Principles 1: Not rocket science Principles 2: Relax Principles 3: Caveat Investor

Sensible-Investor: Principles -- Part 2 

Relax. Here's what you don't have to do

You don't need to pick next year's winning stocks, or even pick next year's winning stock-pickers. Identifying stocks that are undervalued and about to rise in price is so difficult a task that it's a job for professionals -- or it maybe a job that's simply impossible. So few stock-pickers are consistently successful that there's no telling whether they are skillful or merely lucky.

Ways to beat the market

Hundreds of theories have been proposed on how investors can beat the market.  You may have heard about some of them:

  • Dogs of the Dow.
  • The January effect.
  • New spinoffs.
  • Buy what you know.
  • Technical analysis.
  • Fundamental analysis.

All such theories fall into one of the following categories, which buy-and-hold investors can ignore:

  1. Theories that sound good but have been disproved.
  2. Theories that apparently are true to a slight degree  (such as the January rise in stock prices) but that affect prices so little that individual investors seeking to exploit the theory would lose money on transaction costs.
  3. Theories that remain valid only until the general investing public learns about them and tries to exploit them.
It’s quite possible that stock-picking is no more a talent than coin-flipping. Consider a hypothetical group of 1,024 investment advisors who choose stocks to buy by flipping coins in a hypothetical world where stocks go up whenever the stock-picker tosses heads and go down when she tosses tails. On average, after one toss 512 of the stock-pickers will have a coin that came up heads. On average, after two tosses 256 of them will have a coin that came up heads twice. After three tosses, 128 will have consistently thrown heads. After four tosses, 64 will remain in the heads-only category. Fast forward to the 10th toss. On average, one stock-picker will have flipped heads 10 times in a row. Is she skillful or lucky? Should she write a book about her strategy for success? Should you buy it?

    "It has been amply demonstrated that a monkey with a handful of darts will do about as well at choosing stocks as most highly paid professional money managers." (Tobias, Only Investment Guide, p. 6)

Many studies have shown that few or no mutual fund managers consistently beat the market. The following results are summarized from the textbook Investments by Zvi Bodie, Alex Kane and Alan J. Marcus (Irwin McGraw-Hill, Boston, pp. 372-376):

  • From 1984 to 1993, fewer than 30% of stock mutual funds had returns better than the Wilshire 5000 Index, which incorporates the returns of almost every American company with publicly traded stock. From 1971 to 1993, the Wilshire index achieved an average annual return of 12.0%. Managed funds averaged only 10.85%.
  • Managers of bond funds did no better. From 1983 to 1992, the annualized returns of managed bond funds averaged 1.5% below the Lehman Brothers Bond Index.

Individual fund managers' past records tell little or nothing about how they will do in the future. For example, in one study the later achievements of managers who excelled during 1983-86 were compared to those who did the worst during that period. During 1987-90, both groups had equally average records.

From 1965 to 1984, out of 143 stock mutual funds, 127 achieved returns that were statistically indistinguishable from the overall market. Only 12 did better and four did worse. As Burton Malkiel states,

    "I have become increasingly convinced that the past records of mutual fund managers are essentially worthless inpredicting future success. The few examples of consistently superior performance occur no more frequently than can be expected by chance." (Random Walk, p. 442)

MIT economist and Nobel Prize winner Paul Samuelson is even more blunt. After examining the uninspiring record of money managers vs. the market as a whole, he writes,

    "Do I really believe what I have been saying? I would like to believe otherwise. But a respect for evidence compels me to incline toward the hypothesis that most portfolio decisionmakers should go out of business,“ take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed." (Paul A. Samuelson, "Challenge to Judgement," The Journal of Portfolio Management, Fall 1974)

Like portfolio managers, individual investors don't want to hear that, either. "Telling an investor there is no hope of beating the averages is like telling a six-year-old there is no Santa Claus. It takes the zing out of life," Malkiel writes. (Random Walk, p. 459)

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There's nothing wrong with investors who have the inclination and the resources to try their luck at picking a winning stock. But what they are doing is closer to gambling than to risk-averse investing. It does have one big advantage over lotteries and casino gambling: The odds are in your favor because stocks overall tend to rise. If you choose stocks at random, you're more likely to choose ones that will rise than ones that will fall, because the trend of the stock market is upward.

Except for their expenses, mutual fund managers don't have trouble making as much money as the market in general; but they have a great deal of difficulty outperforming it consistently.

Making money on the stock market is relatively easy in the long run, if you keep your holdings well diversified. With all its ups and downs, the overall stock market tends to rise an average of 10% to 12% per year, growing as the American economy grows. (Those percentages are average yearly returns. One -- the 10% average -- is calculated from the peak of stock prices 10cents-2in the 1920s. The other, the 12% average, is based on stock prices at the trough of the 1930s.) The problem for a short-term investor is that the stock market might hit that average by going down 5% one year and up 17% the next, or up 30% one year and down 15% the next. A short-term investor can end up with the 5% or 15% drop, while a long-term investor will get the 10% to 12% rise.

You can tap into the long-term growth by buying index mutual funds, or you can buy any reputable mutual funds run by professional mutual fund managers. In either case, your investment will be in good hands --“ just don't expect fund managers to beat the market consistently. If they do, consider yourself (and them) lucky.

More things not to worry about

Unless you want to, you don't need to pay attention to the daily financial news, check the stock tables, or try to guess the short-term future of interest rates and the Dow. Nobody knows which direction the market will go tomorrow. But you don't need to know that. All you need to know is that in the long term it goes up. If you try to outguess the market, you're likely to lose money. As Burton Malkiel states:

    "Switching your investments around in a futile attempt to time the market will only involve extra commissions for your broker, extra taxes for the government, and poorer net performance." ( Random Walk, p. 405)

Checking on your investments too frequently can be hazardous to your financial health and fatal to your peace of mind. "If there's anything that makes it difficult to succeed in stocks, it's that investors can see how they're doing throughout the day," Tobias writes. "Stocks move up and down all the time, but that doesn't mean there is significance to every move." (Only Investment Guide, p. 132) Further, he states, "unless you get a kick out of it, you needn't spend a great deal of time reading investment guides, especially long ones. ... Because if you can find the right forest -- the right overall investment outlook -- you shouldn't have to worry much about the trees." (Only Investment Guide, p. 6)

Next: Caveat Investor


Principles 1: Not rocket science Principles 2: Relax Principles 3: Caveat Investor

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