Fool's Bet: Amateur Stock Investing

Author: John Honovich, Published on Nov 05, 2015

Investors in public companies, including video surveillance, have a massive information edge. This is something I have witnessed first hand talking to them over the past 7 years for various surveillance manufacturers. 

Like playing the lotto, any fool can win once in a while, but amateurs face a vast disadvantage against the pros.

In this note, I share examples of things that professional investors know and do that impressed me and show how much more sophisticated they are compared to amateurs.

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Comments (26)

Those investors are typically going after information from specific individuals that is unpublished anywhere.

Frequently, these are going to nuanced, critical pieces of information that no amateur is ever going to access.

Trading on non-public material information is illegal though, no?

Consult your attorney.

There are different types of information and surely some is fine, some is not and some is grey.

Just one example, you meet with company execs and even if they do not say anything materially new, your conversation about politics, the weather, personal stuff can give you a lot more clues into their personality, tactics, etc.

Ok, sure there's legal information to gleaned from palaver. But is that all the 'tens of thousands of dollars' is buying?

I'm not disputing any facts of the article, I'm just pointing out that the law is quite clear that trading for profit on 'critical pieces' of 'unpublished information' from 'specific individuals' is likely illegal.

Two examples: Martha. Stewart.

Different elements.

If you are a company that can buy millions or tens of millions of dollars of stock, you will get special treatment from public companies. Let's assume it is all within the confines of the law, but you will get to meet with them, ask various questions, feel them out etc. All for free, just based on the potential of your deal. It's like Wal-Mart asking a video surveillance manufacturer for a demo system. Who is going to turn them down?

Outside of clearly insider info, like 'we are going to fire the CXO next week', there is lots of important legal info you can learn with money and time. For example, what are the key trends of the market? Amateurs rely on out of date high level market numbers ("Hey the market is growing 10% a year"). Professional investors have the resources to check / validate this directly with key players on the front lines to see if the info is wrong or things are changing.

Martha Stewart was not convicted for insider trading - she went down for obstruction of justice and lying to investigators (about her actions involving the insider trading investigation of her broker)

Did you miss this or did you not think it applied to my example?

Washington, D.C., Aug. 7, 2006 - The Securities and Exchange Commission today announced that it has reached an agreement to settle insider trading charges against Martha Stewart and Peter Bacanovic relating to Stewart's sale of ImClone Systems stock in December 2001. Under the settlement, Stewart agrees to an injunction, disgorgement of losses she avoided, and the maximum penalty of three times the losses she avoided, for a total of about $195,000 in monetary relief

Mark K. Schonfeld, Director of the Commission's Northeast Regional Office, said, "This settlement achieves everything we sought to accomplish in pursuing this case. The combination of monetary relief and future professional restrictions serve both to sanction the defendants' insider trading and to restrict them from future positions of investor trust."

This was on the CIVIL side of the situation AND had nothing to do with the CRIMINAL findings...

Who said it did?

Both, please stop.

Insider trading is on topic but the particulars of martha stewart are not.

I worked for one of the largest investment organizations in the US, whose analysts researched by visiting the organizations they were researching, looking at the operation, speaking with employees (gauging morale), as well as speaking with their banks, their customers (gauging service, product quality, etc.), their suppliers (do they pay on time?), and so on. None of this information is readily available in publications, but is acceptable research for them.

The individual investor wouldn't necessarily have access to ALL of this information, but could certainly visit the operation, talk to their customers, and so on.

David, good feedback!

The main issue I see with visiting operations is that companies are likely to be less motivated to let smaller investors tour their operations or speak with their people. They would generally feel that such visits are not that useful / productive, given the low dollar potential investment.

Yep! Totally agree with you, John. It's a matter of degrees. How many dollars being invested. The individual investor would have much more limited access.

Still, if I wanted to invest in ABC Mart, for example, I could learn a lot about it inside the store (cleanliness, morale, organization, management effectiveness), outside the loading dock (security, safety protocols, etc.), and so on.

As a video end user, I learn a lot from IPVM. I am less likely to purchase a product from a manufacturer with extensive turnover at the top (are they distracted from managing quality, people, customer support?) or in financial straits (are they cutting back on quality, staff overworked and fatigued?) Same principles apply to investing.

You're right that there's limited resources for smaller investors. We have to make the most of what is available.

I completely concur with John's premise regarding the deck being stacked against amateur investors.

Frontline did a great piece on insider trading and hedge funds last year called To Catch a Trader which showed pretty clearly that trading/leaking of information is - or at least has been - a very common occurrence within the world of professional trading. I highly recommend viewing it.

One of the things Frontline talks about in the documentary above is the use of what they call 'expert networks' - just like GLG referenced above by John.

