The Guru Investor E-Book

John P. Reese

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 455

Veröffentlichungsjahr: 2009

Beschreibung

Today's investor is faced with a myriad of investment options and strategies. Whether you are seeking someone to manage your money or are a self-directed investor deciding to tackle the market on your own, the options can be overwhelming. In an easy-to-read and simple format, this book will dissect the strategies of some of Wall Street's most successful investment gurus and teach readers how to weed through the all of the choices to find a strategy that works for them. The model portfolio system that author John Reese developed turns each strategy into an actionable system, addressing many of the common mistakes that doom individual investors to market underperformance. This book will focus on the principles behind the author's multi-guru approach, showing how investors can combine the proven strategies of these legendary "gurus" into a disciplined investing system that has significantly outperformed the market. Gurus covered in the book are: Benjamin Graham; John Neff; David Dreman; Warren Buffett; Peter Lynch; Ken Fisher; Martin Zweig; James O'Shaughnessy; Joel Greenblatt; and Joseph Piotroski.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Acknowledgements

Introduction

Part One - WHY YOU NEED THIS BOOK

Chapter 1 - Learn from the Worst

The Fallen

The Futility of Forecasting

Expert, Shmexpert

Market Timing: The Most Dangerous Game

Need for an Emotional Rescue

The Best Way Not to Miss the Boat: Don’t Get Off in the First Place

Now, the Good News . . .

Chapter 2 - The Cavalry Arrives

A Numbers Game

Why Them?

Meet the Dream Team

Crucial Similarities

Part Two - THE VALUE LEGENDS

Chapter 3 - Benjamin Graham

Who Was Benjamin Graham?

Value Investing: Good Companies, Low Prices

Safety First

Graham’s Strategy: Step by Step

The Graham-Based Model Performance

Chapter 4 - John Neff

Who is John Neff?

Low P/E Investing: There’s Gold in the Market’s Dregs

Growth: Steady, Sustainable, Sales-Driven

Don’t Forget the Dividend

Discipline and Dedication

Neff’s Strategy: Step by Step

The Neff-Based Model Performance

Chapter 5 - David Dreman

Who Is David Dreman?

The Contrarian Strategy: Psychology Meets Investing

Taking Advantage

How to React to a Major Market Crisis

Redefining Risk

Dreman’s Strategy: Step by Step

The Dreman-Based Model Performance

Chapter 6 - Warren Buffett

Who Is Warren Buffett?

The Man behind the Fortune

The Patient Investor Strategy: Buy (with Great Care)-and-Hold (for a Long, Long Time)

By the Numbers

The Buffett Strategy: Step by Step

The Buffett-Based Model Performance

Part Three - THE GROWTH LEGENDS (WITH A VALUE TWIST)

Chapter 7 - Peter Lynch

Who Is Peter Lynch?

P/E/G Investing: Start With What You Know . . .

. . . But End With Fundamentals

Lynch’s Famous P/E/G Ratio

A True Disciplinarian

Lynch’s Strategy: Step by Step

The Lynch-Based Model Performance

Chapter 8 - Kenneth L. Fisher

Who Is Kenneth L. Fisher?

Price-Sales Investing: A Revolutionary Approach

Beyond the PSR

Always Evolving

The Fisher Strategy: Step by Step

The Fisher-Based Model Performance

Chapter 9 - Martin Zweig

Who Is Martin Zweig?

The Conservative Growth Strategy: Earnings, Earnings, and More Earnings

If Sales Aren’t Driving, Don’t Get in the Car

All About the Indicators

Zweig’s Strategy: Step by Step

The Zweig-Based Model Performance

Part Four - THE PURE QUANTS

Chapter 10 - James O’Shaughnessy

Who Is James O’Shaughnessy?

United Cornerstone Investing: Discipline, First and Foremost

Allocation Matters

Buy and Hold—But Not Forever

Simplicity—and a Surprise

Ever Improving

O’Shaughnessy’s Strategy: Step by Step

The O’Shaughnessy-Based Model Performance

Chapter 11 - Joel Greenblatt

Who Is Joel Greenblatt?

