Do Your Homework?

Investment advice usually comes with the admonition to "Do your homework!"  While the writer is providing information intended to be helpful, investing is not a "one size fits all" process.

What is the Assignment?

Jim Cramer has a homework rule taken from one of his books.  It lays out some minimal requirements quite clearly.  The most important is that doing the homework may require as much as one hour per week per position.  Cramer quite correctly points out that using a buy-and-hold strategy on growth stocks will not work. 

I can assure you that you will be soundly beaten
by professional managers with good track records who are actively
searching for good stocks all of the time.

This is excellent advice, but probably ignored by most of his readers.

The Intelligence Trap

In most endeavors intelligence is an asset.  At "A Dash" we can tell from our feedback that we have a sharp audience.  Investors in our products are also very smart and quite successful.  We get plenty of questions and comments from them, invariably based upon their own reading and research.  They have been doing homework.

Here is the problem.  Intelligent people are likely to believe that success in their chosen profession means that they will also be successful as investors.  They read the Wall Street Journal and Fortune and a few other publications.  Some of them also do online research, checking out the leading websites and blogs.

A little knowledge can be a dangerous thing….

It is possible to learn just enough to get into trouble.  Most of my investors can discuss any current market issue for a few minutes at a cocktail party.  Put another way, they have very good knowledge of information that everyone else already knows, information already printed in the paper and reflected in market prices.

Research Tools

There are some wonderful tools available to facilitate stock screening and back-testing of systems.  Television advertising assures the investor that this is easy to do.  The ads target investors who have some "dogs" in their accounts, evidence that their investment advisor was a clueless bozo!  Since there will always be a wide range of account results, there is always a market for this type of appeal.

Powerful tools are great for users who understand both the subject matter and research methods.  Those requirements would eliminate nearly all individual investors.

Examples

Here are two very simple illustrations.  These are chosen because in each case there is only one obvious error.  Doing research with more parameters increases the chance for error quite dramatically.

The yield seeker.  A few years ago a friend who was a small client expressed an interest in income from dividends.  For his own reasons, he wanted to own stocks, and he had read some articles that emphasized the importance of dividends.  He went to a popular stock screening tool, entered a couple of requirements, and soon had a list of the highest-yielding stocks with acceptable market cap and liquidity.  He sent us the list for our consideration.

What do you suppose that  we found?  It was a list of companies which were about to cut their dividends!  Nearly all had some problem with earnings, debt, or both, so the dividend was in peril.

The pro with a system.  Back in the "bubble era" we had dramatically changed our investment style, reflecting the market risk we perceived.   One Saturday we read with interest a column in a prominent weekly financial publication.  A professional manager, highlighted in a feature article, had described a group of laggard stocks that one could safely sell short against an aggressive growth portfolio.

We were amused to see two of our own holdings on the list of laggard stocks.  What was the problem?  These were both asset plays!  In one case we were waiting for real estate and timber to come into favor  (which it soon did).  The companies involved looked like laggards on a P/E basis, but only if one failed to look at the asset holdings.  The person developing the system did not carefully consider all of the relevant variables.

And that was a professional!  It was someone deemed worthy of a feature article.

We used the list to see if there was anything else worth buying!

Conclusion

Doing homework requires a commitment of time and a lot of specialized knowledge.

Future articles will examine whether popular investment sites help the investor get the homework in on time.

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2 comments

  • JohnDiddler July 21, 2007  

    i am a big note-taker, and i plan out my strategies by debating myself within my notes. recently i’ve been reviewing notes from like three years ago (when i wondered if i should buy aapl at 14). i can tell how ignorant i was, thinking i just needed a system, a simple system… and that’s true… but only one that demonstrates above-average return on identifiable patterns back-tested across time and confirmed legitimate. which is basically impractical for me so i hone it down to time-tested principles like asset allocation and position size, respecting the recommendations of organizations that have a solid track record of recommendations for the kind of investing i do, and the rest is position management, and learning to take a profit and cut a loss and don’t look back.

  • Jeff Miller July 21, 2007  

    John —
    Thanks for sharing these very sensible conclusions and ideas.
    Jeff