Updated: Jun 5, 2020
In the past three months, I’ve been seeing many different articles that advocate investing in individual stocks.
The narrative that gets spun in these stories is that certain companies are either well-positioned to thrive in the current state of the economy or have seen their stock price fall so low that they now offer compelling value to investors.
In this article, I am going to explain the massive flaw in this kind of thinking and why picking individual stocks in a recession amounts to gambling with your money. I’ll also review a more rational way to invest.
The two stock-picking narratives
Every day I see a new article giving advice on stocks to buy during the recession. These stock picks come in two varieties.
Investing in technology companies or other businesses that will thrive in the “work from the home economy.” Zoom is the company I see cited most often.
Investing in companies whose stock price has already fallen dramatically. The idea is that these companies have somehow been “oversold,” and when things turn around, these stocks will come roaring back. Airlines and hotels would be prime examples.
Both of these narratives try and sell the reader on the idea that they can achieve fantastic investment returns.
Admittedly, these narratives seem compelling to the average person who may not know much about investing in the stock market. If you examine these narratives with basic knowledge of how the stock market works, you realize these are nothing more than stories.
You are not the first person to have that investment idea
Let’s start with the idea of picking stocks that will thrive while so many people are working from home. I’ll use Zoom as a stand-in for all of these types of companies, as it is the stock cited most often in these types of articles.
At the time I write this, Zoom’s stock price has increased by 150% from where it was on December 6th, 2020.
150% in 5 months. That sounds incredible, and it is, to an investor who bought Zoom stock on December 6th. For an investor who is thinking about purchasing Zoom stock today, that 150% return means absolutely nothing.
You might argue that companies like Zoom will see a massive increase in future revenue, so we should expect to see an enormous rise in its stock price.
Anyone making that argument does not understand how the stock market works.
Yes, we would expect Zoom to have a massive increase in its earnings as more people work from home.
That expectation is the reason the stock price increased by 150% from December to May.
The only way Zoom stock will continue that type of gain is if it’s earnings are significantly higher than what investors have already priced in.
By the time you read an article telling you about how much money Zoom is going to make, you are too late to capitalize as an investor. The fact that Zoom is going to make a lot more money is already reflected in the stock price.
If you wanted to make a killing with Zoom stock, you should have bought it in December.
If you buy Zoom stock today, you are making a bet that Zoom’s earnings will outperform what the market has already priced in.
The keyword is “bet.”
When you chase past returns of individual stocks, you are gambling.
More companies go out of business in a recession
Now let’s address the narrative that you can make a killing by investing in stocks that have seen the deepest decline in prices during the recession. I’ll use airline stocks as a stand-in for all of these types of stocks.
This narrative is also very appealing and intuitive at first glance. After all, we’ve all heard the saying “buy low and sell high.”
At the time I write this, many airline stocks are down nearly 70% in the past 3-months. This is the ultimate “buy low” opportunity, right?
That’s true if you assume the airline you bought stock in will recover.
The biggest risk of investing in individual stocks is that the company goes out of business, and you lose all of your money.
Under normal economic conditions, average businesses go out of business every day.
During a recession, good companies can go out of business.
During a lockdown of whole sections of the economy, nobody knows what businesses will survive because we have never had that happen before.
If you are considering buying an airline stock which has fallen by 70%, the first question you need to ask yourself is, why has it fallen 70%?
The answer is that the business is likely teetering on the edge of bankruptcy.
Yes, there will likely be airline stocks that survive this recession. This presents two unsolvable problems for an investor.
We have no idea which companies will survive and which will go bankrupt.
We have no idea if the airlines that survive will ever return to the level of profitability they had before the recession.
Investing in individual airline stocks will have three potential outcomes.
Conditions in the world change allowing the stock price to come roaring back, and you make a considerable profit.
The company goes bankrupt, and you lose all your money.
The company survives but never returns to its previous level of profitability, and you simply made a lousy investment.
No one knows which of these three outcomes will playout for any individual airline stock, which means investing in them is a gamble.
The massive flaw in any stock-picking idea
Any investing strategy that relies on picking individual stocks in any circumstance is almost certainly doomed to fail or at least depends on luck to be successful.
To realize why that is true, you need only look at the efficient market theory, which states that stock prices are unpredictable and reflect all available information.
If stock prices reflect all available information, and we can’t predict how they will change, it’s next to impossible for investors to outperform the average return of the stock market consistently.
Even if we accept that markets are not perfectly efficient, they are efficient enough that 81% of fund managers underperformed compared to the S&P 500 index over the past five years.
If the brightest people on Wallstreet can’t pick stocks well enough to outperform the market, ask yourself what the blogger who is telling you to buy airline stocks knows that these people don’t?
A more rational approach to investing
If you accept that markets are reasonably efficient, that means you must accept that the odds of you consistently outperforming the market are about the same as you beating Lebron James in a 1–1 game of basketball.
The rational investor looks at the evidence and concludes that you can’t control, predict, or beat the stock market. If you can’t beat the stock market, the next best thing is to buy the entire stock market. The simplest way to do that is to invest in index funds with the lowest fees.
We know one thing, the economy will eventually recover. We don’t know which companies will lead that recovery. Investing in the entire stock market allows investors to profit from that recovery regardless of which companies fail and which thrive in the future.
Invest your money, don’t gamble with it
Two of the most common narratives spun by stock pickers are to invest in companies like Zoom, which are expected to thrive in this recession or companies like airlines that have already seen their stock prices plummet.
The current price of any individual stock tells us next to nothing about where the stock price will be in the future. That is because the stock market is at least “reasonably efficient,” making it nearly impossible to predict how stock prices will change moving forward accurately.
Buying individual stocks is an excellent idea if you have a time machine, or you can see the future. Otherwise, just buy the whole stock market at the lowest possible price and move on.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions