Friday, April 6, 2007

Ignore most of what you read...Buying Stocks to Beat the Market is tough

As do most personal finance bloggers, I enjoy reading the financial news and stock recommendations. There is something exciting about believing you might read something that will add to your personal wealth. But, ultimately, the key to success in investing is to ignore most of what you see on financial news networks, newsletters, magazines, etc. Ironically, beating the averages is easy using some basic tools I'll give you.

The key to understanding why this it the case is to understand how the market works. Stock recommendations generally take one of two forms; Either
1. The growth philosophy. This stock has huge growth potential, earnings are predicted to go up dramatically, it has a large moat, etc...
2. The value philosophy. This stock is cheap, it has been beaten down, it has prospects for a turnaround, etc...

The problem with both philosophies is that the details are already known. The information was already public record. The talking head has told everyone that is listening of this info. It is priced into the price of the stock. The story sounds good, it probably even is right, but all that and much more is already reflected in the price of the stock.

Colleagues regularly come to me indicating they have bought, or are thinking of buying, a stock. When I ask why, they quote details that everyone knows...earnings are growing 20% per year, it is leading its field, they just read a positive story about its prospects, etc. I tell them that, while the stock may be a good investment, to beat the market you have to understand or perceive something that others do not. If you are buying something based on well known public information, the best you can hope for is to match the market because that information is priced in to the point of making it an average investment. While it is possible to do better or worse than average on any particular stock, the chances of regularly being right in perceiving something others do not, are pretty low.

So, at best, buying based on well known public information is a recipe for average performance. Unfortunately, there is a likely worse case...If the stock price is being forced up because many are buying the stock based on the talking heads recommendation, the likely returns are being forced down. In this case, to get ahead you have to be going against the crowd, a process known as contrarian, buying based on a perception about the stock that others do not have. After years of trying, I gave up trying to beat the market on this basis. After long observation I also gave up on trying to anticipate in advance which advisor might be able to do it. And, though many haven't yet realized it, this is the reason that 80% of investors underperform the averages, a prospect that seems contradictory. Hopefully the above helps you understand how something so contradictory can be true.

But, here is the good news. By taking advantage of this understanding and taking the emotion out of the equation by using some mechanical tools, you can easily beat the market averages. The tools? Index funds, dollar cost averaging, rebalancing and my own version of this process, "Dollar Cost Averaging on Steroids". For more details, see previous posts on this blog.

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