You are not a good stock picker

I recently spoke with someone who was asking for a “stock tip”. He was looking to invest in a company that he could buy at a low price now and then sell high in a few months when the holiday shopping boom hits. Buying low and selling high is a great idea, but of course it isn’t that easy.

Markets are efficient

In investing, there is a concept called “efficient market hypothesis”, which states that current stock prices reflect all available information. The fact that retail sales increase in the holiday season is known by everyone, and the price of the stock is set today in anticipation of the sales boom – this is commonly referred to as a piece of information being “priced in”.

It’s not just seasonal sales cycles that get priced into a stock: Presidential elections get priced in; government regulations get priced in (remember the tariff dustup from April of this year?) New technology is priced in. Basically, anything that affects or can affect the future earnings of a company is priced into the value of its stock today.

Compare this analysis to that of a layman who might say “They sell more dolls at Christmas” or “I really liked the Barbie movie so I know it’s a good investment” and you will see how chumps like us are at a disadvantage.

Analysts abound

And how are prices set, anyway? Certain financial institutions employ analysts whose job is to review all information relevant to the earnings potential of a company. One who is analyzing toy maker Mattel might review sales trends and marketing efforts, as well as the costs of raw plastic, freight, etc. They are also reviewing the company’s financial statements to make sure they are not carrying too much debt, for example.

The analysts use this information to create a price target, which gets shared with the traders at the company. The traders use the price targets of many publicly traded stocks to buy the companies that are undervalued and sell those that are overvalued. When dozens of financial institutions analyze and trade on public stocks, the “market price” is established. It all works like an auction, except that prices can move both up and down.

Prices are not fixed. Arriving daily is new information that can impact the future earnings of the price of a stock, and sometimes the analysts look foolish in hindsight. The point is not that analysts know certainly what is going to happen, it’s that the dozens of analysts, collectively, know more about a stock than you or I could ever hope to.

So if you can’t pick the “best” stock, what’s the alternative?

First, in response to my friend looking for a stock tip, you should never buy stocks for a short-term gain. I tell people any money you need within 5-10 years should not be invested in stocks; there is just too much short-term fluctuation in pricing.

Next, don’t try to pick individual stocks. These prices are set by dozens of analysts whose entire day is spent researching the many factors that impact the earnings of a company; you won’t find an edge anywhere.

Instead, look to invest in a low-cost fund that is diversified across many companies and industries. Buying a basketful of stocks is the best way to make sure you find at least a few winners.

This article is not a recommendation to buy or sell Mattel, Inc. or any other security.

About the Author

Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.

402 Financial helps people who are in or nearing retirement spend their money. Joe always acts as a fiduciary and never takes commissions on product sales.

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