Magic Formula Investing: It (Only) Takes Two

You Gotta Believe

Portfolio Management

Greenblatt’s Strategy: Step by Step

The Greenblatt-Based Model Performance

Chapter 12 - Joseph Piotroski

Who Is Joseph Piotroski?

The High Book-Market Strategy: A Critical Distinction

Piotroski’s Strategy: Step by Step

The Piotroski-Based Model Performance

Part Five - FROM THEORY TO PRACTICE

Chapter 13 - Putting It Together

Six Guiding Guru Investing Principles

Chapter 14 - The Missing Piece

Selling Smart

Staying a Step Ahead of Uncle Sam

Remember, Nobody’s Perfect

Conclusion

Appendix A - Performance of Guru-Based 10- and 20-Stock Model Portfolios

Appendix B - Guru Yearly Track Record Comparison (Actual or Back-Tested Returns)

References

About the Authors

Index

Copyright © 2009 by John P. Reese and Jack M. Forehand. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Limit of Liability/Disclaimer of Warranty:While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials.The advice and strategies contained herein may not be suitable for your situation.You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Reese, John, 1953- The guru investor : how to beat the market using history’s best investment strategies / John P. Reese, Jack M. Forehand. p. cm. Includes bibliographical references and index.

eISBN : 978-0-470-44677-5

1. Investments. 2. Investment analysis—Data processing. 3. Capitalists and financiers—United States—Biography. 4. Quantitative analysts—United States—Biography. I. Forehand, Jack M. II. Title. III. Title: Best investment strategies. HG4521.R368 2009 332.6—dc22 2008040631

To Michael, Daniel, and Heather

—John P. Reese

To Mom, Dad, and Aimee

—Jack M. Forehand

Acknowledgments

We would like to thank our partner, Justin Carbonneau, whose tremendous contributions to this book began the day we decided to write it and didn’t end until the final draft was submitted. A huge thank you also goes to Chris Ciarmiello, whose writing, editing, and insightful advice made this book possible.We also want to recognize the efforts of Keith Guerraz, who was always willing to take the time to discuss and review our ideas for the book, and Philip Moldavski for his design work and consultation. In addition, we would like to thank the founding members of Validea.com, Keith Ferry, Todd Glassman, Dean Coca, and Norman Eng, for all their work in the creation of the guru-based investing system utilized in this book.

We certainly wish to acknowledge the gurus who are the basis for this book. These legendary investors and researchers are not only unique in their extraordinary investing accomplishments, but also in their willingness to share their approaches with others. Although this book can never totally capture the true genius of these men, we hope that our outline of their quantitative principles can be a benefit to investors just like their original published writings were.

We would also like to thank David Pugh, Senior Editor at John Wiley & Sons, for his encouragement and support throughout this process, and Kelly O’Connor, our go-to Development Editor whose wisdom, insights, and patience were also invaluable.

Last, but certainly not least, we would like to thank our families, Ellen, Michael, Daniel, and Heather Reese and Jack, Sandy, and Aimee Forehand, whose support and patience throughout the many years of work that went into developing this investing system were essential to its success.

Introduction

Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.

—AUTHOR DOUGLAS ADAMS, LAST CHANCE TO SEE

The list of books written about investing is long, perhaps too long, but I’m pretty certain none of the investment books you’ve read has begun with the author admitting what I’m about to admit to you right now: When it comes to the stock market, my instincts are not good. In fact, they’re pretty bad.You could even say I’ve made just about every mistake possible, and have made them with my own money.

This admission, of course, leads to an obvious question:Why would someone who admittedly has poor investing instincts be wasting your time with a book on investing? (And, just as importantly, how would he get a book deal?) The answer is complicated and requires a deeper look at the realities of investing, and at a series of cold, hard facts that your broker, financial advisor, or mutual fund manager probably don’t want you to know. It was the understanding of these facts that led me, bad instincts and all, to find a way to consistently beat the market—and beat it by a wide margin.

