I bought my first stock when I was in college. $1,000 invested in Novell. In those pre-Internet days, I watched the Nightly Business Report every evening to see how it performed. The stock rose, I took a healthy profit, and I thought I was a genius – until I bought my second stock.
Since then I’ve spent over a decade interviewing countless investment managers, hedge funds, private equity shops who spend all of their time researching securities and deals. Every single idea they espouse sounds compelling at the time. Just like I felt about Novell. But the good managers admit they are wrong almost as often as they are right. The trick is to make more money when you are right than when you are wrong.
The stock market is an auction. Whenever you buy a stock, there is someone on the other side of the trade who is just as convinced it is time to sell.
25 years ago the person on the other side of the trade was probably an individual, a retail investor. Now greater than 90% of trades are by institutions, firms which spend all of their time researching securities, who have dozens of analysts and access to reams of research. They build elaborate spreadsheets forecasting earnings and speak frequently with company management, customers and suppliers.
When I buy a stock the underlying assumption is I have an informational edge, that I know something about the company the institution on the other side of the trade doesn’t know. In fact, when I buy a stock I’m saying I know something the majority of market participants don’t know, which is why the stock is undervalued.
The fact is I don’t know more than the person on the other side of the trade. I have no informational edge when it comes to individual securities, and I would argue very few investors do.
I admit my ignorance up front so when there is a company that interests me, I buy stock options. I purchase just enough options that if they expire worthless, I’m willing to accept the 100% loss. But if I win, I win big.
When you invest in individual stocks and have no informational edge, it is no different than gambling. Consequently, you might as well structure the investment just like a bet. Double or nothing. That is the beauty of stock options.
