The majority of investors are attracted to stocks because it seems like the easiest asset class.
There are the success stories, the books, Warren Buffet , Value Investing aficionados and etc.
We all know, more or less, what a company is and what their shares represent.
It’s easier to relate to than commodity prices, bond yields or foreign currencies.
Most people invest or trade stocks from companies that they believe they understand.
Let's See: If you go to Starbucks, Dunkin Donuts or Krispy Kreme for your morning coffee and donuts, you have a connection with one or all of these firms. On the top of it, you grab your hands (and read) all you can find about it, therefore it is fair to say that you have a very good understand how their business works.
The sames goes for you new neat iPhone 6 and iPad; You are an Apple Fan. Most likely, you read a lot about Apple, its products, interesting facts. competitors and get know a lot about the firm. This builds a strong motivation to buy Apple stocks.
All sounds nice and easy but in fact, this is an illusion.
Your experience with Starbucks coffee, Krispy Kreme or Apple iPhones is not really helpful for predicting future stock prices.
It only seems like it, after the fact.
This is an illusion that it’s very easy to be fooled by.
When you look at the names of publicly traded companies and relate your own experiences with them, it’s easy to get influenced by this.
More so when the greatest investor of all time - Warren Buffett - tells you to do so, right?!
If you like their products, you feel that the share price should rightfully move up. If you think that they’re outdated or have a flawed product, you feel that the price should be falling soon.
Most likely, these ideas are not helpful in trading the stock in question.
In financial circles, this is called INFORMATION BIAS!
It’s very easy to look back at a larger price move and think that it was so obvious that this should have happened.
Perhaps you look at the dramatic rise in Apple or Microsoft stock prices historically, and hasty conclude that it was easy and obvious to say that they would have dominated not only the software business but the whole stock market.
After all, these are the makers of some of the most wonderful tools we use today.
This was, in retrospect, a NO BRAINER!. Crystal Clear, wasn't it?
And yet, it was very far from clear at the time.
Let's look at Microsoft for a second.
Sure, in the generally prevailing insanity of the Dot-com era, everyone threw money at any tech stock like there was no tomorrow.
But the people buying Microsoft were generally the same that bought Worldcom, Global Crossing, AOL and many other companies that dominated Headlines by filling for Bankruptcy and often enough by Defrauding investors in spectacular fashion.
It just looks obvious looking back ins't it?
Quite often companies with great products and seemingly great strategies perform poorly in the stock market.
Equally often it’s the other way around, with insane sounding concepts skyrocketing.
Again, wait until after the stock has moved enough to make headlines, and now it seems so obvious to everyone why it all happened.
There are certainly people who are very good at fundamental analysis of companies and industries.
They’re experts in figuring out what will happen in the long run and usually go into extreme details in their analyses.
This is a very difficult game and it goes a lot deeper than liking or not liking products.
These analysts are often specialized on just one sector or even a few stocks. They follow every detail and analyze every row of their income and balance sheets.
It’s a perfectly valid approach to the financial markets, given sufficiently hard work of course, but it’s a full time profession in itself and not easy to pull of.
A very similar illusion is the belief that you have an advantage in trading the stock of the company you work for.
It would seem to most people as if their inside knowledge of the company helps them understand the market and achieve an edge in trading. Unless you’re part of the top echelon of your firm, this is non-sense!.
Even if you’re top management or a non-executive director, it’s doubtful that you will have any advantage more than at special situations such as just before an important announcement.
Those special situations are of course illegal to trade on, generally speaking.
In fact, buying the stock of the company you work for is irrational.
First, you don’t have any sort of advantage in trading it compared to any other random stock out there.
Just stop and think about it for a second:
If it worked that way, the employees of any publicly traded company would make more money on trading these stocks than they would on their salaries.
It’s just an illusion.
But it get's worst!
By investing in the company you work for, you’d be compounding your existing risk in a single company.
Yes, you’ve already got a risk exposure against the company you work for. Just think about it.
If they don't perform well, you might get fired. but If they do well, you might get a raise and a promotion.
By purchasing the stock, you’re just increasing your risk against the same entity, without any rational reason for doing so.
The Stock Market gives people the illusion that there are endless possibilities and you can diversify risks away always being safe.
Well, the problem is that when things go wrong, they all behave the same. When Crisis happen, Regardless how well you diversify, you will be in for a very rough ride.
The so called correlation in stocks works in a very funny way.
In Bull Markets, most Stocks advance, with the GOOD STOCKS OUTPERFORMING.
In Bear Markets, They all get hit!
And they do so, EQUALLY!
Meaning, they FALL AS HARD AS THEY CAN AS FAST AS THEY CAN... a la Financial Crisis 2007/2008!
So, that is when a WELL DIVERSIFIED PORTFOLIO THEORY go out of the window!
So, before deciding Long Term or Short Term, Educate Yourself!
That is the best Investment Strategy - either Short and Long Term!