When have you done enough research?

Eric November 13, 2023

How much research do you do for your stock analysis? Maybe you do a lot. Maybe you do a little. But how much is enough?

There’s a near infinite number of things you could know about the economy, a stock, or another tradable asset. More knowledge equals more power, right?

Not so fast.

Let’s say you had perfect information about all things. Do you believe this would make you the best trader in the world? Possibly maybe.

Do people with more knowledge perform better in trading? Isn’t there research showing the S&P 500 beats the large majority of hedge funds and other money management firms? If there’s a correlation between knowledge and returns, certainly we would find that active investing is far more profitable than blindly diversifying your portfolio to the S&P 500.

What’s going on?

Let’s identify what knowledge we’re seeking. There is past, present, and future knowledge.

Past knowledge should be easy to get. There’s historical data on asset prices. There’s historical data on the economy, companies, and government interventions. There’s lots and lots of historical data. Do historians make the best traders?

Present knowledge is fleeting. There is a present price for a stock and then another present price, and another present price. As soon as news comes out, you need to figure out what it means. And the market will react, and possibly reverse their initial reaction. Infinite knowledge of the present doesn’t really give you a lot of time to act. In fact, present knowledge my already be too late!

Future knowledge is what people “really” want. We want to “know” the future. We want certainty. And to the extent we can predict the future, we have a lot of confidence in our decisions.

Wouldn’t it be lovely to predict the future? You can fantasize about it all you want. As far as I know, it can’t be done with any consistency.

I suppose that is what people are trying to do. So what tools do people have to try and predict the future? It seems the only tools available is past and present information.

Isn’t that a predicament? Using past and present information to predict the future?

People say, “history doesn’t repeat, but it rhymes.”

That’s a fun saying. Although, applying it is challenging.

S&P 500 drops 30%. Do you buy? Chances are, you won’t want to, even if history says you should. Or does it also say that it can drop another 20% for a low of 50% from its highs. What happened during the Great Depression? Are we going there? Or are we just going to experience a drawdown similar to that of the Great Recession.

What’s COVID?

Another suggestion…

????? It’s 2020! What’s COVID???????

Predicting the future using past and present information is hard work. It’s also not all that reliable. However, it’s the only thing we have.

Risk and the Future

Until you find that crystal ball, you’re going to need a different approach to understanding the future movement of asset prices that doesn’t rely on certainty in the future.

The future is uncertain. That is why asset prices move. People are currently uncertain about what the future will hold. They even disagree on what the future will hold. As a result, people adjust their personal investments based on their beliefs about the future.

This is where traders make money. When there is an uncertain future, asset prices fluctuate to provide opportunities for profit. These opportunities can skew very aggressively in one way, allowing for an asymmetrical reward to risk ratio.

The biggest problem with the crystal ball analogy is that it makes you think that the key to becoming a consistently profitable trader is a matter of telling the future. It also leads you down a path of thinking that your ability to tell the future is about gathering more data in the past and present.

Why is this a problem?

Your psychology prevents you from using more data effectively to make better decisions.

The Data Trap

Let’s say there is a stock ABC. A hedge fund with a lot of resources is able to collect 1,000,000 facts about ABC stock. In it’s analysis, it has identified 600,000 reasons to buy it and 400,000 reasons to sell it.

Compare that with you. You don’t have infinite resources. But you’re able to collect 1,000 facts about it and you’ve found 700 reasons to buy it and 300 reasons to sell it.

And finally, compare that with Mr. Random McGee who flipped a coin and it came up heads, meaning that he’ll want to buy ABC stock.

All of you buy ABC stock and you make money. Who’s method was better? Did the hedge fund really need to exhausted resources to collect those 1,000,000 facts? Does Mr. Random McGee have the best method since he was right with a coin flip, saving a ton of resources?

What happens if all of you bought ABC stock and you all lose money. Maybe something random happened that no one anticipated, maybe there was fraud, or maybe, even with all the information, everyone was just wrong. Does this mean you should have paid more attention to the 300 facts, or that the hedge fund should have focused more on the 400,000 reasons to sell it?