We’ll get to those facts, and how you too can take advantage of them, soon enough. But to fully appreciate them, I need to go back about a decade-and-a-half and explain to you how my investing journey began. Back then, I was a successful computer engineer and had been fortunate enough to build up my own computer networking company, which I sold to a much bigger firm for a good deal of money. It was very rewarding to see all the hard work that I had put into building my company pay off. What I didn’t know at the time, however, was that I had absolutely no idea what to do with the money once I got it. There was of course one obvious choice—spend it—but I wanted to use the money I had made to secure my family’s financial future.

This was the 1990s. Grunge music was king, the Beanie Baby craze was sweeping the nation, and the only type of investment that seemed worthwhile was stocks. The markets were performing well and I was constantly hearing from friends about all the money they were making—and how easy it was. So I began to invest the chunk of money I got when I sold my business. To do that, I used a variety of methods. I picked some stocks on my own, tried following the advice of several newsletters and tips from popular financial media sources, and worked with several brokers (these guys come out of the woodwork when you come into a large amount of money) to try to produce a reasonable return on my investment.

How did this whole process work for me, a successful businessman with degrees from MIT and Harvard Business School? In short, not well. It was a humbling experience, to say the least. If it had worked, I would be writing a book about how you can rely on your own instincts or broker to invest your money, but that turns out almost always not to be true.

Eventually, I became frustrated with my poor returns and the fact that I seemed to consistently lag the market averages. I knew there had to be a better way, but I didn’t know how to find it. Given my background in engineering and computers (while at MIT I was a member of the Artificial Intelligence Laboratory), I approached the problem analytically. I began researching the issue, and one thing I quickly learned was that my investment experience was far from unique—even among the pros. In fact, most (actually most is being nice; the actual figure, depending on the study you look at, is around 75 to 80 percent) active money managers underperform the market over the long term.

Think about that. Of all the “experts” who appear on CNBC and other programs, offer advice online, or write recommendations in the major financial newspapers and magazines, only a very small percentage actually deliver any value to their viewers and readers. Only a few help you achieve better returns than you’d get if you just bought and held an index fund like the S&P 500, which simply tracks the broader market’s movements.

So it seems professional investors have something in common with television weathermen:They are in one of the few professions in which you can make a good deal of money while still being wrong most of the time.

I make this comparison not because I want to start a quarrel with the meteorological community. Far from it. In fact, I have a good deal of respect for weathermen because they are put in the precarious position of having to predict something that is impossible to predict on a consistent basis.

But that, alas, is exactly the same position in which most professional investors find themselves—trying to make predictions on the short-term movements of the stock market. If you watch business television, you will see some of the smartest people in our country tell you where the market is going this year, and do it with the type of conviction that makes you want to believe them. The problem is that despite their intelligence and bravado, history suggests they are going to be wrong just as often as they are going to be right, if not more.

Okay, so most professional investors may not be as good as they would lead you to believe. But what about individual, nonprofessional investors? I hadn’t succeeded in picking stocks on my own. Maybe I was in the minority. Maybe making money in the market is less about having the research and analytical tools that professional investors have, and more about common sense. Would I be better off just listening to the investing advice of friends or neighbors? Could my butcher hold the secrets to my stock market success?

Well, there is not a ton of data available about how individual, nonprofessional investors perform relative to the market (the little guys are not required to report their results to regulatory agencies like the pros are), but what little there is doesn’t bode well. According to “Quantitative Analysis of Investor Behavior,” a study performed by the investment research firm Dalbar Inc. in July 2003, “Individuals have historically underperformed the markets, earning just 2.6 percent versus the S&P 500 gain of 12.2 percent between 1984 and the end of 2002.”The study explains that “research in the U.S. has shown that this dramatic underperformance comes as a direct result of client behavior, or more specifically, the attempt to avoid bad performance while seeking out better returns.”

