Saturday, May 31, 2008

How can I win the stock-picking contest at my school?

Reader's Question: I am taking a finance course in college. Our teacher has set up a competition on Virtual Stock Exchange, where students build their own portfolios and the student who has the highest return at the end of the trimester wins. I'm new at this. Which stocks should I buy?

As you set out to pick your stocks for the contest, I suggest keeping in mind two "facts" about the short-run performance of individual stocks:

1) It is almost impossible to predict with any certainty today which particular stocks will rise and which will fall tomorrow, and

2) Stocks that are volatile today tend to remain volatile tomorrow.

Putting these two principles together, I'll show you how to win the stock-picking contest--at least with greater odds than you might otherwise expect.

A Stock-Picking Analogy: Numbers in a Hat

Imagine that you and each of your classmates are presented with two hats holding cards with numbers written on them. The first hat (call it the "low volatility" hat) holds numbers uniformly distributed between -10 and +10. The second hat (call it the "high volatility" hat) holds numbers uniformly distributed between -50 and +50. You may choose one and only one number from just one of the two hats, and the student drawing the highest number wins.

The million dollar question is: Which hat should you pick your number from, the high volatility hat or the low volatility hat?

The expected outcome when picking a number from a hat is just the average of all of the numbers in the hat. In our example, this average is zero, because in each of the hats the positive and negative numbers are uniformly distributed. The situation up until this point mirrors Principle 1 above, which is equivalent to saying that your expected return when selecting either low volatility or high volatility stocks is zero (or close to zero) over a short time horizon (and a trimester is a fairly short period of time, so far as investing goes).

Now, if you and your classmates were actually to draw numbers out of the hats as described, you would find that the winner (i.e., the person who is lucky enough to pick the highest number) will almost always be a student who draws a number from the hat with numbers ranging from -50 to +50, and not the hat with numbers from -10 to +10. The prescription, then, is that, if you wish to win the contest, you should draw a number from the hat with the wider range of numbers, i.e., from the high volatility hat, since the winning number will almost always be drawn from this hat. You might be able to see intuitively why this is so, but for anyone interested in seeing how the probabilities work out, I'll provide a bit more detail.

Probability Analysis

(You may skip this section, but it's an informative application of probability if you are willing to put a little effort into following the math, which really is not very difficult.)

For the idealized case of uniformly distributed numbers in each hat, suppose you draw a number from the (-50,+50) hat, while everyone else in your class picks from the (-10,+10) hat. Three outcomes are possible:

a) If the number you draw is between -50 and -10, you will lose the contest, and this will occur 40% of the time;

b) If your number sits between +10 and +50, you will win, and this outcome also has a 40% chance of occurring;

c) The remaining 20% of the time, your number will be between -10 and +10, and you will typically lose, since the expected value of the highest number drawn by your classmates from the (-10,+10) hat approaches +10 as the number of your classmates drawing from the (-10,+10) hat becomes large, i.e., the best draw from the (-10,+10) hat will typically beat your middling draw from the (-50,+50) hat.

Overall, when you are the only one drawing from the (-50,+50) hat, you have a 40% chance of winning the contest, which is much better than the odds of winning you would have (e.g., 1/30 or about 3.3%, if there are 30 students) if you, along with everyone else, were to "follow the herd" and pick from the (-10,+10) hat.

Now, what happens if some of your classmates also decide to draw from the (-50,+50) hat? Suppose that N students, i.e., you and N-1 others, pick numbers from the (-50,+50) hat. The probability that at least one of these N students (including you) draws a number exceeding +10 is equal to one minus the probability that all of these N students draw numbers between -50 and +10, which is (1 - 0.6N). Also, since your draw is just one among N from this high volatility hat, we need to divide by N to arrive at your probability of winning the contest. The result is:

P(N) = (1 - 0.6N)/N

For N = 1, P(1) = 1 - 0.6 = 0.4, which represents the 40% chance you have of winning when you are the only one drawing from the (-50,+50) hat. For larger N, i.e., when some of your classmates also follow the high volatility strategy, your probability of winning declines:

P(2) = (1 - 0.62)/2 = (1 - 0.36)/2 = 0.32 = 32% chance of winning
P(3) = (1 - 0.63)/3 = (1 - 0.22)/3 = 0.26 = 26% chance of winning
P(4) = (1 - 0.64)/4 = (1 - 0.13)/4 = 0.22 = 22% chance of winning
P(5) = (1 - 0.65)/5 = (1 - 0.08)/5 = 0.18 = 18% chance of winning

In the limit of large N, your probability of winning will fall to 1/N, which is another way of saying that any strategic advantage you have disappears when everyone else learns about and decides to copy your superior strategy (so, keep quiet about how you go about picking your stocks!).

Picking High Volatility Stocks

Based on the above logic, you can generally enhance your chances of winning the stock-picking contest by selecting stocks with the highest volatility possible. You may not be able to determine with certainty whether a particular stock will rise or fall (Principle 1 above); however, because stocks that have recently risen or fallen a large amount are likely in the near future to move a large amount one way or the other (Principle 2 above), you have both greater upside and greater downside when playing the high volatility game. High volatility investing tends to produce large stupendous gains as well as shocking losses.

