Part One
WHY YOU NEED THIS BOOK
It sounds simple enough: Over the past six decades, the U.S. stock market has averaged an annual return of about 11 percent per year. By simply investing in a broad market index and sticking with it for the long haul, the odds are thus overwhelming that youâll end up with returns that dwarf those of savings accounts, bonds, Treasury bills, and even gold. Do a little better than the market average, and youâll really be raking in the profits.
Yet throughout history, the vast majority of investorsâboth amateur and professionalâhave been humbled by the market, failing to come anywhere close to those 11 percent average annual gains. Why do they fail? What is it that makes it so difficult for investors to take advantage of the stock marketâs long-term benefits? And what can we learn from those rare few who have consistently generated outstanding returns over the long haul?
Youâre about to find out.
Chapter 1
Learn from the Worst
From the errors of others, a wise man corrects his own.
âPUBLILIUS SYRUS, FIRST-CENTURY ROMAN WRITER
Peter Lynch, Benjamin Graham, David Dreman, and others have all left roadmaps showing just how the average investor can make a bundle in the stock market. Their formulas are relatively simple and donât involve the kind of complex mathematics that only a rocket scientist could understand.And, to top it all off, between the access Iâll give you to my new websiteâwww.guruinvestorbook.comâand the ease with which you can find stock information on the Internet these days, you wonât have to do too much digging and research to put these formulas into action.This is going to be a piece of cake, right?
Not exactly. While people such as Lynch, Graham, and Dreman have been kind enough to lay out paths to investing success for us to follow, the stock market will throw obstacles and challenges into even the most carefully crafted roads to riches. The first stop along our journey isnât going to be a pretty one. Weâre going examine how and why investors before us have failed so that youâll be ready when confronted with the same pitfalls.
The Fallen
As we begin our survey of the graveyard of failed market-beaters, one thing should quickly jump out: Itâs a pretty crowded place. To start with, there are the professionalsâthe mutual fund managers. Over the past couple decades, mutual funds have become a widely used stock market tool, allowing investors to buy a broad swath of stocks with less transaction costs than theyâd incur if they tried to buy each holding individually. The problem is that most mutual fund managers fail to beat the returns youâd get if you had just bought an index fund that tracks the S&P 500 (The S&P 500 index is generally what people refer to when they talk about beating âthe marketâ).
In fact, in a 2004 address to the United States Senate Committee on Banking, Housing, and Urban Affairs, John Bogleâthe renowned founder of the Vanguard Group, one of the worldâs largest investment management companiesâstated that the average equity fund returned 10.5 percent annually from 1950 through 1970, while the S&P 500 averaged a 12.1 percent return. From 1983 through 2003, as mutual funds became more popular, the gap was even worse: The average equity fund returned an average of 10.3 percent annually, while the S&P grew at a 13 percent pace.
A 2.7 percent spread between the S&P and mutual fund managersâ performances may not seem like all that much. But remember, the compounded returns you get in the stock market can turn that kind of difference into a lot of money very quickly. A $10,000 investment that grows at 13 percent per year compounded annually, for example, will give you a shade over $115,000 after 20 years; at 10.3 percent per year, youâd end up with about $44,000 less than that (approximately $71,000).
Bogleâs not the only one whose research highlights the poor track record of fund managers. In his book What Works on Wall Street, James OâShaughnessy, one of the gurus youâll read about later in this book, looked at what percentage of equity funds beat the S&P 500 over a series of 10-year periods, beginning with the 10-year period that ended in 1991 and ending with the 10-year period that ended in 2003. According to OâShaughnessy, âthe best 10 years, ending December 31, 1994, saw only 26 percent of the traditionally managed active mutual funds beating the [S&P] index.â That means that just over a quarter of fund managers earned their clients market-beating returns in the best of those periods!
In addition, those that beat the S&P didnât exactly crush it. OâShaughnessy said, for example, that less than half of the funds that beat the S&P 500 for the 10 years ending May 31, 2004 did so by more than 2 percent per year on a compound basis. Whatâs moreâand this is a key pointâOâShaughnessy noted that these statistics didnât include all the funds that failed to survive a particular 10-year period, meaning that his findings actually overstate the collective performance of equity funds.
