Do you have a stock portfolio? Have you ever wondered how brokers select the right stocks to invest in?
Investing and trading is a tricky game, and the reality is that not all investments work out for the broker. In most cases, a broker is doing well if they pick the right stocks more than 60-percent of the time.
Brokers make a profit on their stocks suggestions by being right more often than they are wrong, and by limiting their downside risk. To limit risk in a deal, brokers use hard or mental stops. These stops tell them when to bail on an asset or stock when it breaches their expected downside limit on price action.
However, how do they get their investment ideas in the first place? It’s not like the brokers sit down and throw darts at the list of companies on the Dow Jones or S&P500. Brokers spend plenty of hours each week and month deciding on where to place their investments.
Since most brokers work for a firm, their job depends on them consistently picking the right assets and stocks that will make the firm’s clients money. If they start a cold streak and don’t make any profit, the chances are that they will lose their job.
Here is everything you need to know about how brokers pick the right stocks to invest in with their clients’ money.
The Power of Information
In the 1985 classic movie, “Wall Street,” Michael Douglas plays the Wall Street tycoon, “Gordon Gecko.” There’s a part in the film when Gecko is explaining his investment strategy to the young and hungry broker Bud Fox, played by Charlie Sheen. In the scene, Gecko looks at Fox and tells him that the most powerful means of analysis in stock, is information.
This investment strategy is still valid today. Information is still the dominant factor when building an investment strategy. All brokers rely on a steady stream, of data to provide them with the direction of where the stock they are interested in is heading. The information helps them decide whether the stock will move, or it becomes a “dog,” as Gordon Gecko describes losing companies in the movie.
Things have come a long way since 1985, and the advent of the internet changed the way brokers collect their information. Today, there are numerous sources of high-quality data available to brokers, at a click of their computer mouse.
News services like Bloomberg play a pivotal role in providing brokers with stock information and movements in the market. Brokers also use subscription services linked to the trading platform that gives them the latest market news on stocks they are looking at buying or selling. If a stock pops on their trading scanners, then they can verify the movement by looking for a news catalyst.
If a stock is moving, and it has a news catalyst, it gives the broker insight into what price action they can expect from the stock over the trading day. Some 35-years after the movie Wall Street graced the silver screen, Gordon Geckos advice still rings true. Information is the most essential and powerful means of choosing a stock or investment.
Investing in Former Runners
The S&P500 is a list of the top 500-companies on the Dow Jones. These darlings of the investment world are every broker’s favorite stocks. Since the bottom in the S&P500 in 2008, the index rose from 666-points to over 3,000 as of mid-2019.
This incredible bull market run is the most extended in recorded history. Investors and brokers spent the last 11-years making tidy profits from their clients, as the US economy recovers from one of the most significant financial crises in history.
If you take a look at the financial news, you’ll notice that analysts keep talking about the same stocks. Companies like Facebook, Apple, Google, and Netflix continually make a headline on the news channels for their dramatic price action in the market.
Brokers identify companies on the S&P500 that continually make significant moves to the upside or downside. Many people make the mistake of thinking that brokers only invest in companies headed in an upward trajectory. However, in reality, brokers play both sides of the price action.
Investing while stocks are moving up, is known as “going long.” Investing in a stock that has falling price action is known as “going short.” For example, Tesla’s recent flush to the downside caught the attention of many traders and brokers that decided to ride on the bad news coming out of the company concerning management and production problems.
Identifying former runners, allows brokers to build a watch list of companies they are interested in buying or selling.
As discussed, brokers rely on information as a primary means of locating an investment idea. However, in many cases, the broker will spend many hours analyzing the company’s financial data to determine the fiscal health of the company before committing to an investment in the firm.
Brokers spend hours pouring over company financial statements, looking through quarterly reports to find signs that make it worth investing their clients’ money into a specific stock. This strategy is known as fundamental analysis. The fundamentals are the backbone of any value-investing strategy, and brokers need confirmation from data to prove that their investment idea will work.
A great example of fundamentals involving changing the price action of a stock is a biotech company that releases a new drug to the market. If the company is close to receiving FDA approval on the new drug, then brokers taker this as positive fundamental analysis to justify going long in a company.
Similarly, a company that issues weak forward guidance for sales is cause for the broker to opt to short the stock. Balance sheets, dividends, and revenues are all examples of fundamental data that a broker uses to determine if their investment idea holds water.
