Does doing your "research"/"homework" on stocks make any sense?

Question

One thing about investing has always bothered me. You constantly hear people saying you need to "do your research" or "do your homework" on a company before buying their stock. I rarely watch Mad Money but I heard Jim Cramer saying this on there several years ago.

The implication is that a significant fraction of people can do stock analysis and "beat the market". But doesn't this assume that an average person can do stock analysis better than the aggregate of all the professional analysts who publish stock ratings? Does "doing your research" only make sense if you assume that financial markets are not "informationally efficient"?

Furthermore, if you believe in strong-form market efficiency, could you go as far as to say there are no bad stocks, since the prices have already adjusted to their appropriate level, just different levels of risk?

Answer 1

"Doing your homework" means to perform what's more accurately called "fundamental analysis". According to proponents of fundamental analysis (FA), it is possible to accurately determine how much a stock should trade for and then buy or sell the stock based on whether it trades above or below this target price. This target price is based on the discounted anticipated future earnings of your stock, so "doing your homework" means that you figure out how much future earnings you can expect from the stock and then figuring out at what rate you want to discount those future earnings (Are 1000 dollars that you'll earn next year worth $800 today or $900 or only $500? That depends on the overall economic and political climate...)

So does this make any sense? Depends.

• If you believe in the strong efficient market hypothesis, it makes no sense whatsoever, because this hypothesis holds that there is never an exploitable discrepancy between what a stock should trade for and what it actually trades for.
• It still makes no sense if you believe in the weak efficient market hypothesis paired with the assumption that Wall Street is pretty random. Suppose you do your homework on an oil company and decide that they're currently undervalued. You load up on their stock, and then one of their platforms explodes. Suppose you do your homework on a tech company and decide that they're overvalued. You get rid of their stock or even sell short. Then they announce a major breakthrough they've been secretly working on and they stock soars. Risks of these types can be mitigated by diversification, because then on average the unexpected good news and unexpected bad news should cancel.
• Even if you believe that there are information deficiencies that are exploitable, it would still not make sense for the average guy. Remember, for every guy that thinks $X is a good price to buy stock Y, another guy thinks that $X is a good price to sell stock Y. Do you think that your judgment trumps that of the big players?

I'm aware that there are a lot of anecdotes of people researching a stock, buying that stock and doing well with that stock. But poor decisions can at times lead to good outcomes...

EDIT: Due to some criticism, I want to expand on a few points.

• In principle, a stock has a price it should trade for, and the price it currently trades for might be far from that. The problem is that to determine that true price you'd have to be able to see into the future.
• Participants in the stock market can and do behave irrationally, which then leads to bubbles and other phenomena. Again, the problem is that nobody can tell a bubble from a legitimate, genuine rise in valuation: The internet did change the world of business and commerce on a fundamental level so tech stocks soaring in the early 2000s wasn't that strange. Of course, there will always be someone "predicting" the bust of a bubble, but that's easy, due to the cyclic nature of markets. It's no rocket science to predict that a bust will happen, it's much trickier to predict when it will happen. On the other hand, some commodities did see a bubble-like rise but stayed on that high level for an extended period of time.
• Despite individual investor's anecdotes (see comments), almost nobody can consistently beat the market. That's why we are all in awe of star investors like Warren Buffet. If the ordinary guy with a bit of due diligence could regularly beat the market, Buffet wouldn't be a star. Strongest evidence for this claim is that the big pension funds, who manage billions of dollars, rely more and more on passive index funds instead of active management: If those big players, who could pay top dollar to whomever can consistently beat the market, don't trust in any individual's ability to do so, then neither should you. Due to statistics, during any given time someone will beat the market, but you can be relatively sure that in the next cycle that someone will be someone else. (For example, the top funds managers of the year 2012 will be quite different from the top funds managers of the year 2013). There's also a reporting bias here: The internet is, of course, full of people who brag how they made 20% or more with their particular strategy, because, well, people like to brag. The people who lost 20% or more with their particular strategy usually are not that vocal.
• The admonition to do your homework can be an easy cop-out for people giving you poor investment advice: If your trade goes well, obviously it's because you did your homework. If it goes poorly, obviously you didn't do enough homework. But since there's always more homework you could have done, this excuse will work all the time.

