Why Stock Prices Go Up and How to Make Great Investments
People as a whole are poor capital allocators. Being a cutting-edge neurosurgeon, a brilliant CPA, or a savvy programmer does not provide the skillset required to be long-term successful in markets. What does then? Before we dig into that, we need to first understand why stocks go up in the first place. On the surface, this feels like an extremely complicated question, and you may even be wondering if I’m trying to trick you. No tricks today. The answer is surprisingly simple:
Stock prices go up when there are more buyers than sellers.
Stock prices go down when there are more sellers than buyers.
Valuation, growth prospects, profitability, and the macro environment are nothing more than signals to bring buyers and sellers to the market. Ostensibly, not all signals are corresponded to rationally; for example, a fantastic earnings report may result in a stock price decline. Why would people sell off a company who posted strong results?! It might surprise you to know that stocks trade based on what is expected to happen in the future, so the alignment of earnings against expectations is what ultimately matters. When future expectations are used as the yardstick for pegging stock prices, short-term volatility is a corollary.
If you knew which days buyers were going to outnumber sellers, you’d have found the holy grail to stock market investing; you’d make money on every trade! It suffices to say that many have tried to build analytical models and systems to predict market direction. Unfortunately, those systems tend to work until they don’t. There are too many variables involved, including emotions themselves, that incentivize people to buy and sell securities. Market prediction mechanisms are more apt to lull an investor into a false sense of security than create meaningful and consistent profits.
The randomness of stock price movements is referred to as Brownian motion. The classic example of Brownian motion is dropping a single bead of food coloring into water and trying to predict where it will go. Hot and cold water, much like the macro environment, will impact the rate of movement, but the actual movement is inherently random.
Brownian motion at work
If markets are indeed random, what odds does that leave for an investor who is trying to build a retirement portfolio? If, after all, stock trading is nothing more than spinning a roulette wheel each day, why not build your retirement at the casino? The truth of the matter is that all short-term movements in the stock market are random, but long-term movements, while still having many unknowns, are much more predictable if you know how to do the proper analysis. Analysis is complex, imperfect, and can be summarized as the act of increasing sets of known information while reducing sets of unknown information until a conclusion regarding an investment can be reached.
Earlier, I mentioned that most people are not successful in making money in markets over the long-term. This is because most people are either traders or other ill-equipped investors. Let’s take a quick look at the difference between a trader and an investor to better understand why.
Trading vs. Investing
These two words get mixed up a lot and in most situations, they can be used interchangeably without any need for correction. But it’s important to differentiate trading from investing for the intents and purposes of this entry.
Trading: Placing a bet on a stock
Investing: Placing a well-educated bet on a stock
Notably though, not all investments are long-term and not all trades are short-term. A trader is making a decision based on emotions, prior price movements, or an idea that lacks sound qualitative and/or quantitative fundamental reasoning. A key difference in investment is the research of various imperatives to determine that there is a substantial chance for material gain relative to material loss; I like to call this differential the asymmetric upside of an opportunity. Proper research also provides the right framework to make better decisions as more information becomes available over time. While even the best investors are occasionally wrong, the successful ones are good not only at making money but also at not losing it. Furthermore, an investor can tolerate a position moving against them for a very long time, assuming the underlying reason for investment has not changed and another more appealing, alternative opportunity has not come onto the scene.
Think of the difference between trading and investing like the difference between Blackjack (trading) and Poker (investing).
In Blackjack, you start every hand with zero information and are simply wagering what you think you can afford to lose; the odds are stacked against you. The dealer will even help you make better decisions, and the drinks may soon become free. Just like your stock broker who wants to keep you trading, the casino wants to keep you playing. Any short-term success will eventually succumb to the inevitability of probable losses if you stick around for long enough. The bid-ask spreads also rack up in trading, a common complaint among those who advocate against selling order flow.
In Poker, on the other hand, each hand brings a series of knowns and unknowns, and you can immediately fold your hand at minimal investment. There are an incredible amount of datapoints that emerge throughout each hand: cards, player styles, bluffs, probabilities, bet sizes, etc. This puts you in the driver seat, allowing you to make bigger bets when the odds are in your favor; and perhaps more importantly, to cut your losses when the status quo becomes unfavorable. And no matter how good you are at Poker or investment, you may still lose even when the odds to win are heavily in your favor, something Poker players call a bad beat.
There are still two grey areas in the differentiation of a trader and an investor:
Time: If a trader holds a poorly researched position for years, are they an investor by fiat?
Sufficiency: How much information must one have to support a position to be considered an investor vs a gambler?
The nuance begged by the above two questions probably doesn’t even matter; those who hold poorly researched positions, even over a long time horizon, are going to make more human judgment errors, resulting in suboptimal asset accumulation over extended periods of time.
How to Be a Successful Investor
Being an above-board investor is incredibly difficult because it requires a massive time commitment to do things that most would consider extremely boring. As mentioned earlier, an investment skillset is very similar to that of a Poker player: long hours of grinding away until the right opportunity strikes; then, careful movement in and out of it. When done this way, long-term stock market success becomes much more predictable; of course, short-term movements are still random, and no market participant wins every single time; therefore, the investor is burdened with sizing his positions accordingly.
The skills to be a superb investor are difficult to define, but here are some of the more basic requirements:
Know the goals of your portfolio. You can’t allocate if you don’t know what you’re targeting.
Look for ideas everywhere. Every 100 ideas probably only has 1 or 2 good leads.
Read the stock’s respective SEC 10-K and 10-Q and have a fundamental understanding of income statement, balance sheets, and cash flows analysis.
New information can’t be ignored. Risk/return trade-offs can change in an instant.
Having exit criteria going in is important; otherwise, how do you know when to increase your bet or cut your losses?
Know how to size your bets. I’ll post another article on this later, but this is a major differentiator between good and bad investors. It’s more mathematical than you might think!
Leveraging an experienced and talented investment advisor can give you instant access to a propitious long-term portfolio without having to commit time and energy to learning a skillset that takes years of careful study to develop with no guarantee of having the knack for it. Pairing with an advisor is one of the best ways to make the most of your career earnings. Unfortunately, most people tend to delay the process until later in life, which subsequently delays their retirement goals.