In following the high volatility strategy, you should realize that the chance you will end up performing the worst in your class equals the chance you will end up being the top performer. However, in stock contests like the one you are participating in, the benefits of winning first place usually far outweigh the drawbacks of being the last place finisher, since kudos and recognition go to winners, while everyone else, no matter how low in ranking, is simply not mentioned at the awards ceremony. Within the context of your stock-picking contest (at least as I am imagining it), you will be better off increasing your odds of "winning big" with risky high volatility stocks than "playing it safe" with more conservative low volatility stocks.

As a practical matter, you are probably wondering how to identify high volatility stocks. One easy way is to go Yahoo! Finance and examine the daily lists of largest percent price gainers and largest percent price losers. (Although I have not used MarketWatch's Virtual Stock Exchange, I have noticed that their website also provides lists of largest percent price gainers and losers.) On any given trading day, there will typically be a handful of stocks that have moved 20% , 30% or more, up or down. In some cases, the large price movement will have been driven by buyout, earnings or new product announcements, so that the large price move will typically not be followed by another large move--avoid these one-time news situations. Instead, focus on the large percent gainers and losers that have moved on no news.

More often than not, the "no news" movers will be stocks of small companies, so-called microcaps or "penny stocks," which are highly volatile, trade in small volume (or at least small dollar volume) and most institutional investors stay away from. Have you ever heard of RXI Pharmaceuticals (RXII), Aristotle Corp. (ARTL), ULURU Inc. (ULU), or I-Many Inc. (IMNY)? Most people probably have not, since they are by no means household names. However, these four stocks were among those that moved more than 20%--two of them up and two of them down--in Friday's trading, on no significant news. Your job will be to do the research and identify stocks whose volatility is likely to remain high, and, if you are lucky, you'll pick stocks that will actually rise (or fall, if you are allowed to go short in your contest).

So, while your classmates are holding Google (GOOG), Apple (AAPL), Microsoft (MSFT) and other such popular stocks in their portfolios, you will be off buying and selling shares of small companies that no one has ever heard of. Due to their high volatility, the stocks of these microcap companies are the venue of daytraders, stock promoters and others "gambling" for a quick profit. As you are engaged in your game with your classmates, the short-term traders will be the ones doing all of the heavy-lifting, causing the stock prices to ramp up and down, allowing you to ride the opportunity for potential profit within the safe harbor of your stock-picking contest.

Best of luck paper-investing or paper-trading, as the case may be. I hope you win the contest!

P.S. Over the weeks ahead, could you please post a comment to let us know how you do in the stock-picking contest compared to your classmates? Thanks.

Important Note: The strategy I outline above for your stock-picking contest is not the strategy I would recommend following when you actually invest your own money in the real world outside of the classroom. Within the confines of an in-school contest, even the worst case outcome of a dismal investment return will probably not drag down your grade (but check with your teacher to make sure before entering your trades), since educational environments generally adhere to a philosophy that "it doesn't matter whether you win or lose; it only matters how you play the game" (yet it is nice to win, and that's why you've asked for my opinion, right?). When you are using real money, the potential downside inherent in trading extremely high volatility stocks, namely, the miserable prospect of losing all or most of your money, is just too damaging financially, psychologically and emotionally, and should be avoided. For a strategy I suggest following in any real-world investing you do in the future, please read a five-part series of articles on long-term investing I have written, accessible through the last part in the series here.


Anonymous shelly said...

have you seen the project? Sounds like a good way to me to make yourself more aware of the market forces

2:47 PM, June 22, 2008  
Anonymous Pro said...

A very well written and informative article. I would however question your second assumption since volatility often normalises (there is a good chance what had an unusually high volatility yesterday will return to the mean tomorrow). That said, I agree with pretty much everything you wrote.

I would suggest an alternative approach - one that can be used in real life too.
Step 1: Analyse the big stock indices (Dow Jones 30, S&P 500, Nasdaq) and determine if the market as a whole is trending up or down.
Step 2: If the market is trending up, choose stocks which are breaking out into new highs (55 day / 6 month / longer). If there are several, choose the ones which have moved the most in the last 3 months.
Step 3: Keep a stop loss - if the price falls, or fails to move up within a certain time replace the position with a new one.

Good luck with the game!

7:30 AM, July 02, 2008  
Anonymous Banjo Smyth said...

Great Blog

Well considering its a game what about picking a couple of stocks and buying CFD's - you will get massive leverage and the only risk is losing the game :)

Cheers Banjo Smyty

9:19 PM, July 03, 2008  
Anonymous Invest Money said...

Interesting and informative blog you have. I am now learning to blog about stock market as well, hope to learn more from you.

11:48 PM, July 12, 2008  
Anonymous Penny stock newsletter said...

I would like to comment about winning the stock picking contest. Everyboby has this idea about stocks that is if you are a good trader thats how you make lots of money in the stock market' nothing could be further from the truth. I specialize in low dollar stocks which includes stocks under five dollars and sometimes stocks under one dollar. If you buy a really decent company trading at a really really bargain price' and hold the stock for a number of years you can sometimes make an enormous amount of money with a very modest amount of risk' who has heard of such a thing' I think his first name is warren.

9:35 PM, October 24, 2011  
Anonymous site said...

This will not have effect as a matter of fact, that's what I suppose.

12:07 PM, July 26, 2012  

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