Ugly truths in stock-picking

February 27, 2021

I’ve invested in the stock market for 7 years and picked stocks for the last 5. I’ve also traded stock options. For each stock I had a entry point, and exit point, and plans for when the trade went south. I wrote this to remind myself the of the truths of stock-picking, and what makes it fun and dangerous.

The ugly truths of stock-picking:

  1. Having a job with stock compensation is a surer way to wealth than trading full time

I work in tech and pick stocks to diversify away from tech. In addition to providing an income the job provides a 401(k) which allow gains to grow tax-free. Working also limits overtrading, which hurts returns.

  1. Investing and trading is not entertainment

Only on reddit do writers spew: “diamond handed apes riding whales screaming war cries in their final push before entering the gates of Valhalla”. While reddit is entertaining, blindly following someone’s tips is a sure way to lose money. Reading reddit is a fun way to get trade ideas, and after research most ideas don’t check out.

  1. It’s easier to grow and/or destroy smaller accounts

Articles titled “Robinhood investors’ top picks are blowing away hedge funds” make the ordinary sound extraordinary. The average account size in Robinhood is only $1,500, while a medium sized hedge fund manages billions. It’s easy to double a molehill but not a mountain. The inverse is also true; it’s easy to destroy a molehill, but not a mountain.

Fun highlights I’ve experienced in stock-picking:

  1. Buy and hold can double your money

I bought Disney(DIS), Apple(AAPL), and Home Depot(HD) back in 2019, when the threat of Chinese tariffs and the popularity of Netflix rattled these stocks. Now in 2021 Apple almost quadrupled while both Disney and Home Depot doubled: thanks to COVID these companies grew bigger. This is an example of how “let your profits run” can yield impressive returns.

  1. Intra-day trading can double your money

At the tail end of the GameStop(GME) craze, when the stock dropped from $80 to $60 in February 2021, a put for $30 strike price expiring that week grew from $2 to $3 in one day. Buying and selling that would have netted 50% return in less than 8 hours.

  1. The underlying stock matters

I have short-term positions on GameStop to take adantage of volatility, but not on HD or Apple or Disney. Each stock is different and requires following.

How to lose money via stock-picking

  1. Selling options and overtrading

Option education courses say selling options is like operating a casino; you make a little money on each transaction, so to make more money, make more transactions. I disagree; the only casino in the investing/trading game are the brokerage houses and the clearing houses; they make money on volume while the retail traders lose money from locking in losses.

There is also the opportunity cost: I’ve lost out on returns by selling cash-covered puts during the bull market of April and May 2020, and also by selling covered calls on Salesforce(CRM) and Nvidia(NVDA), when their prices peaked.

  1. Following someone’s stock tips blindly

When a course/chart/person promises to predict the future, run. No one knows the future. The experienced investors have a plan of what to do when a trade goes south, and when to take the winnings off of the table, but they know about the future as much as a beginner does.

  1. Too many stocks

Charlie Munger, Warren Buffe’ts business partner, said: “It’s ‘absolute insanity’ to think owning 100 stocks instead of five makes you a better investor”. Doing due diligence is costly. Filtering out trade ideas takes time, and each position requires baby-sitting, especially for short-term positions for volatility play. Volatility is like fire; it can increase returns, but it can also burn down the portfolio.

Given the bad news, how to be a good investor?

  1. Avoid overtrading

There’s a research and monitoring cost per trade, which makes stock-picking expensive. Long-term holds require less monitoring but when their price drops significantly I still look into it. Perhaps the best antidote to overtrading is not to trade at all; Warren Buffet, the famed investor, advises against stock-picking, and I agree with him; it’s the best alternative for the majority.

  1. Have a hypotheses per position and do scenario planning

Research is the most time-consuming part of stock-picking; having a hypothesis directs the research. For example when selling puts I expect a stock to stay above a price point by a certain date. To determine the price point I read the news, look at historical performance, and compare with peers.

  1. Compete against self, not S&P 500 or an arbitrary target

Goals on how much to generate, eg. generate 2% returns montly for a $20,000 account, are detrimental to long-term growth because they focus on short-term gains and ignore the context. Last year I was able to double an accounts; this year I don’t expect the same performance since the COVID impacted stock already turned around. I still look for stocks that are temporarily hampered, with long term growth potential.

There you go, the truth, the fun, and the dangerous. Keep the day job and have fun learning about individual stocks, or go with an index fund and skip stock-picking altogether. The stock market is supposed to be boring and profitable, not a source of entertainment.