Why Buy and Sell Ratings hurt Your Returns!
Today, in less than 5 minutes, I'll explain to you how Buy and Sell Ratings hurt your Returns and what to focus on instead!
I used to like reading articles with clear buy and sell ratings at the end. It gives you a sense of clarity after what might have been a rather complex stock pitch.
I myself mention in my articles whether I think a stock is a buy at current prices. However, I also provide context, such as what I am looking for in a stock (hurdle rate), what risks I am willing to take, and what position size this stock will have in my portfolio.
Today, I want to tell you how the Buy and Sell ratings most people give hurt your performance.
The Psychology of Buy and Sell Ratings
A big part of how Buy and Sell ratings influence us is psychological. Here are the two main reasons why they affect us:
Cognitive Simplicity:
We tend to simplify complex matters to minimize cognitive effort. Uncertainty, which is inevitably part of an investment, is such complexity.
If we see a reasonably good analysis, we feel like we have a better understanding, but the more nuanced it is (and a good analysis is nuanced), the more uncertainty remains.
If we see a buy or sell rating instead, the situation suddenly seems a lot easier. Buy = Analyst expects good investment; Sell = Analyst expects bad investment
We are immediately more willing to significantly overweight the aspects of the analysis that were positive (if Buy Rating) or negative (if Sell Rating).
Confirmation Bias:
That last sentence might have reminded you of this bias, the confirmation bias.
We actively seek information that supports our existing beliefs and ignore evidence that contradicts them.
As soon as you see whether the stock was rated a buy or a sell, you focus on the information that supports that thesis.
(Of course, the same goes for the person researching the stock. If you know your analysis's result beforehand, you’ll find the evidence you need…)
Apart from the psychological side, individual circumstances influence how much risk we are willing to take and how much return we want to achieve.
Good Investment for Me; Bad Investment for You
The inevitable uncertainty is why we must assess investments based on their risks and possible rewards. But someone else’s situation might be totally different from yours. If so, the investments that fit your strategy differ from those that suit them.
In 2022, I interned in a Family Office. Family Offices have very wealthy clients who are mostly focused on steady, low-volatility returns. They don’t expect 20% a year.
However, if you’re just building your wealth, you should focus on higher returns and care less about volatility.
If you’re in your 20s or 30s, you have most of your career, and most of your “lifetime salary” is still ahead of you. You can take a lot more risk than someone in his 60s.
That’s a highly relevant point! Because of the above factors, I would be fine with allocating +40% to a single position. However, I would never advise my father to do the same. My risk with a 40% position is significantly lower than his.
Side Note: I’ve now added my cash position to my Portfolio. That way, the weighting of my positions is no longer "inflated.” As mentioned here, my investment activity will increase significantly this year; thus, I expect this capital to be allocated to attractive investment opportunities soon.
Here’s an explanation of what a Founding Member is and how you can save 84% on your subscription if you sign up now:
How to use Stock Research the Best Way
Reading stock research is one, if not the best, way of studying to invest (besides investing on your own). I’ve read tens of thousands of pages on investing, but my biggest progress came from reading good stock research and doing it on my own.
Here’s how to use stock research and stock pitches to learn (and benefit financially) the most:
1. Know your Risk Tolerance
In almost everything I write, I give you my perception of the risks. Where can the stock go in the worst case? How does it compare to the possible returns?
If you know your risk tolerance (based on age, capital, psychology), you know exactly if the stock is for you.
2. Price Targets
In my valuations, I give you multiple possible outcomes (E.g. base-case, best-case, worst-case). Why? So you (and I) don’t anchor one price, especially the best-case scenario price, and thus break down the entire case only to that number.
Articles that only quantify the upside, not the downside, do not show the wide range of possibilities.
3. Position Sizing
If I consider a stock a “Buy” (after giving all the context above, of course 😉), I also include what position sizing I will give to the stock.
Some stocks have risk-reward ratios where they might lose 50-60% but could also go up 5x or more. While I mostly buy stocks with a significant margin of safety, sometimes I find a situation like this attractive. For other people, taking such a downside risk would be wrong.
However, those stocks would obviously not be the +40% position mentioned earlier.
You can see how a buy rating without the position sizing aspect makes little sense.
That’s it for today!
I hope you enjoyed this quick article. My next stock pitch (as can be seen in the schedule) will be published on Friday!
Best
Daniel