So, is homework completely for naught? No!

• Different asset classes (stocks, bonds, real estate, cash) have different expected returns, different tax implications and, in general, different properties. Educate yourself on those differences
• For your particular situation in life, a particular mix of assets makes the most sense, so do your homework on asset allocation.

Answer 2

The markets are not as information efficient as some might have you believe.

But on the contrary, looking up what the aggregate professional analysts have said is also part of "doing your homework"

Answer 3

TL;DR: Sure, "do your own homework" is sometimes a cop out. But that doesn't mean we shouldn't do our homework.

I agree that in many cases this is a cop-out by commentators. However, even if you believe in perfect market efficiency, there is benefit in "doing your homework" for many reasons. One of which you already mention in the question: different stocks all with the same "value" might have widely ranging risk. Another factor that might vary between stocks is their tax consequences. High dividend stocks might be a better fit for some buyers than others.

• One stock might be priced at $40 because there is a small chance they might get regulatory approval for a new product. This might make this stock very risky with a 20% of being $150 in 12 months, and a 80% chance of being $20.

• Another stock might be priced at $40 because the company is a cash cow, declining in revenues but producing a large dividend of $0.40 per quarter. Low risk, but also with some potential tax disadvantages.

• Another stock might be priced at $40 because it's a high growth stock. This would be less risky than the first example, but more risky than the second example. And the risk would be more generalized, i.e. there wouldn't be one day or one event that would be make or break the stock.

In short, even if we assume that the market is pricing everything perfectly, not all stocks are equal and not all stocks are equally appropriate to everyone. Sometimes when we hear an analyst say "they should have done their homework" they are really saying "This was a high risk/high reward stock. They should have known that this had a potential downside."

And that all assumes that we believe in 100% pure market efficiency. Which many disagree with, at least to some extent. For example, if we instead subscribe to Peter Lynch's theories about "local knowledge", we might believe that everyone has some personal fields of expertise where they know more than the experts. A professional stock analyst is going to follow many stocks and many not have technical experience in the field of the company. (This is especially true of small and mid cap stocks.) If you happen to be an expert in LED lighting, it is entirely feasible (at least to me) that you could be able to do a better job of "doing homework" on CREE than the analysts. Or if you use a specialized piece of software from a small vendor at work, and you know that the latest version stinks, then you will likely know more than the analyst does.

I think it is somewhat akin to going to a doctor. We could say to ourselves "the doctor is more knowledgeable about me than medicine, I'm just going to do what they tell me to do." And 99% of the time, that is the right thing to do. But if we do our "homework" anyway, and research the symptoms, diagnoses, and drugs ourselves as well, we can do get benefits. Sometimes we just can express our preferences amongst equal solutions. Sometimes we can ask smarter questions. And sometimes we have some piece of knowledge that the doctor doesn't have and can actually make an important discovery they didn't know. (And, just like investing, sometimes we can also have just enough knowledge to be dangerous and do ourselves harm if we go against the advice of the professionals.)

Answer 4

In fact markets are not efficient and participants are not rational. That is why we have booms and busts in markets. Emotions and psychology play a role when investors and/or traders make decisions, sometimes causing them to behave in unpredictable or irrational ways. That is why stocks can be undervalued or overvalued compared to their true value.

Also, different market participants may put a different true value on a stock (depending on their methods of analysis and the information they use to base their analysis on). This is why there are always many opportunities to profit (or lose your money) in liquid markets.

Doing your research, homework, or analysis can be related to fundamental analysis, technical analysis, or a combination of the two. For example, you could use fundamental analysis to determine what to buy and then use technical analysis to determine when to buy.

To me, doing your homework means to get yourself educated, to have a plan, to do your analysis (both FA and TA), to invest or trade according to your plan and to have a risk management strategy in place.

Most people are too lazy to do their homework so will pay someone else to do it for them or they will just speculate (on the latest hot tip) and lose most of their money.