The Experts
 Everybody's Got a System
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By Scott
Lummer
Chief Investment Officer, mPower
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Editor's note: Scott Lummer is competing in the X Games
this week (Event: X-treme Market Swings), and was unavailable to write a column. He'll be
back next week, if he doesn't break anything.
This week's question is:
I read about stock picking strategies in various
magazines and web sites. They seem to have a better track record than the S&P 500
index. My company allows us to buy individual stocks in our 401(k). Can you recommend one
of these strategies?"
The first time I traveled to Las Vegas, I was sure I had
figured out a way to win at blackjack. After all, I was a math major, and had read several
books on concepts that would help me beat the house. And after the first night, I was
doing really well. Celebrating my good fortune by buying everyone in the casino deli a
50-cent shrimp cocktail, I was drawn into a conversation with two grizzled Vegas veterans.
When I told them the source of my newfound riches, one of them looked at the other and
said, sarcastically, "Everybody's got a system." The other smiled knowingly.
That was over two decades ago, but I still remember the
look in their eyes as they pondered yet another rookie with a "can't miss"
strategy. Over time, I came to realize that "can't miss" strategies can and do
miss -- how else could those fancy buildings in Vegas pay their monstrous electricity
bills? (It's not with the profits from $3.99 buffet dinners!)
Well, I've now been following the capital markets long
enough to qualify as a grizzled veteran. I hear about many investing strategies that seem
logical on the surface. And although I'm tempted to believe them, because like all
investors I would like to find the Holy Grail of philosophies, I usually end up with the
same degree of cynicism that my two "friends" showed that night in Vegas. I'm
not going to tell you that it's impossible for you to outperform the S&P 500, but you
should be aware of the difficulties and risks you face.
First let me share with you three characteristics a system
must have in order for you even to consider using it.
- It has to have a historical track record -- and I'm not
talking about just the last 3 weeks.
- There has to be an explanation of why the results occurred.
For example, a few years ago the popular press seemed enamored with the "Super Bowl
effect". Some researcher found that if you invested in stocks in years when the NFC
team won, and in money markets in years when the AFC team won, you would outperform the
market. Of course there was no logical explanation of why this occurred. And it hasn't
really occurred over the past two years (how have money market investments performed
relative to stocks since January of 1998?). I know the Super Bowl strategy sounds silly,
but the foundation of many other tactics is not much more solid.
- Here's the tough criterion: there has to be a reason why the
strategy will continue to work even after everyone knows about it. In the '70s and early
'80s, the money managers who invested in stocks immediately after the Fed cut interest
rates earned impressive returns. However, since the mid-'80s, when that strategy was
discussed publicly, it hasn't done very well. Today, the stock price reacts in
anticipation of the Fed announcement.
Very few strategies fulfill all three criteria.
You also should be aware of your competition. In attempting
to find a system, you are battling tens of thousands of professional money managers. Your
typical opponent has at least 15 years of investment experience, a CFA designation (which
results from a rigorous training program), and a staff of well-trained analysts. Oh -- and
he or she is pretty smart as well; aware not only of your system, but also of 200 variants
of it that perform differently in various types of market conditions. It's kind of like
going to an island to hunt for buried treasure with a faded map, and seeing thousands of
Indiana Jones's with Global Positioning Devices on the boat with you.
There are a couple of other dangers to think about.
Recognize that almost any investing strategy attempting to beat the market will involve
some costs. The more active the strategy, the more expensive it will be. And the costs are
usually reduced by volume -- what is cheap to someone managing a $5 billion portfolio will
be costly if you are investing "only" a few hundred thousand dollars. Although a
concept might work for professionals, the commissions can chew you up. Moreover, some
investing tactics add significant risk to your portfolio. Investing heavily in a style
(like small-cap growth companies) or a sector (financials) can reduce the diversification
in your portfolio, and cause huge dips when the strategy doesn't work out.
One last thought, although maybe it's obvious. If you had a
really great investing strategy -- one that you were sure would do well, would you
publicize it in a magazine or on a web site? I wouldn't.
Now on the other hand, if you have an original idea -- tell
me about it. If I like it, I'll even spring for a shrimp cocktail!
 Lummer's Logic Archives
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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