Stock Trading

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Should you buy or should you sell?

BACKGROUND

Investment is one of many interests I have. The goal of investment is to achieve financial independence.

The two primary investment vehicles are stock investment and real estate investment. Historically speaking, stock investment offers higher returns but higher risks. Real estate investment tends to have lower returns than stocks but lower risks as well.

Of course, this is not absolute. For example, in China, real estate outperforms the stock market, with higher returns and lower risks than stocks.

STOCK INVESTMENT

Generally speaking, there are two types of stock investment, differ by how it pick stocks. One is stock picking by human, i.e. professional fund manager. The second one is stocking picking by computerized model, aka quantitative trading.

Whether stock picking is done by a human professional or computerized model, their goal are the same : generate alpha, aka riskless arbitrage. How do measure this? The metrics is risk-adjusted return or Sharpe ratio.

How can we know if a human professional is good or great? Well, we look at his/her past records, although we know past performance is not an indication of future performance.

How can we know if a computerized model is good or great? Well, since it’s a computerized model, you can look at the backtesting simulation result. Thus, there has been  experimental lab testing to verify the computerized model stock picking is good.

To illustrate this, take a look at the following quantitative model backtesting simulation result chart for the Australia stocks.

This simulation assumes an initial investment is $300,000 in Australian dollar, investment time period is late 2012 to early 2017, aka 4.5 years :

  • Australia stock market investment returns over $440,000 in profits in 4.5 years, aka 148% returns.
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Australia Stocks Picking Backtesting Result

MISPERCEPTION

For most people, they give their money to a professional money manger to manage. It’s a misperception that professional money manager must be good or better than themselves managing money. There is some truth and some fallacy to this.

According to research study, more than half the professional money manager can NOT beat S&P500. Thus, if you just invest your money in S&P500, you will beat more than half of the professionals.

However, it doesn’t mean all professional money mangers are not good. It’s just difficult to identify/search for the good ones. Some money managers have great performance in a few years, then suddenly drop off a cliff. It’s very difficult to find one that can consistently outperform the market index. Thus, this presents a hefty “search” cost for the good money managers.

Furthermore, even if you identify a good money manager and want to give your money to him/her to manage, he/she is under no obligation to accept your money. For example, Bridgewater – the largest hedge fund in the world with $200 billions AUM (assets under management); they are not going to take your $500k in cash and accept you as its client.

To summarize, the chance of failure, meaning underperforming the market index is high when give your money to professional money managers because :

  • > 50% of failure, let’s theoretically say 60% of failure
  • Good managers don’t take your money, let’s theoretically say it’s 20%
  • High search cost for good managers

Thus, theoretically a rough guess on your chance beating the market index when giving your money to professional money manager is 20% without accounting for search cost.

SUGGESTIONS

So what do you do if you don’t want to give your money to professional money manager?

Here are my suggestions for your simple investment portfolio construction:

1, Invest in S&P 500.

  • I already discuss this above, more than half of the professionals can NOT beat S&P 500.
  • Moreover, during bull market, maybe even 80% of the professionals can NOT beat S&P 500.
  • Why? One of the reasons is that hedge funds in general are designed to underperform to market index in bull market, but outperform the market index in bear market.
  • During bull market, the “hedge” part of the hedge fund, such as shorting stocks, become costly. However, during bear market, the “hedge” helps to outperform the market.

2, Invest in stocks that you understand or can experience.

  • Since my background and experience is technology and finance, my examples of stocks I understand are “Google, Amazon”, etc.
  • On the other hand, “Costco, Sears” are stocks that I can experience, meaning I can go to these retails stores to see the foot traffic to have a sense of whether the business is good or bad.
  • Of course, there is always the question on whether the current stock price is priced in the current and/or future performance of the company.
  • A good set of invest in stocks you understand/experience is about 20 stocks.

3, Invest in unknown but potential super high returns stocks.

  • Identify unknown stocks (e.g. Telsa) but have super high return potential.
  • For instance, if you identify 5 of these stocks, you might want to bet 5% of your portfolio. If you hit all 5 stocks, you will most likely outperform the market. If you hit 1 stock, and totally miss the other 4, meaning the other 4 stocks’ values go down to 0. You could still break even since the 1 stock you hit could have jump 500%.
  • Have to remember you must adjust your investment (aka betting size) due to these stocks are risky investment. Thus, that’s why these stocks should be allocated as a small portion of your portfolio.

Simple don’t do(s) :

1, Don’t do use derivatives, i.e. options, etc. It’s too complicated for regular people, and it’s time consuming to understand it. (i.e. you should understand the Greeks associated with options) You better off use your energy elsewhere.

2, Don’t invest in structured products. Again, it’s too complex for most people to understand. During the financial crisis of 2007 – 2008, a lot of people in Hong Kong invested in “Accumulator” structured product. Those people lost most of their investment  .

 

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