The bottom line: It’s probably best to leave your relationship with your butcher strictly meat-based.

By this point in my research, I was quickly running out of places to look for investing help. I had been failed by my investment advisors and my own instincts, and now I was learning that the vast majority of amateurs and professionals didn’t have the answer as to how to beat the market. Still, I was convinced that there must be a way, that there had to be some strategy that I could use to succeed in the market over the long term. After all, the fact that my own data suggested that the majority of active managers underperform the market had a flipside to it—there had to be a group of investors that did beat the market. I wanted to know how they did it, and how I could do it. And that’s when Peter Lynch, the man considered by many to be the greatest mutual fund manager in history, walked into my life.

Alright, maybe it wasn’t as much Lynch walking into my life as it was me walking into a bookstore and picking up Lynch’s book, One up on Wall Street. For dramatic purposes, I prefer the former image. Whichever way you slice it, the event was a watershed moment in my investing career. Lynch had established one of the greatest track records ever at Fidelity Investments’ Magellan Fund (he averaged a 29 percent annual return during his 13-year tenure) and his book, written in a style that laypeople could understand, explained how he did it. And the best part was that most of the techniques he outlined were not all that complex. In fact, many can be performed by a computer using the fundamental information that companies are required to file with the Securities and Exchange Commission when they report their results at the end of each quarter.

Reading Lynch’s book was really the first step in my evolution from an investing pessimist, who had been burned by constant underperformance, to the market optimist I am today, who believes anyone who shows some discipline and follows some simple and sound techniques can beat the market over the long term..

Moreover, while Lynch’s book had given me just what I was looking for—a proven, implementable stock-picking strategy I could use to beat the market—it was also only the beginning of my search for stock market success. I began to wonder if there were others out there like Lynch, who had beaten the market and told how they did it.

What I quickly found was that Lynch was not, in fact, alone, and over the last 12 years I have identified many other individuals with outstanding long-term track records who have written books detailing the techniques they used to achieve those outstanding results. People like Martin Zweig, James P. O’Shaughnessy, David Dreman, Benjamin Graham, and Kenneth Fisher had also written about strategies that consistently beat the market over the long run. A little-known college accounting professor, Joseph Piotroski, had even written a research paper about a fairly simple quantitative strategy that would have trounced the market from the mid-1970s to the mid-1990s. And Warren Buffett’s daughter-in-law, who worked closely with Buffett for a period of time, had also written a book that provided wonderful insights into the stock selection techniques used by Buffett, who many consider to be the greatest investor of all time.

Reading these books was the easy part. The hard part was figuring out how to take an incredibly large volume of data and condense it into something that could be used to pick stocks. I hired a couple of researchers to help me and founded Validea.com (yes, this is a shameless plug). The goal of Validea.com was to take the strategies outlined in the published writings of the Wall Street legends mentioned above, break them down into simple steps, and make them easy to use for the individual investor.

The best way to do that, I found, was through my background in computers. Using the criteria that each of these investing greats had laid out in their writings, I was able to develop computer models that simulated their approach. In some cases, the gurus had referenced very specific criteria, making the process pretty straightforward. But I should be clear that in other cases, some of the gurus had left a bit of room for interpretation, so I did my best to interpret what they were saying.

After creating my models, I linked up with a financial data service, allowing me (and the users of my site) to filter thousands of stocks through my “Guru Strategies” and find out which stocks passed which guru’s approaches.

Being able to get a report card showing how a stock stacked up at any given time against some of the most successful investment strategies of all time was a powerful tool. But it was a tool that I didn’t yet know how best to use practically (i.e., to make money). Should I pick my favorite strategy and follow it, or should I use more than one of them at one time? Should I buy the top couple of stocks selected using the system or should I build a much larger portfolio? And perhaps the most difficult question of all, when do I know it is time to sell a stock? I was, in a sense, like someone who had just built a souped-up Porsche with a standard transmission, but didn’t yet know how to drive stick.

