Problems with Newsletter stock tipsters

In a recent release of a free daily newsletter that exudes emotive copywriting to sell subscriptions and that regularly has a go at the mainstream press on many fronts, it stated:

“A quick stocktake of the 31 stocks we tipped in Our Investigative Story Writing Newsletter and Another of Our Riveting Story Writing Newsletters last year shows that 23 are currently up, one is flat and seven are down.

Importantly, the average result across all those stocks is a gain of 24.8%.”

Quote unquote, except for the names of the newsletters. When I see supposedly “expert” market commentators quote records such as these it infuriates me for a few reasons.

Quoting an average of 24.8% on such a small sample is meaningless and misleading to any investor using it to make investment decisions.

The average would only be meaningful if a portfolio was being managed, all the trades were opened at the same time at the beginning of the year, all trades were allocated the same amount of money, and the portfolio was fully invested. Then an average return of 24.8% could have been achieved over the year.

However, I suspect that these stock tips were drip fed over the year (that’s what newsletters do), investors would not have taken all the trades and I’m even more certain they would not have allocated the same amount of money to each position.

Let me explain by example. Assume a portfolio of $200,000. If the investor knew that there would be 31 positions then $6451 per trade could have been kept aside to take all positions as they were tipped by the newsletter. Of course, in the real investing world this is not how a portfolio of investing capital is managed.

Running with this example, there would be a large amount of the portfolio capital sitting in cash for a large part of the year receiving cash interest rate returns that are far lower than the average quoted return of 24.8% because not all positions were tipped simultaneously. Under such conditions it would almost be impossible to achieve the quoted average return.

Let’s examine this subject from a different perspective, that of the more realistic scenario where the investor doesn’t know how many stock tips will flow for the year. This uncovers an even bigger problem for any investor following a newsletter of this type: how much of their portfolio capital to invest in each position as it is tipped.

This is called money management or position sizing. And it requires a bit more mathematical effort than just dividing your capital up evenly or just tipping in more capital (excuse the pun) as each stock tip is received.

Let’s assume that the investor took a stab at different position sizes, maybe based on how convincingly the story was written by the newsletter tipster. This might sound silly in the context of a few words in a blog such as this but in the absence of any position sizing approach provided by the newsletter story writer what else can the investor use? They are left to their own devices, biases and additional subjective analysis.

One investor might have put an average of $20,000 in the seven losing trades and an average of $10,000 in just six of the winning trades before running out of capital thereby subjecting $140,000 to the losing trades and $60,000 to only six of the winners, which could also have been the smaller winners of the 23.

Others may have taken all the loss trades with no profit trades and others all the profit trades with no loss trades with varying degrees of keeping cash aside in their portfolio waiting for the stock pick that they really like.

And even if all the winning trades had been picked how is the newsletter subscriber assured that they will repeat their brilliant subset of stock picking the following year?

Let’s examine one last problem this week before looking next week at the biggest problem with newsletters. Newsletters pick stocks regardless of what the overall market risk may be at any given time. It has been shown that overall market risk has the biggest effect on individual stock prices and yet this is not accounted for in the stats provided above. What input did the newsletter provide, if any, about the market risk at the time of each pick and how would have that affected the subscribers decision of which pick to take and how much to invest in any one stock pick?

The point is: the subjectivity and lack of portfolio management input provided by a newsletter tipster could have led to the mixture of trades taken by a lot of investors actually losing money for their portfolio even though the win rate from the newsletter tipster for the year was 74% from the small sample of 31 tips!

It pays to be more objective and learn to rise above emotive copywriting, especially when it comes to reading stories about listed companies.