The trouble with investing in stocks

I have come to a point in my life where I have a sizable nest egg in savings, and my financial future is very much a function of how that nest egg is managed. I don't have goals of changing the world. Rather, I'd like my nest egg to increase in value, hopefully in a way that the after tax returns at least make up for inflation.

The consensus appears to be that historically, over long terms, the market has had about 7% growth per year, and that one was better off having the money in the market than in bonds or other interest bearing investments.

Of course, we'd rather not be content with 7% returns. We'd rather beat the market. The problem is we'd all want to beat the market. But how do you beat the market? Well, the market has a lot of professional fund managers in it, whose full time job it is to study companies to try to figure out which ones will do well, and which ones will not. Of course, we know most funds underperform the market. And you always hear the stories of good investment people made. Surely, its possible to better than that!

And so its time to look at the stuff oneself. And its easy to see, looking at a historical graph, where one should have bought and sold. Its just a matter of picking those times next time they come up, right?

Technical analysis

And for that, we have this black magic called technical analysis, which is to study stock charts and based on patterns, make an educated guess as to wether a stock will go up or down. It turns out, there are many companies in the business of facilitating technical analysis, including one such company that I know the CEO of - Recognia - they specialize in recognizing known stock patterns that are supposed to give indicators.

So its really quite simple. Just analyze the chart, figure out if its going to go up or down, and buy or sell based on that, right?. Except of course, one of the vexing things about stock patterns is that as soon as people try to exploit them, they go away. But maybe they haven't been fully exploited yet. Maybe somebody can recognize them faster than others.

Value analysis

Ok, maybe technical analysis is all a bunch of hooey. Maybe one should just focus on what a stock is really worth. But how do you tell what a stock is worth? For all the exciting stocks that have shown a lot of growth, like Apple Google, or RIM, the stocks 'value' has always been mostly speculative. And if one always sells a stock as soon as it goes up, and buys once it has gone down, one is sure to own a stock when it crashes, and sure to not own a stock when its seeing dramatic gains. And it seems that value and technical analysis usually suggest opposite actions. And certainly, value analysis would have lead to not owning Google, but likely owning Nortel when it fell through the floor.

The need for losers in the game of Stock poker

But really, I think its a giant poker game. No matter how many analysts and speculators play with the market, that in itself will hardly make workers work harder or engineers be more inventive. So there's the 7% average annual growth. Doing better than that means doing better than average, and most certainly better than others.

So past the 7% average, its really more like winning at poker. You can only win if others lose. Of course, playing poker can in fact be profitable. There is such things as poker bots that people deploy on online poker to make money. They work, so long as there is suboptimal human players in the game as well. In order to win, somebody else must lose.

So, if everybody plays the market optimally, nobody will do better than the 7% on average. But as long as there's losers in the market, you can do better.

So just like at poker, we need losers in the market, so that we can win at it. But who might those losers be? Well, probably people who are only amateurs at it, not as skilled as the people that do it for a living.

And who might those losers be? A likely candidate would be individual investors like me! But just like some people with online gambling, we are still drawn to it. We may even have the illusion that with our skills, we are adding value to the system! That illusion was easy to maintain in the run up from 1997 to 2000. Kind of collapsed after that, but memories are short. Thankfully, I didn't have much money in the market at the time.

Well, in the mean time, I'll do what politicians do - study the problem some more. The allure of easy money is just too appealing. And maybe I'll come up with some magic predictive formula that is slightly more right than wrong. If I do, I'll be sure to use it - until the patterns change :)

Update - Oct 2007:

To explore the idea of pattern based trading a bit more, I created a stock charting website:
      Chartgame.com

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