As time went on, however, I didn’t just learn how to drive my guru-based models; I learned how to use them to run laps around the market, developing a system that combines my individual guru strategies to minimize risk and maximize returns, while also letting me know when I should buy, hold, and sell individual holdings. Using this system, all 10 of the 10-stock model portfolios I track on my website based on the strategies in this book have beaten the S&P 500 since their respective inceptions, with nine more than doubling it, eight more than tripling it, and five more than quadrupling it (as of this writing).

In the coming chapters, I’ll teach you about each of the gurus that inspired me, laying out their investment philosophy and achievements, detailing step-by-step the secret formulas they used to beat the market, and explaining why these legendary investors considered certain factors to be so important when analyzing individual stocks.You’ll also get another benefit: access to www.guruinvestorbook.com, a website I’ve created specifically so that readers of this book can, free of charge, utilize some of my guru-based stock screening tools.

Just as important as giving you access to these individual guru-based models, I’ll also explain how you too can combine and implement these approaches to get the most out of your stock investments. I’ll share with you the system I’ve developed for building and managing portfolios, which includes my key rules for when to buy, when to hold, and when to sell.

Put another way, I’ll give you both the keys to the car (the free use of my guru-based models) and the training you need to drive it.

Before we get started, I do want to make a disclosure. Although I have spent a portion of this introduction talking about how research shows that professional money managers consistently underperform the market, I am, in fact, a member of this group. My firm,Validea Capital Management, manages money for high-net-worth individuals using the principles that I outline in the following pages. I wrote this book, however, because I believe all investors can learn from the thinking, the writing, and the experience of Wall Street’s greatest investors. The coming chapters will teach you the lessons of those greats, and give you all the tools you need to put those lessons to use.

And now, without further delay, let’s take to the road.

Authors’ Note:The Validea investing system detailed in the coming chapters is one that has evolved in several ways over the years. Both John Reese and Jack Forehand have played major roles in different parts of that evolution. To differentiate between their experiences, references to “I” generally refer to John, and his work in developing the initial idea for Validea and the quantitative, guru-based models that rest at its core. References to “we” generally refer to John and Jack Forehand, and the collective thoughts and experiences they have had in implementing and refining these strategies and developing the overall investment approach and model portfolio system that has evolved at Validea over many years.

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 you’ll 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 you’ll really be raking in the profits.

Yet throughout history, the vast majority of investors—both amateur and professional—have 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 market’s long-term benefits? And what can we learn from those rare few who have consistently generated outstanding returns over the long haul?

You’re about to find out.

Chapter 1

Learn from the Worst

From the errors of others, a wise man corrects his own.

—PUBLILIUS 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 don’t involve the kind of complex mathematics that only a rocket scientist could understand.And, to top it all off, between the access I’ll give you to my new website—www.guruinvestorbook.com—and the ease with which you can find stock information on the Internet these days, you won’t 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 isn’t going to be a pretty one. We’re going examine how and why investors before us have failed so that you’ll 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: It’s a pretty crowded place. To start with, there are the professionals—the 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 they’d incur if they tried to buy each holding individually. The problem is that most mutual fund managers fail to beat the returns you’d 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 “the market”).

In fact, in a 2004 address to the United States Senate Committee on Banking, Housing, and Urban Affairs, John Bogle—the renowned founder of the Vanguard Group, one of the world’s largest investment management companies—stated 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 managers’ 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, you’d end up with about $44,000 less than that (approximately $71,000).