Do you think you would have been more successful if you did more research? Found more reasons to sell? Would that even be possible? How far would you go? Is 1,000,000 facts not enough? Would 2,000,000 have prevented the bad outcome?

Sampling the Truth

What research could you possibly do to predict the future? There is not enough past and present information that could possibly be sufficient to accurately predict the future. Therefore, trying to predict the future is a fool’s game.

What you’re really trying to do with trading is trying to understand the truth of the current situation. You do this by researching what happened in the past and what is currently happening. When you’ve finally figured out what is going on, you can then properly assess the reward to risk profile of the trade you’re about to make. That’s it. Nothing more. No prediction. Just assessing the reward to risk profile of your next trade.

Let’s say you have a wooden barrel that you can’t see through. You know there are 1,000,000 black and white marbles but you’re not aware of the ratio of the two. So you begin to take one marble out. It’s black. Then the next. It’s black. Then the next, it’s white.

How many marbles do you need to take to have some degree of certainty of the ratio of black to white marbles? Let’s say you took out 100 of them and there were 53 black marbles and 47 white marbles. Would you guess that there are 50/50? Do you think you need 1,000 marbles to get a better sense that it’s 50/50? Or are you the type that needs to count all the 1,000,000 marbles to know FOR SURE that it is 50/50.

If you’re the last person, stop being dumb. I don’t mean to be cruel. But stop being dumb.

You can’t know things for sure. Furthermore, you DON’T want to know things for sure. The uncertainty in markets is the primary reason why trading opportunities exist. If we had absolute certainty with markets, markets wouldn’t move because we know everything.

Knowledge vs. Reward to Risk

It’s not really about how much knowledge you have that will make you a consistently profitable trader. It will be your ability to:

Identify good reward to risk ratio trades

Exercise those trades to minimize your downside and maximize your upside

Here you’ll need a strong process to get that done. Check out the Introduction to Professional Level Trading (IPLT) and the Professional Trading Masterclass (PTM) for how to identify good trade ideas. Check out the Professional Options Trading Masterclass if you want to use options to minimize your downside and maximize your upside.

Every trade is uncertain and carries inherent risks. The knowledge is not meant for you to predict the future with more accuracy. It is meant to understand the current state of affairs so that you’ve identified a very high reward to risk ratio.

Let’s say there’s a growth stock that is skyrocketing to the mooon! But you’ve done analysis to demonstrate that this growth has been priced in. Therefore, in order for it to go up higher, it’ll have to have unsustainable levels of growth. The product is great, for sure. But is it so great that it can beat it’s expected 70% growth rate? Possibly. But what’s the likelihood? What can you research to identify whether this growth story can continue? How long can it last? When will the reward to risk begin to shift against the bullish growth story sentiment? When will the growth story break? How will it break?

Psychological Biases in Sampling

Pulling yourself away from the crystal ball mindset to a reward to risk mentality is hard enough. I’m sorry to say that even if you’ve successfully shifted your mind from needing certainty to embracing uncertainty with probabilities, you still have one major hurdle that prevents you from trading success.

It’s your own mind.

We are simple creatures. We like things that give us pleasure. We hate things that cause us pain. We hate it so much that we often go towards pleasurable things and avoid painful things on deep subconscious levels. This is the case even when these actions significantly hurt us in the long run.

Don’t believe me? Why do people eat garbage? Why are people addicted to drugs? Why do people stay in bad relationships? Why don’t investors cut their losses? Why don’t traders let their winners run?

It’s all about avoidance of pain.

When you research an idea, you’re excited about the potential it may bring. When you’ve finally crystallized the idea, there is a high chance that the idea becomes a part of your identity. It’s YOUR research, YOUR brain on the line. If you win, YOU are awesome. And if you lose, YOU suck.

As you’re doing research, your mind naturally begins to collect information that confirms your original stance. This is called “confirmation bias”. It is when you seek out information to support the idea you already have. You naturally seek out confirmatory information and tend to neglect opposing information.

