An article by Christian Hudspeth on Business Insider promises to teach you in four minutes how to tell whether it’s time to sell a stock. The premise of this article is fundamentally flawed. Investors who follow his advice may be disappointed.
Personally, I don’t understand why investors purchase individual stocks. The expected return of a stock is the same as the index to which it belongs, but the risk is much higher. This is because individual stocks have “idiosyncratic” risk, which is risk unique to that stock (like the death of a key executive). This risk can be mitigated through diversification, which is why it makes more sense to purchase a mutual fund consisting of many stocks. Why would you adopt an investing strategy where you have the same expected return as an index of similar stocks, but significantly more risk?
Let’s assume you ignore this advice. You own a bunch of individual stocks. Should you follow Hudspeth’s advice and sell a stock when his “warning signs” appear?
His first warning sign is a “shockingly high price-to-earnings ratio.” Unfortunately, this metric alone is not a reliable measure of future returns of a stock. If a company has a high P/E ratio, it means that investors still expect higher earnings growth and they are willing to pay that multiple of earnings for that stock. Investors as a group could turn out to be right or wrong, but few advisers would recommend basing a decision solely on the P/E ratio and many financial experts advise against using it in this manner.
The balance of Hudspeth’s “warning signs” are on shakier ground. They include:
The fundamental problem with paying attention to these “warnings signs” is they are a day late and a dollar short. Once this information is in the public domain, the millions of traders all over the world instantly factor them into the price of the stock. If the market agrees with Hudspeth that these are negative signs, the price of the stock will be reduced to reflect this assessment. This kind of information would only be useful if you knew it before it became public, but then you would be illegally trading on inside information.
Hudspeth refers to no peer reviewed studies to support the reliability of his “warning signs.” His failure to do so is understandable. Finance is extensively studied in major universities all over the world. Exhaustive studies about market behavior are published in respected journals, like the Journal of Finance. If there was a formula consisting of “warning signs” that would tell investors when to buy and when to sell stocks, you can be assured it would be published in one of these journals. The author of such a study would be considered for the Nobel Prize.
Daniel Kahneman is a recipient of the Nobel Prize in Economic Sciences. You would be well advised to heed his advice about stock picking. Kahneman told Forbes stock picking in principle is “impossible” but notes the irony that “everybody personally thinks they can do it.”
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.
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