HFT and Algorithmic Trading
With the financial markets going digital in the early 2000s, it led to the rise of high-frequency trading, (HFT.) HFT involves the use of complex algorithms to trade the markets, instead of relying on fundamental analysis. “Quants,” which is a term for a math genius that develops algorithms, use these algorithms to identify trading opportunities in nano-seconds. HFTs have no specific investing strategy, other than to make as much money as possible. They achieve this by producing as many trades as possible in a fraction of a second.
By using algorithms to trade stocks, the HFTs supposedly add liquidity to the market, allowing other traders to get in and out of stocks when they want. However, some brokers and traders state that HFTs do precisely the opposite of this, removing liquidity from the market when traders need it most.
HFTs typically like to trade in crowded markets where there are plenty of shares available, and plenty of traders to “front-run” their orders. HFTs buy and sell orders between market makers in nano-seconds, making tiny amounts of profit with every transaction that add up to billions of dollars in profits annually.
Charts provide brokers with a story of the companies past price history. Candlesticks charts are the most common form of charting used by brokers to determine the stock’s price action in the market. It takes years of practice to read price action on a stock chart, and understand how the stock moves concerning the price action.
Charts come in different time-frames, allowing brokers to check what patterns are forming in the stock’s price action over a given period. Traders and brokers that practice a scalping strategy may use low time-frames, such as the 10-second and 1-minute chart. Brokers practicing a swing-trading strategy rely on the daily and 4-hour chart to monitor price action.
Without charts, the broker has no idea of the past performance of the stock they are interested in buying or selling. Think of it as sailing on the ocean without a map; you won’t know where you came from, or where you are going.
Leaving Out the Emotion
One of the factors that determine a broker’s success is their ability to avoid becoming attached emotionally to a stock. If the broker has an emotional response to their trade, then they may end up losing a substantial amount of their clients’ money.
For example, let’s say the broker is a Tesla fan, and they recently bought themselves a Model-3. Being a Tesla fanboy, they may decide that investing in Tesla is their game. Since they have a bias toward the company’s performance, they are likely to have a preference for its price action as well.
Therefore, they take a position in Tesla, expecting the stock to rise in price. However, the company announces the news that half the management team is leaving, and the stock starts to drop. Because the broker has an emotional bias toward Tesla, they refuse to sell their shares, hoping that the price recovers. However, the stock continues to fall, and they start hemorrhaging cash until the fund is wiped out.
An unemotional response for brokers is to cut their losers before they do too much damage. Every broker knows that there will be winners and losers. Their job is to remain impartial and stick to their trading strategy – even when they are wrong about their stock choices.
Should You Invest in Stocks Without a Broker?
The only time you should ever invest in stocks without the assistance of a broker – is if you are in a position where you are as educated about the markets as a broker. Brokers spend years learning and executing on an investment strategy. They fine-tune their strategy to produce the results they want, to the advantage of their clients.
If you decide that you can do better than your broker, with no knowledge of the markets, that’s like saying that they could do your job as well as you. It’s a silly proposition to think that you could learn how to trade and invest in stocks, by merely reading the financial section of the newspaper every morning.
If you want to learn how to find stocks to invest in, then you need to start by getting an education. There are plenty of stock trading courses available on the internet. Pick a mentor that offers a strategy that you think matches your trading style.
If you don’t have time to trade during the day, then a swing-trading strategy may suit you. If you only want to invest in companies for a short period, then day trading may be a better option for you. It takes time to understand what you want out of your investment strategy.
After finding a strategy, you’ll need to spend a few months playing around with a trading simulator. A simulator allows you to experience how markets move, as well as the nuances of how to buy and sell stocks electronically. You’ll also need to select a trading platform and learn how to execute trades successfully.
In most cases, it can take years to learn how to invest in the right stocks, and how to trade like your broker. If you already have a full-time job, or you run a business, then you may find it challenging to learn fast enough. As a result, very few people that try their hand at investing, ever manage to make a success out of their efforts. It’s best to rely on your broker’s experience and emotional control over the markets.
Wrapping Up – Know Your Strategy and Risk Tolerance
When trying to find a broker that suits your investment style, you must understand your risk tolerance.
To discover your risk tolerance, ask yourself how you feel about losing money. Any broker will tell you that they hate taking a loss. However, losses are part of the game, and successful brokers don’t get attached emotionally to their losses. If they take a loss, they come back to trade the following day, without any hard feelings about the previous day’s performance.
However, if you can’t stand the thought of losing money, then you may want to find a broker that takes a low-risk strategy to invest money in the markets. Always speak to your broker about their investment style before you fund an account with their brokerage.