Back in the bad old days, Wall Street swarmed with knaves and
shysters who hawked moneymaking magic: Buy our tax shelters!
Invest in a low-return, high-cost mutual fund! Let me trade
soybean futures for you!
These days, the get-rich-quick gang talks about "empowerment"
and "taking charge of your own life." Too often, this ends up
meaning that you can pick your own pocket, instead of paying
someone else to do it for you. Although there are people who
consider this progress, I am not one of them.
Everywhere you turn, someone is selling investment hogwash:
seductive-sounding ideas that will supposedly enable you to beat
the market and buy a tropical island with the proceeds. Using
your own wits and the new weapons of online information, say
these folks, you can make Wall Street's pros look like
birdbrains--but you've got to hurry.
Fidelity.com, for instance, tells you, "Every second counts."
Business Week lionizes a retiree who used the Internet to trade
in and out of his mutual funds 22 times in the first four months
of 1999. The Motley Fool says it has a system enabling you to
"crush" the market in just 15 minutes a year. Time magazine
columnist Jim Cramer says "there's good reason" for you to become
a day-trader. Robert Markman, a prominent financial planner,
declares in Worth magazine that diversification is a stupid idea.
What it means to be right
In the past year or so, many investors' minds have been hijacked
by these false beliefs; as Third Avenue Value Fund's manager
Martin Whitman likes to say, "The inmates have taken over the
More than ever, people think the test of an investment's
validity is whether it "worked." If they beat Standard & Poor's
500-stock index over any period, no matter how dumb or dangerous
their tactics, people boast they were "right." But investing
successfully over the course of a lifetime has nothing to do
with being right in the short term. To reach your long-term
financial goals, you must be sustainably and reliably right.
While the techniques that are so trendy now--day trading,
ignoring diversification, flipping funds, following
"systems"--may seem right on a given day, they slash your odds
of being right in the long run.
Imagine that two places are 130 miles apart. If I observe the
65-mph speed limit, I'll drive this distance in two hours. But
if I go 130 mph, I can get there in just one hour. If I try this
and survive, am I "right"? Should you be tempted to try it too
because it "worked"? The flashy new ideas for beating the market
are much the same: In short streaks, if you're lucky, they will
work. Over time, they will get you killed financially.
To see whether someone is truly right and an investing idea
really works, you have to test it as a scientist would. First
you need a hypothesis, a commonsense explanation of why the
technique should work. Then you need a large amount of accurate
data testing the idea both before and after it was discovered.
Finally you need to ask: Could this just be dumb luck?
The "Very Stupid" portfolio
Let's test a trendy "strategy" in detail--and see how to stay out
of trouble by analyzing any investing idea skeptically.
The Motley Fool website and books have popularized the idea that
you can beat the market with a basket of four high-yielding
stocks in the Dow Jones industrial average. At first, the
"Foolish Four" seems sensible: Stocks with big dividend yields
are cheap, so they should do well in the future.
But the folks at the Motley Fool can't leave well enough alone.
They claim you'd have "trashed the market averages over the last
25 years" by picking the five lowest-priced, highest-yielding Dow
stocks. Then you'd discard the one with the lowest price and put
40% of your money in the second lowest-priced stock and 20% each
in the third, fourth and fifth lowest. (This way you'd have
beaten the S&P 500 by 10.1 points a year from 1973 to 1997.) Or
you could pick the five Dow stocks with the highest ratio of
yield to the square root of stock price, then drop the one with
the highest ratio and buy the second through fifth highest. (This
would have beaten the S&P by 11.5 points annually for 25 years.)
No, I'm not making this up--and yes, you're right to be confused.
As financial planner Bill Bernstein has pointed out, there's no
way these cockamamie contortions add up to a rational hypothesis.
Why on earth should the square root of a stock's current price
(divided into its yield or anything else) affect its future
return? Why would anyone in his right mind drop the stock that
scores highest for a desirable quality but keep those that score
second through fifth? (The Motley Fool folks assert that the
single lowest-priced stock can be "dangerous," since it's often
financially troubled; but they don't explain why the stocks whose
prices are right behind it should be any safer. And they say a
stock's volatility is generally affected by its price, but they
offer no reason why this should be true for the Dow.)
In short, the Foolish Four is investment hogwash in its purest
form. Just as we can "predict" yesterday's weather with 100%
accuracy, we already know exactly which stocks outperformed in
the past. If we look long enough, we can find some attribute they
share--but it's far more likely to be a complete coincidence than
an actual cause of their high returns.
To show how easy it is to concoct something that works like the
Foolish Four portfolio, I tried it myself. With the help of Kevin
Johnson, a money manager at Aronson & Partners in Philadelphia, I
studied up to 10,500 stocks a year back to 1980.
Here's what we found: Beating the market over the past two
decades was a breeze. All you had to do was buy stocks whose
names are spelled without repeating any letters. To heck with
that Motley Fool complexity: Texaco, good (no repeated letters);
Exxon, bad (two X's). I call this the "Very Stupid"
portfolio--since that title, like our stocks' names, repeats no
This year, Very Stupid is chock-full of stocks like Numex Corp.
(up 316%), Grey Wolf (up 208%) and Ultrafem Inc. (up 100%); last
year, Very Stupid would have held Jam Inc. (up 4,900%), IFX
Corp. (up 409%) and Gap (up 138%). During our nearly 20-year
period, a Very Stupid investor would have beaten the market by
1.3 percentage points a year.
But I didn't want just to beat the market; I wanted to pound it
to a bloody pulp. So we tinkered some more and cooked up the
"Extra Dumb" portfolio, which holds only the bottom 25% (by
market value) of stocks without repeat letters in their names.
That portfolio whupped the market by six points a year for two
Am I kidding? Yes and no. Our data do prove what we say; a Very
Stupid or Extra Dumb investor really would have beaten the
market for nearly 20 years. But that doesn't mean that we're
right, or that this portfolio will work in the future. If Kevin
and I can't explain why it makes sense--and believe me, we
can't--our "strategy" can only be dumb luck.
What really works
There's a lesson in all this nonsense: Unless someone has a
sensible explanation and good data to document a strategy's
returns--both before and after it was created--you're dealing
with investment hogwash.
When 90% of professional investors, with their M.B.A.s and
powerful computers and multimillion-dollar research budgets,
can't beat the market, why should you believe anyone who says
you can do it by day trading? (After all, the new information
that comes to you over the Internet comes to the pros too.)
When a financial planner says that diversification doesn't work
and you should put all your money in big U.S. growth stocks, ask
why you would ever want to bet everything you've got on what's
been hot in the recent past--instead of holding a wider, safer
variety of assets that should go up in the future.
When someone trades his mutual funds 22 times in four months, ask
whether there's a shred of evidence that he can earn more money
that way than he could merely by sitting still.
If the inmates take over the asylum, here's a simple solution:
Steer clear, stay sane and stick to what's always worked in the
fullness of time--a diversified portfolio of U.S. and foreign
stock and bond funds that you hold for years on end. In the long
run, that's the best kind of empowerment for most investors.