Why Retail Investors have no business buying Individual Stocks
Investing in the stock market was never meant to be easy. The act of buying and selling a stock is the only aspect of investing that does not require any skill. But ironically, a lot of money and effort has gone into making this process easier and seamless. Every other aspect of investing needs years of painstaking effort, and it requires a certain kind of temperament to be a successful investor.
There is not a single documented story of an individual stock trader making money over an extended period. So I won’t dwell into stock trading, as time and again it has been proved that it is a futile exercise. Despite this, if one thinks that they will be the first-ever person to build wealth by dabbling in the stock market, good luck to them.
A novice stock picker is essentially entering a boxing ring with Mohammad Ali on the other side. You are competing with seasoned fund managers, institutional investors, and others who have spent a lifetime studying the markets. That is not to say that the experts always do well; it only means that the odds are even worse for a retail investor.
Beating the market is a zero-sum game. So technically, individual investors need to outperform the industry players to do better than the market. In most cases, these are the same players from whom they would have got the stock advice in the first place. Imagine a marathon race where everyone who finishes in the top quartile is rewarded. In such a case, it would be natural for the experienced runners to wish that the race had no entry requirements and was open to anyone, so as to increase their odds of being in the top quartile. Similarly, the financial services industry has serious incentives in luring gullible investors into this game of stock picking.
Legendary fund manager Peter Lynch wrote in his seminal book – One up on Wall Street, that anyone could invest in the stock market and outperform the benchmark by following a process called as buying what you know. But today, businesses are more complex than ever before, and their competitive advantages, if any, come in intricate ways. More recently, companies whose products or services are ubiquitous do not necessarily translate to healthy fundamentals, such as Uber.
The proliferation of commission-free trading Apps
In a marriage, if all one had to utter is the words “I don’t want to live with you anymore” to get a divorce, I guess that most marriages won’t last. Similarly, Mobile trading apps gratify the whim of novice investors by providing a one-click trading experience, and this can lead to poor investing decisions.
The latest fintech mobile trading apps have indeed reduced the cost of trading drastically for small investors. But was transaction cost the major concern for retail investors while investing in stocks? Transaction costs may make a significant difference for short term trading but not for investors looking to build long term wealth.
Another trend that is gaining popularity is micro-investing which involves investing a meager and insignificant amount. But by investing a tiny portion of your savings, all you achieve is a sense of excitement and, in some cases, sleepless nights. You are better off by saving all your money in a bank deposit in that case.
The Rigors of Investing
There are two key aspects to investing in the stock market, the first is to perform a thorough analysis, and the second is to make decisions based on this analysis.
To clear the first stage, one needs to be familiar with the process of investment research that involves analyzing the financial statements, going through company filings & management interviews, valuing the company, due diligence, etc. This is a time-consuming process and requires knowledge in finance and accounting. A lot of professional analysts do this full time, and therefore, it will take some doing on one’s part outdo them.
The second step involves the decision-making process, and this is behavioral in nature and is the more challenging part. Based on the analysis, one needs to answer the following questions.
- Is the current price attractive?
- How many shares should I buy?
- What if the price changes before I buy it?
- Do I have a predetermined holding period?
- Do I have a target price?
- How much money can I afford to lose in this particular investment?
- How should I react to the barrage of conflicting analyst recommendations?
- How should I react to industry news?
- How should I react to company-specific news?
One needs to have a clear sense of how they would react to all these questions before entering a trade. Even if you believe you have the answers to all the questions, it will be a completely different ball game to have the same clarity after you take a position in the stock. And this is where even seasoned investors fail.
It is critical to be dispassionate about your investments, and one should have the mental fortitude to think independently and not give in to herd behavior. This can be developed over a long time by some, and the rest will never be able to be good at it as it requires a certain bent of mind.
I am not suggesting that institutional investors are inherently smarter than individual ones. All else equal, they spend more time researching and are experienced, which gives them an edge over individual investors.
The advent of commission-free trading and mobile trading apps has made it easy to buy and sell stocks and continuously track price movements. This is against the basic tenets of good investor behavior, and these trading applications are possibly causing more harm to retail investors than good. Most, if not all, retail investors are better off investing in the broader market through passive Index Funds.