Bogle’s not the only one whose research highlights the poor track record of fund managers. In his book What Works on Wall Street, James O’Shaughnessy, one of the gurus you’ll 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 O’Shaughnessy, “the best 10 years, ending December 31, 1994, saw only 26 percent of the traditionally managed active mutual funds beating the [S&P] index.” 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 didn’t exactly crush it. O’Shaughnessy 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. What’s more—and this is a key point—O’Shaughnessy noted that these statistics didn’t 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 investors—some professional and some amateur—who 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 don’t 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 “no evidence to suggest that investment newsletters as a group have any knowledge over and above the common level of predictability,” 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 investors’ 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 investors—professional and amateur—underperform 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 clients’ 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 first—and perhaps greatest—reason, we don’t have to look far: It is the fact that we are human. Our own humanity—the way we think, the way we perceive things and feel emotions—has become a major topic in the investing world in recent years. There are even branches of science—behavioral finance and neuroeconomics—that 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 you’ll 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 species’ 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, “Our incorrigible search for patterns leads us to assume that order exists where it often doesn’t. It’s 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.” But the truth, he says, is that it can’t—at least not in the day-to-day, short-term way that most investors think it can.

You don’t 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, analysts’ rating changes, a report about how retail sales were last month—all 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 market’s day-to-day machinations; the earnings reports, analysts’ 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 company’s new products, the decisions of institutions to buy and sell because they have hit an internal target or need to free up cash for redemptions—all 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 interpreted—sometimes inaccurately—as a sign of how the rest of companies in their industries will perform.

What’s more, when it comes to the monthly, quarterly, or annual economic and earnings reports like the ones I’ve mentioned, the market doesn’t 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 analysts’ expectations. Or conversely, it can announce earnings growth of 200 percent, but fall if analysts were expecting 225 percent growth.

Finally, let’s throw one more monkey wrench into the equation: the fact that good economic news doesn’t even always portend stock gains, just as bad economic news doesn’t 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 wait—aren’t we forgetting something? A certain group of people that the media refer to as “experts”? 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, they’re experts; don’t they have to be at least pretty good at predicting economic and stock market tends?

Unfortunately, research shows that they don’t. 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 “experts” 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 couldn’t make money by picking a top performing expert as measured over a short period of time and following him or her.

But you don’t have to trust my experience to find out that “experts” 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 predictions—over 82,000 in total. The study, Colvin noted, found that the best forecasters—even the “experts”—couldn’t 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. “Consider what this means,” Colvin wrote. “On all sorts of questions you care about—Where will the Dow be in two years? Will the federal deficit balloon as baby-boomers retire?—your judgment is as good as the experts’. Not almost as good. Every bit as good.”

There’s more. Colvin also noted that the study found that the experts’ “awfulness” 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 “but one consistent differentiator: fame. The more famous the experts, the worse they performed,” Colvin said.

So, if that’s the case, why do so-called “experts” 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 “is not just a big game of dice,” he wrote, “that things happen for good reasons and wise people can figure it all out.” 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 time—and the experts like to get that air time because it pays, Colvin noted. Tetlock himself described this relationship as a “symbiotic triangle,” explaining, “It is tempting to say they need each other too much to terminate a relationship merely because it is based on an illusion.”

The bottom line: Just because someone sits in front of a camera with a microphone and speaks confidently doesn’t 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, they’ll be wrong!

Market Timing: The Most Dangerous Game

With all of the research that shows humans—even experts—have pretty terrible predictive abilities when it comes to economic and stock market issues, you’d think that people would refrain from trying to predict the market’s short-term movements. They don’t. Every day, millions of investors try to discern where the market will head tomorrow, next week, or next month. And the way this manifests itself is the doomed practice of market timing.

Market timing occurs when people move in and out of the stock market with the intent of taking advantage of anticipated short-term price movements. Market timing can be as simple as you want it—maybe you’ve heard from a friend that the market is about to take off, so you invest in stocks—or as complex as you want it—perhaps you’ve developed an elaborate model that uses various economic indicators to predict which way the market will go in the next month. Whatever way you go about it, though, it’s not likely to end well, because the market is simply too complex and irrational in the short-term for anyone to correctly and reliably predict its movements.

Want proof that market timing doesn’t work? There’s plenty. Take, for example, the research performed by Dalbar, Inc. In its “2007 Quantitative Analysis of Investor Behavior,” the firm notes that the S&P has grown an average of 11.8 percent per year from 1987 through 2006, an impressive gain. During this period, however, the average equity investor averaged a return of just 4.3 percent. The reason? As markets rise, the data shows that investors “pour cash” into mutual funds, and when a decline starts, a “selling frenzy” begins. In other words, the research shows that investors tend to do the opposite of the old stock market adage, “Buy low, sell high.”

