May 14, 2012

A(nother) Lesson for Stock Pickers

There’s much to reflect on following the announcement from J.P. Morgan that it lost $2 billion on a hedging strategy gone bad; “retiring” top executives, Jamie Dimon’s crow eating and supporters of the Volcker Rule saying “I told you so”. Another, less media-driven angle on the story, is a lesson on the futility of stock picking. Finance theory suggests that stock price movements are driven by news, the implications of which are very quickly processed by market participants with the resulting price movement effectively discounting the news’ impact. Since news is by definition unpredictable, stock price movements are also unpredictable. The J.P. Morgan news is a case in point. Only by knowing ahead of time that J.P. Morgan was about to announce a $2 billion trading loss, would an investor have been able to avoid a loss on (or profit from) the 10%+ drop in J.P. Morgan’s stock price in trading immediately following the after-hours May 10th announcement.

A better approach is to except the futility of stock picking and instead implement a strategy of holding all stocks (in combination with an appropriate allocation of safer assets) thereby dampening the impact of these types of negative news events while maintaining exposure to the equity risk premium, the source of long-term stock performance.