Many stock enthusiasts that I have met told me that they typically use stock charts and recommendations to support their investment decisions. Charts strategy is simple and straightforward. Investors use fundamental analysis to analyze whether stock is correctly priced, and then uses technical analysis to determine on an entry price. However, when it comes to recommendations, I have seen people use the strategy of research on pundit recommendations to see what they say about a certain stock. By doing this, the investor falls into a trap that I call “1 over 100,000”, believing in the opinion of 1 person over the aggregate opinion of 100,000.
Gaming, movie and restaurant industries have evolved to a point where pundit recommendations are simply ignored. With the rise of Rotten Tomato, Metacritics and Yelp, they allow customers to have a clear picture of what they are about to purchase because contributors are speaking from their personal experiences. In my honest opinion, stock market deserves this type of platform because it is very beneficial to investors, and recommenders’ past performances are the best predictor of future return. The problem is that none of pundits keep track of the past recommendations, because they simply take credits from the good ones they make and let go of the bad ones unnoticed. In this blog, I will reveal to you three things you have to know about pundits’ stock recommendations.
1. No better than you and me
Although very few pundits do have a few tricks up their sleeve, generally speaking they are no better than you and me. Even with survival bias in the industry (bad pundits leave the industry), the 60 pundits that a company has conducted in the research have generated an average accuracy of 47.4%, and this can be interpreted as worse than flipping a coin. What’s more interesting about the data is that the best pundit has an accuracy of 68%, whereas the worst is 20.8%.[1] The interesting thing about these numbers is that following pundit would grant you at most a 68% accuracy. If you do the opposite of what the pundit recommends, you would have achieved a 79.2% accuracy. Simply from the numeric point of view, the correct strategy of using pundit recommendations is to do the opposite of what they recommend. However, with all these analytical tools they claimed they have, would it be wise to go against them every time? Thus, with 47.4% aggregate accuracy, there is no clear strategy on how to use their recommendations.
Many famous pundits have claimed they have an edge over the less well-known pundits, and this statement is entirely false. From the same study conducted above, it turns out that famous investors underperform the less well-known investors in terms of accuracy.[2] With correlation between accuracy and popularity factor being negative and close to zero, it is much wiser to follow mass recommendations from regular investors such as you and me for best results.
Many pundits who have claimed that they constantly beat the market often showcase their achievements by comparing their return to the DJIA. But the truth is different trading strategy requires a different benchmark. For instance, study shows that the technology stocks that Jim Cramer recommends did outperform the DJIA for certain time period, but if you compare to QQQQ (technology ETF/Index), his return severely fell short of this index.[3] In another word, you can invest in QQQQ, save on transaction fee and your time, and still outperform pundits.
2. Impossible to copying pundits’ recommendations.
Jim Cramer has claimed that he has used his strategy to make over $100 M in the stock market, therefore, his strategy must have worked! If you were to follow his strategy, would you be $100 M richer? The answer is No.
The problem with Jim’s statement is that he made the most money in the 90s where the DJIA went from $2,500 to $11,200 which was led by technology stocks. Unlike regular investors, Jim used heavy leverage in his stock positions, bought and held many technology stocks for the easy gain. (During that period, it is harder to lose money than to make money.) Although some people can leverage like Jim, but the risk and return are aligned, thus the return you are making is a fair compensation of the risk you are taking.
As you may know, close to half of Jim’s recommendations are short. According to a study, over the long run, Jim’s short recommendations have made double the return than the buy recommendations. Recommendations such as short are incredibly hard for people to follow. We can only treat it as a sell indicator to avoid losses; thus, this portion of return is not realized.
As a finance lecturer, I still have trouble understanding making money by using public information, especially from well-known and well-trusted pundits. By the time that the recommendations have been made public, the stock price immediately reflects the value of the news and eats away any anomaly you could have made from this stock. With the additional transaction fees and commissions, you are looking at a negative sum of return in the long run.
Lastly, websites like Moody and Morningstar adjust stock ratings after events have occurred; thus, there is no predictability value in those websites. Take the European debt crisis and US debt ceiling for example, months after the news are made public, they announce the downgrade on nations’ rating. (The same applies to stocks.)
3. Behind the scene
It is not a pretty world that pundits are living in. Often TV stations are troubled by TV ratings, advertisements and airtime; thus, they typically choose a person with a big personality and distinctive character to host a TV show in the professional financial segment. People who have more information about a stock typically don’t talk publicly, because they tend to monetize the information on their own. If they have a way to make high alpha returns, I can guarantee you that you will be the last one to know.
People also have hidden agenda when they are making recommendations. Bill Gross, a famous pundit, talks down on stock and recommends bond because he manages a $1.236 Trillion bond portfolio.[4]
Lastly, the power of the stock movement lies in the market, not the pundit. Only very few pundits, when making a recommendation, can gain the trust of the public. Consequently, it becomes a self-fulfilling prophecy (notice that you can’t make money this way because it is public information).
So, how you should do it?
When it comes to stock selection where the market decides the movement of the price, there is no one better to ask than the market itself. The market is a large group of individual investors just like you and me, and we together decide the fate of a stock. To put it in the perspective of the 2007 crash, if enough people believed that the housing market would collapse, it would actually collapse. One of the researches conducted by my professor has the following conclusion: if the people live in the same location as where the headquarters locate, they tend to have more private information about the company, and clearly outperform other pundits.
Secondly, always pay attention to stock charts when making an investment. Charts display a lot more information than just transaction volume and stock price. It is the indicator of investor sentiment. It gives you a hint on the stock trend and capital flow.
Lastly, a famous word by David Swensen, the famous Yale endowment officer, said that the only free lunch in investment is diversification.
Remember
Pundits’ recommendations are really no better than random walk. It is really up to the public to decide the fate of the stock, not the pundits. Before making an investment you should read some charts, get to know the company, and gather lots of public opinions on the stocks. By doing this, it will ensure the best chance of making money.
Like always, if you have comments or questions about the blog, don’t hesitate to get in touch with me. You can reach me at fred@nvest.me.
Fred Zhou
[1] http://www.cxoadvisory.com/gurus/
[2] http://www.cxoadvisory.com/3959/investing-expertise/does-accurate-forecasting-get-attention/
[3] http://www.cxoadvisory.com/4811/individual-gurus/cramer-offers-you-his-protection/
[4] http://www.dailyfinance.com/2010/12/06/stock-market-bear-pundit-pessimist-wrong/
