Now let's spend a little time on some of the methods investors use to select stocks. Evidence shows that it is difficult to beat the market, and even those few who do beat the market only beat it by a small percentage.
Still, it's useful to know how people try to beat the market, so let's take a look.
Fundamental analysis is one of the oldest ways to value stocks. Fundamental analysis looks at the ability of the company to generate earnings, and also looks at the value of the company's assets.
Proponents of fundamental analysis look at a company's earnings, growth in earnings, intellectual property, growth in the firm's market, competitors, quality of management and a host of other factors.
Two subsets of fundamental analysis are value investing and growth investing. Value investors favor those stocks that have low price to earnings ratios, low book values or high dividend yields.
Some studies show that value investing has outperformed the market. Value investors look to make money through a combination of dividend income and modest capital gains.
Growth investors, on the other hand, look for companies that offer higher than average growth prospects. Whereas value investors probably would never buy a stock selling at 30 times earnings, growth investors might, as long as the company is growing at 30 percent per year.
Because growth companies need to reinvest their profits for continued growth, these companies pay little or no dividends, so growth investors must be satisfied with most returns in the form of capital gains.
Investors who use technical analysis, on the other hand, often don't care what a company's earnings are or even what a company produces. Technical analysts only care about what the chart pattern of a stock looks like.
Technical analysts look at things like moving averages, stochastics, trend lines and even things like a "double top" or a "head and shoulders" pattern.
There may some validity to a few of the ways technicians look at stock charts. For example, most people remember the price they paid for a stock, and are often hesitant to sell a stock at a loss. So heavy trading volume at a particular price may constitute a "resistance level".
But if you ever hear a technician talking about things like "head and shoulders" patterns, run for the hills because buying stocks based purely on chart patterns is foolish.
I've even read an account of a chartist who was shown the picture of an inverted "head and shoulder pattern", which supposedly is a bullish pattern. Even though the pattern was created by a random number generator, the technician said, "This stock is going straight up! Tell me the name of the stock so I can buy it!"
With technicians like this, it's not hard to see why studies have shown that technical analysts rarely outperform the markets.
One of the biggest problems with technical analysis is that it uses past events to predict the future.
Suppose you toss a coin, and you happen to toss ten "heads" in a row. If you showed this chart of results to a technician, he'd say that the next flip has got to be a "head" because that's clearly the trend.
But if you're using a fair coin, the probability of a "head" on the next flip is still exactly 50 percent. It doesn't matter what the "trend" is.
Purely random coin flipping is somewhat different from actual markets where we're dealing with emotional humans who have memories, but I hope you see the point here. It doesn't matter what happened yesterday. What matters is what will happen tomorrow.
Another problem with technical analysis is that it often gives false buy or sell signals. This means that you buy and sell too many times, losing money in commissions and spreads as you're whipsawed back and forth.