Trading is a relatively recent phenomenon made possible by the technology of communication networks and the development of the paper stock ticker. Details of stock transactions – stock symbols, the number of shares, and prices – were collected and transmitted on paper strips to machines located in brokerage offices across the country. Specialized employees using their memory, paper and pencil notes, and analytical skills would “read” the tapes and place orders to buy or sell stocks on behalf of their employer firms.
As a young trainee on Wall Street in the early 1960s, I remember the gray-haired, bespectacled old men bent over and concentrating on the inch-wide tapes spooling directly into their hands from the ticker. As technology improved to offer direct electronic access to price quotes and immediate analysis, trading – buying and selling large share positions to capture short-term profits – became possible for individual investors.
While the term “investing” is used today to describe to anyone and everyone whoever buys or sells a security, economists such as John Maynard Keynes applied the term in a more restrictive manner. In his book, “The General Theory of Employment, Interest, and Money,” Keynes distinguished between investment and speculation. He considered the former to be a forecast of an enterprise’s profits, while the latter attempted to understand investor psychology and its effect on stock prices.
Benjamin Graham – whom some consider to be the father of security analysis – agreed, writing that the disappearance of the distinction between the two was “a cause for concern” in his 1949 book The Intelligent Investor. While Graham recognized the role of speculators, he felt that “there were many ways in which speculation could be unintelligent.”
While there are observable differences in the goals and methods of the different philosophies, their successful practitioners share common character traits:
- Intelligence. Successful investors, speculators, and traders must have the ability to collect and analyze diverse, even conflicting, data to make profitable decisions.
- Confidence. Success in the securities market often requires taking a position in opposition to the majority view. Like Warren Buffett advised in a New York Times editorial, “Be fearful when others are greedy, and be greedy when others are fearful.” In a letter to Berkshire Hathaway shareholders, he noted the Noah Rule: “Predicting rain doesn’t count. Building arks does.”
- Humility. Despite one’s best preparation, intention, and effort, errors occur and losses inevitably happen. Knowing when to retreat is as important as knowing when to dare. As Sir John Templeton, founder of the mutual fund family with his name, said, “Only one thing is more important than learning from experience, and that is not learning from experience.”
- Effort. Christopher Browne, a partner in the New York brokerage firm Tweedy, Browne Company LLC and author of “The Little Book of Value Investing,” claims, “Value investing requires more effort than brains, and a lot of patience. It is more grunt work than rocket science.” The same applies to intelligent speculation or active trading. Recognizing and translating price patterns and market trends requires constant diligence; success in the stock market requires hours of research and learning the skills to be successful.
Investors intend to be long-term owners of the companies in which they purchase shares. Having selected a company with desirable products or services, efficient production and delivery systems, and an astute management team, they expect to profit as the company grows revenues and profits in the future. In other words, their goal is to buy the greatest future earnings stream for the lowest possible price.
On May 26, 2010, speaking before the Financial Crisis Inquiry Commission, Warren Buffett explained his motive in buying a security: “You look to the asset itself to determine your decision to lay out some money now to get some more money back later on…and you don’t really care whether there’s a quote under it [at] all.” When Buffett invests, he doesn’t care whether they close the market for a couple of years since an investor looks to a company for what it will produce, not what someone else may be willing to pay for the stock.
Investors use a valuation technique known as “fundamental or value analysis.” Benjamin Graham is credited with the development of fundamental analysis, the techniques of which have remained relatively unchanged for almost a century. Graham was primarily concerned with the metrics of companies.
According to Professor Aswath Damodaran at the Stern School of Business at New York University, Graham developed a series of filters or screens to help him identify under-valued securities:
- PE of the stock less than the inverse of the yield on Aaa Corporate Bonds
- PE of the stock less than 40% of its average PE over the last five years
- Dividend yield greater than two-thirds of the Aaa Corporate Bond Yield
- Price less than two-thirds of book value
- Price less than two-thirds of net current assets
- Debt-equity ratio (book value) has to be less than one
- Current assets greater than twice current liabilities
- Debt less than twice net current assets
- Historical growth in EPS (over last 10 years) greater than 7%
- No more than two years of negative earnings over the previous decade
Warren Buffett, a disciple and employee of Graham’s firm between 1954 and 1956, refined Graham’s methods. In a 1982 letter to shareholders of Berkshire Hathaway, he cautioned managers and investors alike to understand “accounting numbers are the beginning, not the end, of business valuation.”
Buffett looks for companies with a strong competitive advantage so the company can make profits year after year, regardless of the political or economic environment. His perspective when he decides to invest is always long-term. As he explained in another shareholder letter, “Our favorite holding period is forever.”
