Why stock picking is a losing game
Don't bet on it. Here's why trying to outguess the market will always be a losing game.
(Money†Magazine) -- Imagine that the Man Upstairs is really, really pleased with you and has decided to make you fabulously wealthy. How would He do it? The simplest way would be to give you a bunch of no-brainer opportunities to make a killing on stocks and bonds. Then He'd put on this earth a host of suckers willing to take the opposite side of your bets.
Millions of investors - and their brokers - seem to believe their own personal version of this fantasy. Because whenever somebody tells you he has found a simple strategy for beating the market, what he's really saying is that the market, apart from him, is populated by patsies.
Consider, for example, newsletters with ranking systems that tell you when it's time to buy or sell a stock. You aren't the only one who can pad down to the library or click online to look up the latest ratings. If the newsletters worked, what rube would be willing to part with a stock rated "buy" and sell it to you? And who would buy it back from you when the mighty oracle pronounced a sell rating? (The newsletter writer must also be pretty clueless to be selling this priceless knowledge to total strangers for a few hundred bucks.)
Sometimes you'll spot an opportunity for a trade that seems screamingly obvious - and that's exactly when you'd better stop to ask yourself what's wrong with it.
Here's one strategy I'm often asked about. Say 10 years ago you bought a 12-year muni yielding 5% a year. Its maturity is now two years away, and other two-year bonds on the market yield just 2.5%. So your bond can be sold on the market for well above its par value. The genius move must be to sell the bond, pocket the premium, and replace it with a longer bond yielding 5%. Not so fast.
The good news is that you will find no shortage of buyers for your bond. The bad news is that these buyers aren't dummies. They understand that bonds closer to maturity carry less risk. By selling, you've locked in a gain, but to get 5% on your money anywhere else you now have to buy a longer bond and take more risk.
You'll win that bet sometimes and lose it at other times. It's roughly a fair trade - or would be if bond transactions were free. In fact, munis are among the most expensive securities to trade. Doing so frequently will send your broker's kids to private school but will do nothing good for you.
All such strategies have two things in common: First, they won't work. And second, the reason they won't work is that the anonymous investors on the other side of the trade usually have more on the ball than you imagine.
Remember, when you venture into the markets, you're competing against Warren Buffett, the giant Yale endowment fund and a worldwide army of hypercompetitive M.B.A.s who wake up before you do and go to sleep later as well. (And that's not even mentioning corporate insiders, who know more than any analyst.)
Heaven knows the pros can make their own lousy bets - we're living with the consequences of Wall Street's hubris right now. But the fact that Lehman Brothers and Merrill Lynch, with all of their resources, can't always outsmart the market is all the more reason for the rest of us to be humble. Those guys had a surefire system too.
The best way to win this game is to not play it. Stick with low-expense index funds - under 0.2% in annual charges - that simply own all of the market, both in the U.S. and abroad.
I'm sure you've heard that while it's fine to ride the market's gains when times are good, you need an expert stock picker when the bear roars. Wrong: Active money managers do not suddenly gain an extra 20 IQ point advantage over the rest of the market just because the Dow is falling. The record shows that their funds have trouble competing with the index in the bad times too.
Finally, always remember what your father told you about playing poker: If you look around the table and don't see a patsy, then you're the patsy.Send feedback to Money Magazine