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.
1.It has to have a historical track record -- and I'm not talking about just the last 3
weeks.
2.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.
3.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
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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