Along with fund managers, another group of market underperformers mired in the stock market muck are newsletter publishers. These are investorsâsome professional and some amateurâwho write monthly or quarterly publications (many of which are published online) that give their assessment of the economy as well as their own stock picks. They sound official and authoritative, and sometimes even have large research staffs working for them. But while they can attract thousands of readers, more often than not their advice is lacking. In fact, Mark Hulbert, whose Hulbert Financial Digest monitors investment newsletters and tracks the performance of their picks (Hulbert is considered the authority on investment newsletter performance and has been tracking newsletters for over 25 years), said in a 2004 Dallas Morning News article that about 80 percent of newsletters donât keep pace with the S&P 500 over long periods of time.
And just as their individual stock picks are often subpar, newsletter publishers also have a difficult time just picking the general direction of the market. A National Bureau for Economic Research study of 237 newsletter strategies done in the 1990s found that, between June 1980 and December 1992, there was âno evidence to suggest that investment newsletters as a group have any knowledge over and above the common level of predictability,â according to the International Herald Tribune.
So, while their advertisements and promises may sound tempting, the data indicates that newsletter publishers and money managers have a weak record when it comes to beating the market. Their collective track record, however, is far better than that of individual investors, whose poor performance we examined in the Introduction.
Bogle has also addressed the issue of individual investorsâ returns, and his findings paint an equally glum picture. He told that congressional committee in 2004 that he estimated equity fund investors had averaged an annual gain of just 3 percent over the previous 20 years, during which time the S&P 500 grew 13 percent per year.
The Futility of Forecasting
Having established that most investorsâprofessional and amateurâunderperform the market, the obvious question is, why? After all, professional investors are, for the most part, intelligent people. Just about all of them have college degrees, some from very prestigious schools, and they are required to pass multiple licensing examinations before being allowed to invest clientsâ money. Similarly, there are a lot of very smart amateur investors out there. As I noted earlier, I have degrees from Harvard and MIT and successfully built up my own business, yet I struggled for a long time to beat the market. How can so many smart people fare so poorly?
Well, for the firstâand perhaps greatestâreason, we donât have to look far: It is the fact that we are human. Our own humanityâthe way we think, the way we perceive things and feel emotionsâhas become a major topic in the investing world in recent years. There are even branches of scienceâbehavioral finance and neuroeconomicsâthat examine how psychology and physiology affect the way we deal with our money. And, in general, the findings show that we humans are investing in the stock market with the deck stacked against us.
Some great research into this topic has been done by Money magazine writer Jason Zweig (no relation to Martin, another of the gurus youâll soon read about), who last year authored a book on neuroeconomics titled Your Money and Your Brain. One of the main points Zweig stressed is that human beings are excellent at quickly recognizing patterns in their environment. Being able to do so has been a key to our speciesâ survival, enabling our ancestors to evade capture, find shelter, and learn how to plant the right crops in the right places. Zweig further explains that today this natural inclination allows us to know what train we have to catch to be on time, or to know that a crying baby is hungry. Those are all good, and often essential, things to know.
When it comes to investing, this ability ends up being a liability. According to Zweig, âOur incorrigible search for patterns leads us to assume that order exists where it often doesnât. Itâs not just the barus of Wall Street who think they know where the stock market is going. [Barus were divinatory or astrological priests in ancient Mesopotamia who declared the divine will through signs and omens.] Almost everyone has an opinion about whether the Dow will go up or down from here, or whether a particular stock will continue to rise. And everyone wants to believe that the financial future can be foretold.â But the truth, he says, is that it canâtâat least not in the day-to-day, short-term way that most investors think it can.
You donât have to look too far to find that Zweig is right. Every day on Wall Street, something happens that makes people think they should invest more money in the stock market, or, conversely, makes them pull money out of the market. Earnings reports, analystsâ rating changes, a report about how retail sales were last monthâall of these things can send the market into a sudden surge or a precipitous decline. The reason: People view each of these items as a harbinger of what is to come, both for the economy and the stock market.
On the surface, it may sound reasonable to try to weigh each of these factors when considering which way the market will go. But when we look deeper, this line of thinking has a couple of major problems. For one thing, it discounts the incredible complexity of the stock market. There are so many factors that go into the marketâs day-to-day machinations; the earnings reports, analystsâ ratings, and retail sales figures I mentioned above are just the tip of the iceberg. Inflation readings, consumer spending reports, economic growth figures, fuel prices, recommendations of well-known pundits, news about a companyâs new products, the decisions of institutions to buy and sell because they have hit an internal target or need to free up cash for redemptionsâall of these and much, much more can also impact how stocks move from day to day, or even hour to hour or minute to minute. One stock can even move simply because another stock in its industry reports its quarterly earnings. Very large, prominent companies such as Wal-Mart or IBM are considered bellwethers in their industries, for example, and a good or bad earnings report from them is often interpretedâsometimes inaccuratelyâas a sign of how the rest of companies in their industries will perform.
