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The Random and Uncertain Nature of the Stock Market

In recent years, numerous studies have shown that on average, portfolio managers are unable to generate a net return (after transaction costs) greater than that of their corresponding benchmark. In fact, according to renowned finance professors Eugene Fama and Kenneth French, only 3% of them possess the skills required to justify their fees. Fun fact; following an experiment by the Wall Street Journal in 1988, Bing Liang, another finance professor, found that a portfolio of stocks chosen by a reporter by throwing darts at the financial pages of a newspaper achieved substantially the same performance as a portfolio created by an investment specialist. How can one justify this?

To satisfy our desire to establish contributory links, we discuss reasons that motivate the purchase of a stock. Given the random and uncertain nature of the stock market, we have no control over the performance of an investment, so we must accept that anything can happen in the short term – a pill that is difficult to swallow. Nothing beats an example to better appreciate this notion.

On February 1st , Facebook's share price was over $195, a new record high for the social network. Financial analysts' consensus view was very positive regarding the stock's outlook (41 buy recommendations versus 2 sell recommendations), with a one-year average target of $212, a 9% increase. Unfortunately, in the span of a few weeks, the share price fell by almost 25%, dropping below $150 as a result of the Cambridge Analytica scandal. You surely remember: the data of some 87 million Facebook users was unknowingly collected by the consulting firm which specializes in political influence.

Of course, this event was impossible to predict, as was the reaction of the market. Since the stock market is made up of many stakeholders (individuals, pension funds, insurance companies, mutual funds, etc.) who have different strategies, goals and investment horizons, the behavior of a stock will always remain uncertain, regardless of our experience and the quality of our management philosophy.

It is therefore essential to respond appropriately to these situations. One of the most common mistakes is to constantly increase transactions in the hope of anticipating stock market movements, an exercise that unfortunately turns out to be futile. In this regard, researchers Barber and Odean wanted to evaluate the link between the number of transactions made and the yield obtained. To do this, they analyzed the statements of more than 66,000 investors who held self-directed brokerage accounts between 1991 and 1996. The result was conclusive: investors in the top quartile in terms of trading activity had an average annual return of 11.4%, compared to an average annual return of 18.5% for those in the bottom quartile! You know, when we say that less is more...

To conclude, I propose some reasoning from Warren Buffett, CEO of Berkshire Hathaway and certainly the biggest investor in modern finance. He recommends that we stay calm, disciplined and unmoved, and focus on respecting our long-term financial plan. Knowing that between 1965 and 2016, his investment company generated a compound annual return of 19% – a performance almost three times higher than the S&P 500 over the same period – his advice deserves careful consideration, otherwise your performance will likely be random and uncertain...

Sources:

  • Brad M. Barber and Terrance Odean. Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, The Journal of Finance, vol. LV, no 2, April 2000.
  • Henry Blodget. Here's the Real Reason Warren Buffett Doesn't Invest in Technology – Or Bitcoin, Business Insider, March 26 2014.
  • Investment Masters Class. Buffett's Edge, April 21 2018.
  • Max A. Cherney. Facebook earnings: How will news feed changes impact revenue? MarketWatch, January 31 2018.
  • Radio-Canada. Scandale Facebook: Cambridge Analytica a accédé aux données de plus de 600 000 Canadiens, April 4 2018.
  • Spencer Jakab. Heads I Win, Tails I Win, Portfolio/Penguin, 2016.

The author

Michel Villa

Michel Villa

Speaker, stock market blogger and trading coach