As UD1 points out above, it strains credulity that any investor would pay the kind of money they do to use these 'expert networks' if the information that they are able to glean from the $500 calls can't be converted to profitable stock plays. They are not paying to hear about office gossip and who parks in handicap spots, etc.

I wouldn't doubt sometimes illegal info is provided, however (1) GLG is pretty adamant about training / reminding their 'experts' and (2) there's plenty of other information that can be provided that is certainly legal. For example, an investor who gets experts to tell them the relative pricing and performance of top competitors in a market, clearly has an advantage, and there's nothing illegal about that; just a pro-investor out working the amateurs.

I've not dealt with GLG, although I have with AlphaSights, which sounds very similar. They coordinate fees/schedules for me to take phone calls with individuals/companies wanting knowledge about various industry segments, technology, and competition.

I have never been quite certain of their legitimacy after a number of rescheduled calls on the first go around and have turned them down for future calls ever since.

Yes, there's been a number of competitors who popped up, as it appears to be a fairly profitable business - use the Internet to connect price insensitive, very rich customers, etc.

In my experience, GLG had a who's who of blue chip, mega companies using it.

I disagree. I think you are over-emphasizing the research edge. I am a professional investor. I think that the deck is stacked against all sorts of investors:

  • The careless
  • The over-emotional
  • The ill-prepared
  • The gullible
  • Fuzzy thinkers
  • Excessive risk-takers

Investors like the above can be individuals or professionals. I have seen lots of both. Over the long-term, individual investors can do very well, I think, if they exhibit some or most of the following traits:

  • Dispassionate
  • Methodological
  • Observant
  • Curious
  • Clear-thinking
  • Brave
  • Know themselves
  • Understand risk

To be clear, yes investing takes some research. But more than this, it takes work and diligence and patience. You are better off to do no work and to buy the index than to pick stocks with insufficient work. I think Ben Graham, or perhaps another of the great investors, said you should allocate the same effort to selecting a stock as you would to selecting a car or a school for your kids.

The following books lay out very effective methods for stock picking by individuals.

  1. The Intelligent Investor, by Ben Graham, 1949. The bible on value investing.
  2. Common Stocks, Uncommon Profits, by Phil Fisher, 1960. The bible on growth investing.
  3. One Up on Wall Street, by Peter Lynch, 1989. Makes the case that individual investors can outperform professionals.

Thank you for reading.

4, great feedback. I totally agree with you about the important character traits. And I have seen some professionals that lack them. I have also seen some professionals who make money from providing banking or financials services to publicly traded companies that also skews their opinion / position.

That said, in general, professional investors more often have those traits than amateur ones. Stockhouse, e.g., is a showcase of the opposite of your recommend traits.

I am curious, though, given two investors who have those traits, but one has the information edge of a large professional organization, what edge do you think that provides.

Indeed there is a great preponderance of theory and opinion about the efficiency of markets. I remember reading Malkiel's book many years ago when I was reading everything I could find about investing. He seemed eloquent and educated but I don't recall what impression, if any, I had of his central thesis that markets are efficient and as a result nobody can consistently outperform the markets. Perhaps I missed it at the time or was unmoved. These days I reject that view wholeheartedly.

From a personal motivation standpoint, which should you allow to have a greater influence? Three great investors, Graham, Fisher and Lynch, who wrote books in great detail on their methods of investing which generated superior results for decades, or a book by a university prof explaining the theory of why this is impossible.

As it turns out, in the subsequent 20 years I have made a career out of the inefficiency of the markets as a stock picker. Maybe this has worked out because I have a very narrow focus or I am thorough in my work or I am good at pattern recognition or I am lucky. I make a good number of mistakes but I have also improved my method over the years so that my mistakes are less severe and less frequent.

But not once in the past 20 years have I ever stopped myself to say, hold on, Malkiel has proven in theory that what I do is not possible. I am pretty sure the same goes for other, more famous, stock pickers: Buffett, Lynch, Fisher, Gross, Druckenmiller, Klarman, Miller, etc.

Yes it is true that most investors, pros or otherwise, are not very good. This may be why many in the investment industry believe in the efficient market theory. It provides a good excuse for their poor performance. To go back to golf, do hacks look at the collapse of Tiger Woods' career and say that this proves that nobody can sustain a superior result in the game over the long term?

I have met only a handful of very smart institutional investors with long-term track records well above anything the random walk would predict, say 17-20% annual returns for 20 years or more. But the best investor I ever met is an individual, a private investor, who has turned his own small money into somewhere between $40m-140m over a decade or so. He started on his own just a smart guy with a unusual insight into mathematics and cash flow analysis. He pursues the independent research angle a little bit but shyness and a lack of industry expertise get in the way. His real angle is an almost genius ability to interpret financial statements and to uncover hidden jewels trading at abnormally low prices. I have watched him do this repeatedly.