Whatâs more, when it comes to the monthly, quarterly, or annual economic and earnings reports like the ones Iâve mentioned, the market doesnât just move on the raw data in the reports; quite often, it moves more on how that data compares to what analysts had projected it to be. A company can post horrible earnings for a quarter, and its stock price might rise because the results actually exceeded analystsâ expectations. Or conversely, it can announce earnings growth of 200 percent, but fall if analysts were expecting 225 percent growth.
Finally, letâs throw one more monkey wrench into the equation: the fact that good economic news doesnât even always portend stock gains, just as bad economic news doesnât always precede stock market declines. In fact, according to the Wall Street Journal, the market performed better during the recessions of 1980, 1981-1982, 1990-1991, and 2001 than it did in the six months leading up to them. And in the first three of those examples, stocks actually gained ground during the recession.
Expert, Shmexpert
As you can see, with all of the convoluted factors that drive the stock market, predicting which way it will go in the short term is just about impossible. But waitâarenât we forgetting something? A certain group of people that the media refer to as âexpertsâ? These self-assured sounding commentators that we find on TV, the Internet, or print news tell us that they know just what the latest round of earnings reports or economic figures will mean for stocks. After all, theyâre experts; donât they have to be at least pretty good at predicting economic and stock market tends?
Unfortunately, research shows that they donât. Before I created my investment research website and started my asset management firm, my company first specialized in researching how well the stock picks of most âexpertsâ who appeared in the media actually did.What we found was that there was no consistency or predictability in the performance of these pundits. The best performers in one week, one month, one quarter, six months, or one year were almost guaranteed to be entirely different in the next period; basically, you couldnât make money by picking a top performing expert as measured over a short period of time and following him or her.
But you donât have to trust my experience to find out that âexpertsâ are far from infallible. In a 2006 article for Fortune, Geoffrey Colvin examined this concept by reviewing the book Expert Political Judgment: How Good Is It? How Can We Know? Written by University of California at Berkeley professor Philip Tetlock, the book detailed a seven-year study in which both supposed experts and nonexperts were asked to predict an array of political and economic events. It was the largest such study ever done of expert predictionsâover 82,000 in total. The study, Colvin noted, found that the best forecastersâeven the âexpertsââcouldnât explain more than 20 percent of the total variability in outcomes. Crude algorithms, on the other hand, could explain 25 to 30 percent, while more sophisticated algorithms could explain 47 percent. âConsider what this means,â Colvin wrote. âOn all sorts of questions you care aboutâWhere will the Dow be in two years? Will the federal deficit balloon as baby-boomers retire?âyour judgment is as good as the expertsâ. Not almost as good. Every bit as good.â
Thereâs more. Colvin also noted that the study found that the expertsâ âawfulnessâ was pretty consistent regardless of their educational background, the duration of their experience, and whether or not they had access to classified materials. In fact, it found âbut one consistent differentiator: fame. The more famous the experts, the worse they performed,â Colvin said.
So, if thatâs the case, why do so-called âexpertsâ still get so much publicity and air time? Colvin said the reason is another result of our human nature. As humans, we want to believe the world âis not just a big game of dice,â he wrote, âthat things happen for good reasons and wise people can figure it all out.â And since people like to hear from confident-sounding experts who appear to be able to figure it all out, the media likes to give them air timeâand the experts like to get that air time because it pays, Colvin noted. Tetlock himself described this relationship as a âsymbiotic triangle,â explaining, âIt is tempting to say they need each other too much to terminate a relationship merely because it is based on an illusion.â
The bottom line: Just because someone sits in front of a camera with a microphone and speaks confidently doesnât mean he or she has any sort of clairvoyant powers when it comes to the stock market. In fact, the odds are that four out of every five times, theyâll be wrong!
Market Timing: The Most Dangerous Game
With all of the research that shows humansâeven expertsâhave pretty terrible predictive abilities when it comes to economic and stock market issues, youâd think that people would refrain from trying to predict the marketâs short-term movements. They donât. Every day, millions of investors try to discern where the market will head tomo...