Morningstar considered Philip Fisher as “one of the great investors of all time” – as such it is not surprising that he concurred with Buffett and Graham, preferring a long holding period. In a September 1996 American Association of Individual Investors (AAII) Journal article, Fisher is credited with the recommendation that “investors use a three-year rule for judging results if a stock is under-performing the market but nothing else has happened to change the investor’s original view.” After three years if it is still under-performing, he recommends that investors sell the stock.
Investors seek to reduce their risks by identifying and purchasing only those companies whose stock price is lower than its “intrinsic” value, a theoretical value determined through fundamental analysis and comparison with competitors and the market as a whole. Investors also reduce risk by diversifying their holdings into different companies, industries, and geographical markets.
Once taking a position, investors are content to hold performing stocks for years. Fisher held Motorola (MOT) from his purchase in 1955 until his death in 2004; Buffett purchased shares of Coca-Cola (KO) in 1987 and has publicly said that he will never sell a share.
Some market participants might consider an investing philosophy based on conservative stocks with long holding periods to be out-of-date and boring. They would do well to remember the words of Paul Samuelson, Nobel winner in Economic Sciences, who advised, “Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”
According to Philip Carret, author of “The Art of Speculation” in 1930 and founder of one of the first mutual funds in the United States, speculation is the “purchase or sale of securities or commodities in expectation of profiting by fluctuation in their prices.” Garret combined the fundamental analysis popularized by Benjamin Graham with the concepts used by early tape readers such as Jesse Lauriston Livermore to identify general market price trends.
Milton Friedman, writing in In Defense of Destabilizing Speculation in 1960, noted much of the public equates speculation with gambling, with no value as an investment philosophy. However, Friedman contends that speculators often have an information advantage over others, enabling them to make profits when others less knowledgeable lose. In other words, speculation could be defined as the buying and selling of securities based upon a perceived advantage in information.
Paul Mladjenovic, a certified financial planner (CFP) and the author of four editions of “Stock Investing for Dummies,” explained the point of speculation best: “You’re putting your money where you think the rest of the market will be putting their money – before it happens.”
Jesse Lauriston Livermore, named the “most fabulous living U.S. stock trader” in a 1940 TIME article, developed his skill buying and selling stocks in bucket shops – unregulated businesses that were the equivalent of today’s off-track betting parlors, where customers placed wagers on the price movement of stocks, according to Bloomberg. No securities changed hands, and the transactions did not affect share prices on stock exchanges. Livermore’s ability to detect and interpret patterns in the movement of stock prices quickly made him persona non grata in the shops, much like card counters are banned from the casinos of Las Vegas and Atlantic City.
But Livermore’s focus on stock prices and the patterns of their price changes enabled him to identify “pivot points” – now known as levels of support and resistance – that guided his buys and sells. He purchased stocks as they rebounded from a support level, and sold them when they approached a resistance level. Livermore understood that stocks move in trends, but could quickly change direction depending upon the mood of stock market participants. Accordingly, in his book “Reminiscences of a Stock Operator,” he advocated a strategy of quickly cutting losses and letting profits run.
Other Livermore stock trading rules include the following:
- Buy rising stocks and sell falling stocks.
- Trade only when the market is clearly bullish or bearish; then trade in its general direction.
- Never average losses by buying more of a stock that has fallen.
- Never meet a margin call – get out of the trade.
- Go long when stocks reach a new high; sell short when they reach a new low.
Livermore also noted that the markets are never wrong, though opinions often are. As a consequence, he warned that no trading strategy could deliver a profit 100% of the time. Livermore and others following a similar philosophy are willing to be on the sidelines – out of the market – until an opportunity for profit is readily apparent.
The techniques used by Livermore evolved into what is now known as technical analysis by extending Livermore’s pivot points to more esoteric price and volume patterns of price changes such as head and shoulders patterns, moving averages, flags, pennants, and relative strength indicators. Technicians led by John Magee and Roberts Edwards – authors of what many claim to be the bible of price speculation, “Technical Analysis of Stock Trends” – claim that the bulk of information which “fundamentalists [investors] study are past history, already out of date and sterile, because the market is not interested in the past or even in the present! In brief, the going price, as established by the market itself, comprehends all the fundamental information which the statistical analyst can hope to learn (plus somewhat is perhaps secret from him, known only to a few insiders) and much else besides of equal or even greater importance.”