When you get 700 reasons to buy a stock and 300 reasons to sell a stock, we’re assuming that you have an unbiased mind. If you’re biased, it is possible there are only 200 reasons to buy but you’ve gone and dug out an extra 500 just to make yourself feel good. And ignored 200 reasons to sell in the process making the true case 50/50.

This can happen for an individual but can also happen with a hedge fund. For organizations, it often comes in the form of “group think” where people are afraid to challenge ideas of the group for fear of ruining the group’s unity.

As you can imagine, this is pretty dangerous. It also calls into question whether more information is truly going to help you become a better trader.

How do you avoid conformation bias? By seeking out opposing views. When do you stop? When there is no additional information, if found, that will change your view.

When do I Stop Researching?

This is ultimately a personal question. But my hope is that you understand the goals of researching. It is not meant to tell the future. Rather it has 2 purposes:

Identify the appropriate opportunities available to you

Identify the current situation of the specific trade you are considering

All of this is part of a larger process. If you feel you don’t have a strong trading process, please check out the IPLT and PTM courses.

But let’s get practical. Here are 5 steps for you to know you’ve researched enough:

Identify the idea you want to trade

Collect basic information that you would want for all ideas

Fundamentals (Revenue growth, Margins, Net Income, etc.)
Technicals (Stock charts, short interest, open interest in options, etc.)
News (Most recent quarterly reports, upgrades and downgrades, etc.)

Identify your bias relative to the basic information you’ve collected

Ask yourself, “What information would I want to know that would change my bias?”

Research that information to see if it changes your bias. Then repeat step (4) If you don’t have any further information that would change your initial bias, you’re done.

Example

I found a soda company (CELH) that appears to have rapid growth
Basic information tells me that their growth has been strong even during recessionary periods. However, there was a slight sequential dip in revenue growth in the last quarter. And there is an issue with the soda company joining with Pepsi to use Pepsi’s distribution channels
I’m a short bias as it seems as if this growth might not continue forever
I want to ask myself

4-Is the Soda any good? If the soda is good, then I should be careful of being short as a good product is the foundation of a good business.

5-The soda is pretty good. Has a lot of research demonstrating it is healthy. Comes in all sorts of flavors. Has caffeine that is addictive. (Might start wanting to be bullish)

4-What are people saying about it? If people are saying it tastes like crap, or they are concerned about something, then it would cause me to be bearish. But if people love it and there is a cult following, I might want to be bullish

5-People seem to love it. Has lots of flavors, replaces coffee, people feel healthier with it, and it some cases, it is less expensive than Starbucks.

4-Why was there a sequential dip in the Revenue? People could say they love it, and it could be a good product, but if there’s something wrong with production, or they can’t sell enough cans, we have a problem with the growth story.

5-The sequential dip in revenue was due to inventory and accounting shifts with regards to the Pepsi deal, so when adjusted for that deal, there is sequential growth which remains

4-How large is the market anyway? If the market is small, maybe they peaked. If the market is large and growing, the sky is the limit.

5-Consumption of the soda is still small relative to the total caffeinated beverage market. So we’re not at the max total addressable market yet.

4-Am I seeing this growth with my own two eyes? If I’m not seeing it, is there a potential fraud going on?

5-Yup, seeing it in gas stations, Costco, supermarkets, bodegas, everywhere really. It’s becoming ubiquitous in a short amount of time

At this point, I could not imagine any piece of information that would change my current bullish bias. Therefore, I felt my research was sufficient.

It doesn’t mean I necessarily will make money. It just means that I believe the growth story will continue and, if it does, the stock will go my way. Incidentally, it did, and I happened to make money off that trade.

I hope you found that useful. To sum up, here are a few bullet points:

Research is not meant to predict the future. It is only meant to understand the current state of affairs (the reward to risk profile of a situation)

Stop trying to predict the future. Identify High Reward to Risk opportunities

Avoid confirmation bias in your research

Your trading psychology might be the deciding factor for your next BIG win or your next BIG loss.

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