you directly. Equating it to the market, or even drawing an analogy to it, seems specious.
posted by Big Fat Tycoon at 1:17 PM on April 26, 2006