Why You'll Get Creamed As a Trader

Now here's a quote: "2007 is going to suck. All 12 months of the calendar year."

That's the message DR Horton (NYSE: DHI  ) CEO Donald Tomnitz gave at an investor conference earlier this week. Time to sell your DHI shares ahead of the crowd, right? Wrong.

It's been a few days since Tomnitz made that comment, so its implications are long since baked into the stock price. But soon, even if you were at the conference in real time and tried to make a trade on your BlackBerry seconds after you heard the quip, you would be too late.

Meanwhile, in Gotham ...
That's because Dow Jones announced this week that it will begin selling the "Dow Jones Elementized News Feed," a product designed to deliver breaking stock information straight into the computers of the big traders who pay to subscribe. The benefit, as Dow Jones chief product officer Dennis Cahill told The Wall Street Journal, is that the product will "allow the algorithmic trader to, within the half-second of an event occurring, make a trade on this kind of data."

In other words, when DR Horton raises guidance at next year's conference, by the time you type in your user name and password to your brokerage account, the news will be baked into the stock's price.

What this means for us
Quite simply, it means that if your day job is not day trading alongside tens of thousands of dollars' worth of high-powered computer equipment, you're going to get smoked. Rolled up, lit, and smoked.

But there's a "but."

But?
Institutions buy and sell more equities today than ever before. Fidelity, for instance, controls $1.3 trillion in assets under management. The rising importance of 401(k)s and IRAs, coupled with the explosion of exchange-traded funds (ETFs), makes indexing in your portfolio cheap and convenient.

Have you ever thought about how all those new ETFs buy and sell their shares, though? More and more, the answer is via "program trading" -- when institutions trade large chunks of stock through computerized, automatic electronic transactions. Such automated executions have made up 30% of all New York Stock Exchange trading activity for the first three months of 2007.

Let that soak in.

Would you like to play a game?
Trillions of dollars are moving around the market without any human being actually stopping to think, "Hey, does this make sense?" Take, for example, what happens when a stock is added to the S&P 500 index, as CH Robinson Worldwide (Nasdaq: CHRW  ) did earlier this month when it replaced Health Management Associates (NYSE: HMA  ) . Volume (and sometimes price) spikes -- as all of the S&P 500-tracking investment vehicles use program trades to add the stock to their portfolios.

But what does an addition to the S&P 500 really signal about a business's future? You guessed it: Absolutely nothing.

Here are the criteria Standard & Poor's uses to decide who's in and who's out:

  1. U.S. company.
  2. Large market capitalization.
  3. Public float.
  4. Financial viability.
  5. Adequate liquidity.
  6. Maintain sector representation.

The only trait here that speaks to business prospects is "financial viability," but Standard & Poor's defines that as four consecutive quarters of positive as-reported earnings. Not exactly a high hurdle to clear.

In fact, 3,926 U.S.-listed stocks currently meet that standard of financial viability, including Cypress Semiconductor (NYSE: CY  ) , Research In Motion (Nasdaq: RIMM  ) , Baidu.com (Nasdaq: BIDU  ) , and Red Hat (NYSE: RHT  ) . And while we wouldn't go so far as to call any of these stocks financially unviable, all four trade for high earnings multiples and operate in extremely competitive industries. Thus, four trailing quarters of positive gains says nothing about whether they'll make for good future investments.

But the computers don't care. They do what they're told ... and fast.

Here's where you smile
Algorithmic trades and program trades utterly miss two key ingredients that have proved to yield long-term investing success. They are, simply:

  1. A focus on businesses, not stocks.
  2. A long-term time horizon.

So while you can't hope to out-trade the big money, you can hope to out-think them. That's where your advantage as an individual investor lies. And if you're not exploiting it, you're leaving money on the table.

Zag when they zig
At The Motley Fool, we believe you can outperform Wall Street if you stick to your strengths and ignore the artificial pressures -- like keeping pace with the market on a quarterly basis -- that hinder professional investors. If you'd like some proof that it's possible, look at our Motley Fool Stock Advisor scorecard.

By focusing on businesses and recommending companies that are reasonably priced, well-managed, poised to grow, and built to last 100 years or more, Fool co-founders David and Tom Gardner are beating the S&P 500 62% to 26% on average (since the newsletter's inception in April 2002).

That's the reward in being a business-focused, long-term investor in today's stock market, and letting the computers play the trading game. You can take a look at all of our research and recommendations at Stock Advisor free for 30 days. Click here for more information.

Neither Tim Hanson nor Brian Richards owns shares of any company mentioned. Tim and Brian wish they saw more of Crow T. Robot these days. Baidu.com is a Motley Fool Rule Breakers pick. The Fool has a disclosure policy.


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