The folks at CNBC have found a novel way to promote their Squawk Box morning show -- they're engaging in an old-fashioned stock-picking tournament that began last Tuesday and lasts for eight weeks. But while CNBC is billing the contest as the "Squawk Box Fantasy Portfolio Challenge," I'm inclined to say that the "Fallacy Portfolio Challenge" might be more appropriate.
Allow me to explain. Contest participants start out with a million "Squawk bucks" and trade in a funny-money stock portfolio. The person with the highest account value at the end of the eight weeks wins the Fantasy Challenge. Although the CNBC anchors proclaim that the tournament is a test of stock-picking acumen, in my opinion, it's only a step up from a controlled experiment in chance -- and a small step at that.
Simply put, the eight-week time frame is too short to reveal any ability to produce excess returns through stock selection. I can't help thinking that the contest is a classic "Fooled by Randomness" problem -- the winner is more likely to be a lucky fool (and I say that with the greatest respect) than a trading genius, much less a brilliant investor. Over the course of the contest, the main driver of stock prices is erratic change in supply and demand, driven by new and unpredictable information. Investors, as opposed to traders, would be wise to hitch their wagons to a company's fundamental performance for a longer, more profitable journey.
For your time frame, size matters
Let's imagine a different tournament in which a large number of participants are asked to trade stocks to generate the highest return over a fixed one-hour period during the trading day. What would we be able to say with confidence about the winner's ability to select stocks? In all likelihood, nothing. The only advantage that would allow you to reliably predict price movements over such a short time interval would be superior information on order flows at institutional trading desks. (In fact, a recent scandal involved some day traders doing just that. These miscreants had conspired with brokers to be able to listen to the intercom on the trading desks at Merrill Lynch (NYSE:MER), Citigroup (NYSE:C), and Lehman Brothers (NYSE:LEH), for an advantage that let them trade in front of large customer orders).
Would you rush to put your savings in the tournament winner's care to reap the benefits of his or her talent and foresight? I wouldn't recommend it. "It's better to be lucky than good," the old saw goes, but although that might sometimes hold true, in the markets it's a sure path to ruin, particularly if you can't distinguish between luck and skill. Over the long run, time neutralizes any effect from luck, so you don't want to find yourself unwittingly relying on it as your only edge. In the markets as in other areas, luck is a volatile partner that rarely keeps company with the same person for very long. Those who believe they've found a soulmate in her (I always heard that luck was a lady) will inevitably end up heartbroken.
When it comes to investing in stocks, your best chance of achieving meaningful returns depends on your ability to apply a rational approach to stock selection over a long time horizon -- one measurable in years and decades, not months. Over longer periods, volatility is ironed out and gives way to expected return. In the words of Benjamin Graham, the father of value investing: "In the short run, the market is a voting machine, while in the long run, it is a weighing machine."
From that kind of standpoint, I'd wager there's very little difference between an hour and eight weeks; success over the two periods should be relatively meaningless to an investor. This is one of the reasons that value investors such as Warren Buffett favor long-term stock ownership -- they know that long-run returns are driven by business fundamentals rather than investor sentiment. Take Procter & Gamble (NYSE:PG), for example, of which Buffett's Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) is a major shareholder. P&G grew revenues at an annualized rate of 7.3% over the past five years, which is more than twice the corresponding growth rate in the economy -- this for a company almost 170 years old!
Furthermore, for most companies, particularly those with a durable competitive advantage and a low risk of obsolescence -- and those are the companies most likely to provide a satisfactory economic return -- business fundamentals are unlikely to change significantly over an eight-week period. Consequently, we'd expect stock price changes that reflect investor expectations to be muted. Even if you believe you've identified a negative overreaction that provides you with a buying opportunity, you aren't likely to reap the full benefits of a correction over eight weeks. I'm compelled to say this is the boring (but profitable) truth of value investing in particular and of the market in general.
Trading costs matter
To add insult to injury, the "Fantasy Portfolio Challenge" rules inflate returns and, consequently, the illusion of participant skill. No commissions are charged on the fictitious trades. This isn't a Fantasy Challenge; it's every investor's Fantasy Island! In the real world, trading costs eat into your returns, and their impact increases with the frequency of your trading. Similarly, short-term trading gains aren't taxed at the same rate as long-term capital gains, another hurdle that traders need to overcome just to keep pace with long-term investors.
The bottom line
Trying to seek an advantage in stock trading over an eight-week period is illusory, at least in my experience. Stock prices will change on a continuous basis in response to new information -- sometimes relevant, sometimes not -- in ways that are impossible to predict. Even access, speed, and computational power don't provide an obvious edge. A great example is the large number of hedge funds that play in this arena. Hedge funds are tremendously competitive, and very few of them are truly successful. For the individual investor who can't rely on the same arsenal, the lesson should be clear: If you're looking for entertainment, trading is fine. But if you want returns, the stock market is a means to participate in a great wealth-building engine by becoming part-owners of superior businesses. And no reasonable business owner ever expected to strike it rich in two months.
At Inside Value , Philip Durell ferrets out situations in which market overreactions allow you to purchase solid companies at a discount to their true worth. If you'd like to see his recommendations, take a free 30-day trial.
Alex Dumortier doesn't own any of the securities mentioned in this article. He welcomes all (constructive) feedback. The Motley Fool has a strict disclosure policy.