The underlying assumption of speculation or technical analysis is that patterns repeat themselves, so a review of past and current prices, properly interpreted, can project future prices. The assumption was challenged in 1970 by Eugene Fama, professor of finance at the University of Chicago and a Nobel prize winner, with the publication of his article “Efficient Capital Markets: A Review of Theory and Empirical Work” in the Journal of Finance. Fama proposed that securities markets are extremely efficient, and that all information is already discounted in the price of security. As a consequence, he suggested that neither fundamental nor technical analysis would help an investor achieve greater returns than a randomly selected portfolio of individual stocks.
His ideas became popularly encapsulated as the Efficient Market Hypothesis (EFH). While acknowledging critics of EFH, Dr. Burton Malkiel – economist, dean of the Yale School of Management, and author of “A Random Walk Down Wall Street” – defends the hypothesis. He claims that stock markets are “far more efficient and far less predictable than some academic papers would have us believe…[the behavior] of stock prices does not create a portfolio trading opportunity that enables investors to earn extraordinary risk-adjusted returns.”
While the academic battle over EFH continues, adherents of technical analysis – speculators – continue to embrace the philosophy as the best method to pick optimum moments of buying and selling.
Advances in technology, lower commission rates, and the appearance of online brokerage firms have enabled individuals to employ tools and systems of increasing sophistication to follow and interpret the market. Individuals and Wall Street firms alike have embraced a new trading philosophy, with many employing artificial intelligence programs and complex algorithms to buy and sell huge stock positions in microseconds.
A trader is someone who buys and sells securities within a short time period, often holding a position less than a single trading day. Effectively, he or she is a speculator on steroids, constantly looking for price volatility that will enable a quick profit and the ability to move on to the next opportunity. Unlike a speculator who attempts to forecast future prices, traders focus on existing trends – with the aim of making a small profit before the trend ends. Speculators go to the train depot and board trains before they embark; traders rush down the concourse looking for a train that is moving – the faster, the better – and hop on, hoping for a good ride.
The bulk of trading occurs through financial institutions’ programmed systems to analyze price trends and place orders. Emotion is removed from the buy-sell decision; trades are automatically entered if and when specific criteria is reached. Sometimes referred to as “algorithmic or high-frequency trading (HFT),” the returns can be extraordinarily high. A 2016 academic study of HFTs revealed that fixed costs of HFT firms are inelastic, so firms that trade more frequently make more profits than firms with fewer transactions with trading returns ranging from 59.9% to almost 377%.
The impact of high-frequency trading and the firms engaged in the activity remains controversial – a 2014 Congressional Research Service report detailed instances of price manipulation and illegal trading methods such as detailed in Michael Lewis’ book “Flash Boys.” There are also concerns that automated trading reduces market liquidity and exacerbates major market disruptions, such as the May 6, 2010, market crash and recovery – the Dow Jones Industrial Average dropped 998.5 points (9%) in 36 minutes. A similar crash happened August 24, 2015 when the Dow fell more than 1000 points at the market open. Trading was halted more than 1,200 times during the day in an effort to calm down the markets.
While few individuals have the financial ability to emulate the trading habits of the big institutions, day trading has become a popular strategy in the stock market. According to a California Western Law Review report, day trading continues to attract adherents, even though 99% of day traders are believed to eventually run out of money and quit. Many become day traders due to the enticement of day trading training firms, an unregulated industry that profits from the sale of instruction and automated trading software to their customers. The sales materials imply that the software is similar to the sophisticated, expensive software programs of the big traders, such as Goldman Sachs.
Day trading is not easy, nor for everyone. According to Chad Miller, managing partner of Maverick Trading, “Everyone glorifies it [day trading], but it’s hard work…you can’t just turn on the computer and buy a stock and hope you make money.” Day trading generally involves tens of trades each day, hoping for small profits per trade, and the use of margin – borrowed money – from the brokerage firm. In addition, margin traders who buy and sell a particular security four or more times a day in a five-day period are characterized as “pattern day traders,” and subject to special margin rules with a required equity balance of at least $25,000.
Despite the number of new day traders entering the market each year, many securities firms and advisors openly discourage the strategy. The Motley Fool claims that “day trading isn’t just like gambling; it’s like gambling with the deck stacked against you and the house skimming a good chunk of any profits right off the top.”
4. Bogleheads (Index Fund Investing) – A New Philosophy
Frustrated by inconsistent returns and the time requirements to effectively implement either a fundamentalist or speculator strategy, many securities buyers turned to professional portfolio management through mutual funds. According to the Investment Company Institute’s Profile of Mutual Fund Shareholders, 2015, almost 91 million individuals owned one or more mutual funds by mid-2015, representing one-fifth of households’ financial assets. Unfortunately, the Institute learned that few fund managers can consistently beat the market over extended periods of time. According to The New York Times, “The truth is that very few professional investors have actually managed to outperform the rising market over those years [2010-2015].”