There is a theory to support every point of view. But I would encourage people to aim to achieve what others consider impossible.

Malkiel's focus is on funds. I have not read the whole book since my intro to corporate finance course in college but skimming through it on Amazon his main focus is about picking between different mutual funds vs buying an index fund. This makes good sense to me.

My point is about investing / specializing in individual stocks. It is obvious that some people will have better information that the overall market for individual stocks. Take Pedro's exit at Avigilon. I (and presumably) many others were told a few weeks before hand. Now, I don't invest in stocks at all but surely there are people out there who take advantage of this type of early information, while the rest of the market gets hit by it later.

Research is part of it but it's only one part of it. Yes the large institution may spend lots of money to get that information edge, but they are equally free to draw the wrong conclusions, or to get mired in details or to lack courage to make a brave decision etc.

Also, the individual investor does not suffer through bureaucracy, investment committees, portfolio allocation definitions, the need for high-volume, the monthly returns game and other factors which create friction and lower returns for professionals.

Let's compare investing to golf. There are a lot of elements to a successful game, but ultimately nobody does it perfectly. It can be equally humbling for anyone. Your emphasis on research is a bit like emphasizing the putter or driver. All things being equal, will the person with the new titanium driver outperform someone who doesn't have that club? Maybe/maybe not.

BTW I taught my children investing when they were both under 12 years old. We used a simple methodology:

They picked companies they knew: They created a large list of consumer products and services they were familiar with. (Peter Lynch method.)

They screened the companies for financial parameters which show on Google finance: ROE, Cash from Ops, Dividend, PE. These were explained in simple terms they could understand, for example a dividend was described as an allowance you get for owning a stock etc. (Elements of the Ben Graham method.)

They screened the shorter list of companies by visiting the businesses, asking customers and employees about the business and using their own observations. This is research and it didn't cost anything except time. (Elements of Phil Fisher and Peter Lynch methods.)

They bought two stocks and made very high returns, cashing out over a 2-3 year period. Of course, luck and timing and my coaching were part of it, but the main point was to learn a method that they could repeat.

Making money in the stock market, given sufficient time and a modest amount of capital, is not hard. Indexed funds make it relatively easy for most anyone.

Beating the average return by trading in individual stocks is a different story. Every dime above the average is essentially a zero-sum game. You win, somebody else loses.

And who is the competition? How does one know they can be better than the average? On the one hand, I could imagine that someone willing to devote significant energy into the pursuit of returns could do quite well, considering that most individuals don't have the time or ability to do so.

However even though there is a lot of mom and pop investment money out there, what percentage of it is being traded at the stock level by casual individual investors? The dumb money, so to speak?

I'm thinking very little compared to the sums that are effectively controlled by professionals on behalf.

So it's you against the pro's, and the pro's do have certain undeniable transactional advantages due to scale, even if they have some disadvantages as well.

Moreover, I would disagree that the individual investor is free from concerns regarding risk and return, as you mention specifically:

portfolio allocation definitions, the monthly returns game

Individuals have risk of ruin to contend with and recurring income needs that can lead to less the optimal decisions.

I think its a tough game to play.

In short, you may well above the average return, but then you must be well above the average investor.

Which everyone cannot be by definition.

This has been a very interesting and enjoyable discussion. Let me try to take the discussion away from investing momentarily.

I am reading a book on an entirely different topic these days, Full Catastrophe Living, by John Kabat-Zinn. The book summarizes an eight-week course on mindfulness that Kabat-Zinn has been leading at U Mass Hospital since 1979. The course is taught to the chronically ill, depressed, suffering and otherwise pained people who can't cope with some oppression in their lives.

Can an amateur investor do well? Can a startup industry website like IPVM beat the established industry magazines? Can a new entrepreneur succeed in a crowded market like IP video? Can a patient overcome pain?

Consider this passage, which I read today:

"Our doubts about our own abilities become self-fulfilling prophecies... We effectively impose limits on ourselves via our own thought processes. Then, too often, we forget that we have created these boundaries all on our own... You might surprise yourself if you took on a new problem, just for fun, and tried something new, even if you didn't know what you were doing and even if you inwardly doubted your ability to do it... The point is that we don't always know what our true limits are. However, if your beliefs, attitudes, thoughts, and feelings are always producing reasons for not taking on new challenges, for not taking risks, for not exploring what might be possible... then you may be severely and unnecessarily limiting your own learning, your own growth, and your ability to make positive change in your life."

Forgive me for digressing. Perhaps I suffer from being too optimistic about the human spirit. All the best.

"This has been a very interesting and enjoyable discussion."

It certainly has!

John, I appreciate your allowing this discussion to play out, though not necessarily a Security topic.

U-4, love your careful approach to investing and that you shared it with your kids. I tried to get my son started as a child, but he had no interest. He's a science guy.

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