When I think of investing in the stock market, I think of buying a stock with the intent of holding that stock in my portfolio for several years or more.
Therefore, the goal is to pick stocks that have a good chance at appreciating in value during that time frame, and preferably at a rate better than the overall market.
Unfortunately, there are few stock pickers that consistently beat the S&P 500 from year to year. Studies have shown that the vast majority of mutual fund managers underperform the S&P 500 over the long run.
In fact, independent research firm conducted a study in 2010 that indicated that the average annualized investor return in U.S. mutual funds was 4.25%, compared to the S&P 500, which gained 8.21%. Not good!
And, most individual investors who buy stocks have trouble even beating the rate of inflation.
Why is this?
What many people don’t realize is that in any given year, it is a small minority of stocks that drive the rate of return on the major market averages. Also, in the long run, many companies don’t generate much of rate of return at all, if any.
With that in mind, the odds are actually stacked against the individual investor.
Consider this…the mutual fund managers have all of the best information available at their disposal. They have the best Wall Street analysts providing forecasts for individual companies, economists forecasting economic growth, and they even have access to the company executives for the stocks they are following.
Yet, their performance still tends to be weak. So, why would an individual investor think they can do better with less information? Many point to the success of Warren Buffett as a long term investor. However, Buffett has not just bought individual stocks…he has used other instruments such as futures and warrants, along with preferred stock. Furthermore, he’s been in a position to have a say over how a company should be managed. He has also owned privately held companies as well.
With all this in mind, it is my opinion that the average person should forget about trying to pick stocks as long term investments.
Instead, the average individual who wants to speculate in the stock market as a secondary source of income should consider trading high momentum stocks.
This is not necessarily an easy endeavor either. It requires having a detailed plan for trading, the discipline to stick with that plan even when times are bad, and a little bit of luck catching a couple nice trades as you start out, if you are starting with a small amount of capital.
Many people are skeptical that it is even possible to beat the S&P 500, given that most mutual fund managers are unable to do so.
However, individual investors have a huge advantage over these fund managers…your smaller portfolio means you can enter and exit positions far more nimbly than a fund manager can even dream. Therefore, it is much easier to execute a specific trading plan without worrying about liquidity concerns.
It is possible to build enormous wealth trading stocks
In 1957 a professional dancer by the name of Nicolas Darvas had $50,000 in his trading account. He had no computer and no TV with which to monitor the market. His only tools were his weekly Barrons magazine and a telephone. He received price quotes a couple days each week via cable when he was traveling overseas.
After a few years of study, Darvas had settled on a methodology for trading stocks wherein he focused on stocks that were moving up quickly in price with an accompanying increase in the volume of shares traded.
He simply waited for a pause in the uptrend, and then entered a long position when the stock resumed its uptrend. He then exited the position when another, better opportunity came along, or when the stock trend showed significant signs that it was coming to an end.
This is one of the stocks that Darvas exploited with a trend following strategy he developed on his own.
By mid-1959, Darvas had run is $50,000 account to over $2 million through a combination of having a specific strategy for trading the leading stocks in the market, an appetite for risk and a bit of luck. The market was very strong at that time, and Darvas was able to catch some very big winners.
Keep in mind, Darvas did have his share of losing trades during this time as well. However, he tended to exit an initial position if it moved against him by $1 to $2 per share. However, trades such as Lorillard, where he essentially doubled his investment within a few months, more than offset these small losing trades.
Final Thoughts
Darvas and other traders, such as Jesse Livermore, Richard Dennis, Ed Seykota, all of whom employed a trend following approach to trading stocks and commodities, have had a significant impact on many of today’s traders who are managing significant funds as hedge fund managers.
These traders do not concern themselves with the fundamentals of a company, but focus purely on price action. This is an easier approach to employ because it requires no forecasting based upon analyzing a company’s business.
With this in mind, anyone interested in developing an alternative income stream through stock market speculation should consider trading in stocks, rather than investing.
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