Are Bad Stocks Easier to Identify?


Although for someone new to investing it can be tempting to think this way.

I remember back when I was studying for the series 7 exam and first learned about shorting stocks. I was intrigued by the idea you can make just as much money betting a stock will go down as you can that a stock will go up.

It all ties back into the unpredictability of stock prices. When I say you can’t predict the market or stocks, I really, really mean it. And this applies to knowing which stocks will go up and which stocks will go down.

When I first learned about shorting stocks, I wondered if this might be an easy way to make money investing. Maybe it is difficult to pick the winners, but would it be easier to pick the losers? Aren’t the awful companies easy to identify? I’m certainly not the only one who considered this. I know Certified Financial Analysts and experienced investment professionals that hold a (mistaken) belief that it might be easier to make money identifying the loser stocks and shorting them.

And why doesn’t it work?

Quite simply, because if something was this easy, then you better believe it won’t work. Mathematically it must be just as hard to pick stocks that are about to go down as it is to pick stocks that are about to go up. If you could easily pick the loser stocks and make money shorting them, then this would be the most wildly popular investment strategy on the face of the planet. Everyone could use this strategy to outperform the market, and as I wrote in an earlier post, it is mathematically, axiomatically impossible for everyone to outperform the market. Remember, you aren’t trading with a Nebula. You are trading with other people who are in the game to make money themselves. On the opposite side of your short trade must be a buyer – another market participant that has the opposite opinion from you.

I understand how easy it can be to be intrigued by more complex investment strategies. Shorting stocks and using options are some of the most obvious examples. At first, it is easy to think….wow, this may work.

Have you heard of inverse index funds? These are funds that are designed to go up when an index like the S&P 500 goes down. I have literally had investors tell me that they own an S&P 500 index fund, but they aren’t worried if it goes down because they also own an inverse S&P 500 index fund that will go up if the market falls. Does it sounds like a smart strategy? All this investor has done is buy offsetting positions that perfectly cancel each other out. It would be no different than having a lot of money in cash that won’t go up or down no matter what the market does.

In the end, these are just more complex (and generally more expensive) ways to get to the same place of risk vs. return that an investor could achieve in a much simpler and straightforward investment portfolio.

 Image by John W. Schultz