A 117% Gain in a Year? Why, That's Nothin'!
A stock-contest champ shows how to game the system--and why you can never trust short-term returns.
(MONEY Magazine) - At times like these, when the market seems to be treading water in a vat of library paste, stock promoters pop up to cash in on our bull-run fantasies. "Want to make double-digit profits in just DAYS?" gasped one newsletter I got recently. An e-mail topped that with "a 996.3% Gain in 16 Months." The next day, another newsletter promised "2,824% in 24 months!"
Well, I like a 2,824% gain at least as much as the next guy, so I decided to find out how to rack up that kind of return. For guidance I turned to Moshe Milevsky, a finance professor at York University in Toronto who won Canada's best-known stock-picking contest in 2002, 2003 and 2004. His average annual return: 135%.
Of course, a stock-picking game isn't the real world. But paying attention to Milevsky can indeed make you a smarter investor--whether you're the type who takes a flier on every stock tip you get or you just want to figure out if the claims of your broker, financial planner or mutual fund manager make sense.
"Blow Up or Take Off"
Milevsky didn't win the stock-picking contest three years straight by luck alone. He set out to design a system that would propel him to the top. (Each entrant gets to pick one stock; the winner earns 15 minutes of fame and a coffee mug.)
Milevsky explains his key insight: If you're saving for retirement or any long-term goal, you want reliable returns over decades. But to win a stock-picking contest (or attract subscribers to a stock newsletter), you want huge returns over the short run so you have something to hype. There's only one way to do that, says Milevsky: "Find stocks that will either completely blow up or take off."
Milevsky started by looking for stocks with "negative correlation," meaning they zig when the overall market zags. This increases the odds that a stock's return will be either much better--or much worse--than average. Milevsky also searched for shares that had the widest swings between high and low prices. "If I bounce around a lot," he says, "I might get hundreds-of-percent returns [off a low point]."
The result? One obscure, risky stock a year. In 2003, for instance, Milevsky picked a tiny, money-losing oil company called Canadian Superior Energy, whose share price in 2002 had heaved up and down more than seven times as much as the S&P/TSX 60 index, the Canadian equivalent of Standard & Poor's 500.
"Stocks like these can go up more than 100% very quickly," says Milevsky. "But they also offer about a fifty-fifty chance of losing you 95% of your money." Canadian Superior earned Milevsky the stock-picking crown with a 117% return in 2003. Less than three months later, it lost 61% in four days. "Solid companies will not win you this kind of contest," he deadpans. "The same factors that make these risky stocks a great choice for this kind of contest make them a horrible choice for a long-term investment."
Filtering the Hype
Milevsky pulled off an intellectual prank, proving that victory in the short term goes not to the swift or the strong but to the insanely reckless. Out of his trick, however, comes some powerful wisdom.
• GET THE WHOLE STORY It's easy to be dazzled by tales of big returns, whether you read them in a newsletter or hear about them from a friend or a broker. But what about the picks that flopped? Before you listen to any adviser, ask what he got wrong. If he demurs, remember that only liars never have losers. Stay away.
• WATCH THE CLOCK Anybody can rack up a monster return in the short run. But as time passes, too much risk takes a terrible toll. When you see a mutual fund ad bragging about three-year returns, ask yourself: What about the years before? Look up the fund's returns for each of the past eight years at morningstar.com.
• THINK PORTFOLIOS, NOT STOCKS There are always a few stocks doubling or tripling. But those are usually the ones that soon flame out and fall back to earth. There's a beautifully simple way to be sure you can counteract the losers with plenty of winners: Spread your bets over many stocks. The easiest way to do that is through a diversified mutual fund--ideally an index fund that owns every stock in the market. Then you can take all your investing junk mail and toss it in the trash, where it belongs.
Jason Zweig is the editor of Benjamin Graham's The