Dalbar isn’t the only firm that’s found that investors do a pretty awful job at trying to time the market’s short-term moves. A few years ago, the investment research company Morningstar began tracking mutual fund performance in a new way. Normally, mutual fund returns are reported as though an investor remained invested in the fund throughout the full reporting period. A fund’s three-year return, for example, is reported as the percentage increase or decrease an investor would have seen if he had been invested in the fund for the entire three previous years.

In a methodology paper (“Morningstar Investor Return”), Morningstar says it found that this “total return” percentage doesn’t accurately portray how well investors in a particular fund really fare. The reason: While the “total return” percentage measures how a fund does over a specific period, people often don’t stick with the fund for that entire period; instead, they jump in and out of it. And, according to Morningstar, the returns that the typical investor in a particular fund actually realizes (the “investor returns”) tend to be lower than the fund’s total return—implying that people pick the wrong times to jump in and out of the fund (or the market).

While investors themselves deserve some of the blame for this, mutual funds sometimes don’t help. In its investor returns methodology paper, Morningstar states that if firms encourage short-term trading and trendy funds, or if they advertise short-term returns and promote high-risk funds, they may not be looking out for their investors’ long-term interests. Their investors’ actual returns will likely be lower than the fund’s total return. (The fees mutual funds charge also don’t help, something Bogle stresses; those costs make it so that the fund manager has to beat the market just for his client to net market-matching returns.)

Need for an Emotional Rescue

The research that Zweig, Tetlock, Dalbar, and Morningstar have conducted all bears out the notion that we as humans are not good market-timers. This then brings us to our next important question: If we don’t succeed at it, why do we keep trying to time the market? We know that, given the short-term unpredictability of the stock market, it’s pretty much inevitable that we’ll fail if we try to time our participation in stocks, yet we always think we can do learn to do it. “Man, it was so obvious what I should have done last time; now that I’ve learned my lesson, I’ll be able to time things right next time,” we tell ourselves—even though it wasn’t obvious what we should have done last time, and it won’t be obvious when it comes to future market-timing decisions (behavioral finance terms this hindsight bias). And time and time again, when one of our stocks starts declining, we jump off of it and onto the latest “hot” stock, only to watch our old stock rise and our new, flashy stock fall.

Again, one of the main reasons for these habits starts inside ourselves: our emotions. As human beings, we are emotional creatures, and in many cases throughout life, that’s a good thing. When we are in danger, for example, we feel fear, and our brains interpret this feeling as a signal to flee for safety’s sake. In the stock market, however, emotion is one of our greatest enemies. Our instincts tell us to flee when we see danger, and danger is what we see when our investments start losing value—danger of losing our money, danger of not being able to afford to send our children to college, danger of not being able to afford to retire when we want to retire. And, just as with other dangers we perceive, our first reaction is to flee—or, in this case, sell.

Now, when it comes to being attacked by an animal or a mugger who is trying to hurt you, fleeing from harm is a good instinct to have. But in the stock market, fleeing can, in fact, lead to great harm. That’s because the danger we often sense in the stock market is false danger. Perfectly good stocks fluctuate over the short-term (there’s typically a 40 to 50 percent difference between a stock’s high and the low for the previous 12 months), and sometimes it’s due to factors that have nothing to do with their real value. (Think of the bellwether example I referenced earlier, in which one company is negatively impacted when another company in its industry posts a bad earnings report.) And as we’ve seen, because of the array of factors that go into its day-to-day movements, we just can’t predict what the market’s or an individual stock’s short-term fluctuations will be with any degree of accuracy.