Influenced by the studies of Fama and Samuelson, John Bogle, a former chairman of Wellington Management Group, founded the Vanguard Group and created the first passively managed index fund in 1975. Now known as the Vanguard 500 Index Fund Investor Shares with a minimum investment of $3,000, it is the precursor of many similar index funds managed by Vanguard – including the largest index mutual fund in the world, the Vanguard 500 Index Fund Admiral Shares, with assets of $146.3 billion and a minimum investment requirement of $10,000.
Despite the industry skeptics about index investing, Bogle’s faith in index investing was unshaken. The following statements express his views, and is the basis of his book, “The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns.”
- Investors as a group cannot outperform the market because they are the market.
- Investors as a group must under-perform the market, because the costs of participation – largely operating expenses, advisory fees, and portfolio transaction costs – constitute a direct deduction from the market’s return.
- Most professional managers fail to outpace appropriate market indexes, and those who do so rarely repeat in the future their success in the past.
The fund was initially ridiculed as “Bogle’s Folly” by many, including Forbes in a May 1975 article entitled “A Plague on Both Houses.” (The magazine officially retracted the article by Forbes writer William Baldwin in an August 26, 2010 article.) The Chairman of Fidelity Investments, Edward C. Johnson III, doubted the success of the new index fund, saying, “I can’t believe that the great mass of investors are [sic] going to be satisfied with just average returns. The name of the game is to be the best.” Fidelity subsequently offered its first index fund – the Spartan 500 Index Fund – in 1988 and offers more than 35 index funds today.
With the success of index mutual funds, it is not surprising that exchange traded funds (ETFs) emerged 18 years later with the issue of the S&P 500 Depository Receipt (called the “spider” for short). Similar to the passive index funds, ETFs track various security and commodity indexes, but trade on an exchange like a common stock. At the end of 2014, the ICI reported that there were 382 index funds with total assets of $2.1 trillion.
Multiple studies have confirmed Bogle’s assertion that beating the market is virtually impossible. Dr. Russell Wermers, a finance professor at the University of Maryland and a coauthor of “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas,” claimed in an article in The New York Times that the number of funds that have beaten the market over their entire histories is so small that the few who did were “just lucky.” He believes that trying to pick a fund that would outperform the market is “almost hopeless.”
Some of America’s greatest investors agree:
- Warren Buffett. The Sage of Omaha, in his 1996 Berkshire Hathaway shareholder letter, wrote, “Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees.”
- Dr. Charles Ellis. Writing in the Financial Analysts’ Journal in 2014, Ellis said, “The long-term data repeatedly document that investors would benefit by switching from active performance investing to low-cost indexing.”
- Peter Lynch. Described as a “legend” by financial media for his performance while running the Magellan Fund at Fidelity Investments between 1977 and 1980, Lynch advised in a Barron’s April 2, 1990 article that “most investors would be better off in an index fund.”
- Charles Schwab. The founder of one of the world’s largest discount brokers, Schwab recommends that investors should “buy index funds. It might not seem like much action, but it’s the smartest thing to do.”
Adherents to index investing are sometimes referred to as “Bogle-heads.” The concept of buying index funds or ETFs rather than individual securities often includes asset allocation – a strategy to reduce risk in a portfolio. Owning a variety of asset classes and periodically re-balancing the portfolio to restore the initial allocation between classes reduces overall volatility and ensures a regular harvesting of portfolio gains.
In recent years, a new type of professional management capitalizing on these principals – robo-advisors – has become popular. The new advisors suggest portfolio investments and proportions of each allocated in ETFs based upon the client’s age and objectives. Portfolios are automatically monitored and re-balanced for fees substantially lower than traditional investment managers.
Stock market profits can be elusive, especially in the short term. As a consequence, those seeking to maximize their returns without incurring undue risk constantly search for the perfect strategy to guide their activity. Thus far, no one has discovered or developed an investment philosophy or strategy that is valid 100% of the time. Investment gurus come and go, praised for their acumen until the inevitable happens and they join the roster of previously humbled experts. Nevertheless, the search for a perfect investment philosophy will continue.
As a participant in the securities market, you should recognize that owning securities can be stressful. Just as you do not know the events of tomorrow and how investors will react to news and rumors, so you do not have the certainty of profits in the stock market. So enjoy those days when fortune and goals come together, but remember and prepare for the times of disappointment, for they will be many.
What guides your decisions to buy and sell securities? Have you had success with one of the philosophies above?