Nevertheless, we still act on them, and a big reason is emotion. Peter Lynch once explained this phenomenon in an interview with PBS. “As the market starts going down, you say, ‘Oh, it’ll be fine,’” Lynch said. Then “it starts going down [more] and people get laid off, a friend of yours loses their job or a company has 10,000 employees and they lay off two hundred. The other 9,800 people start to worry, or somebody says their house price just went down. These are little thoughts that start to creep to the front of your brain.” People even start thinking about past financial disasters, Lynch said, bringing thoughts of such calamities as the Great Depression to the front of their minds, even if the current situation is nowhere near as bad.

In today’s world of nonstop media hype and sensational headlines, it’s very difficult to keep those thoughts from entering our minds. And the more they do, the more likely we are to make bad investment decisions. Dalbar’s study of investor behavior shows that the percentage of investors who correctly predict the direction of the market is much lower during down markets than it is during rising markets. During falling markets, when people have already been losing money, the fear of losing even more can cause many to cash out, even if the downturn is just one of Wall Street’s periodic short-term hiccups. (Behavioral finance refers to this as myopic loss aversion.) Often, investors are then slow to jump back in when the market turns around, so they miss out on the bounce-back gains.

And it’s important to remember that the market does bounce back, even when your fears and worries are telling you that “this time is different, this time the market won’t recover.” In fact, over time, the market climbs higher than any other investment vehicle. According to research performed by Roger Ibbotson, Rex Sinquefield, and Ibbotson Associates, in the 20-year period that ended at the end of 2006, the S&P averaged an 11.8 percent annual compound return, beating long-term corporate bonds (8.6 percent), long-term government bonds (8.6 percent), and Treasury bills (4.5 percent). When you stretch the time frame out to the previous 30, 40, or 50 years, the spreads between stocks and other investments are similar, and in some cases greater.

This is the great paradox of the stock market: While unpredictable in the short term, its performance becomes quite predictable—and predictably good—when looked at over the long term.

If that seems illogical, imagine, for a moment, that the market is a helium-filled balloon that you set loose outside on a gusty day. From moment to moment, it’s hard to tell where the balloon is headed. It gets pushed around from side to side by the wind—that is, earnings reports, economic data, analysts’ ratings, pundits’ predictions—and sometimes even gets knocked downward. From moment to moment, you’d be foolish to bet someone exactly which way the balloon will go, since there’s no way predict which way the wind will blow. But it’s almost a sure bet that, over a longer period of time, it will end up a lot higher than it started.

The market, just like the balloon, will almost surely rise over time—but it’s not going to rise in a straight line. It will stop and start, fall back at times, and surge forward at other times. That can make for a lot of anxious moments in the short term as the winds of Wall Street blow every which way.

And you should be aware just how blustery it can get. In his book Stocks for the Long Run, investment author, noted professor, and commentator Jeremy Siegel states that the market has averaged an annual compound return of 11.2 percent in the post-World War II period (1946-2006). But Siegel also examines those returns for their standard deviation, a statistical measure essentially designed to show the range of returns in a “normal” year during a particular period. If a stock has returned an average of 10 percent annually over a particular period with a standard deviation of 5 percent, for example, that means that about two-thirds of the time its returns have been between 5 percent (the average return minus the standard deviation) and 15 percent (the average plus the standard deviation).

According to Siegel, the annual standard deviation of the market has been about 17 percent in the post-World War II period, which means that about two-thirds of the time during the 60-year time frame, returns were between -5.8 percent and 28.2 percent—a huge potential year-to-year difference. (And that’s the range returns fell into about two-thirds of the time; in other years they were even further from the average.)

The fact that such major year-to-year fluctuations can—and many times do—occur in the stock market makes for a lot of anxious times in the short term, but that anxiety is simply the price you pay for the excellent long-term returns that the stock market gives you. If stocks earned 10 or 12 percent per year and were a smooth ride, why would anyone ever invest in anything else? This concept is known as the equity risk premium.

The bottom line: There are no free lunches in the stock market. If you want the long-term benefits of stocks, you’ve got to pay the price of short-term discomfort.

The Best Way Not to Miss the Boat: Don’t Get Off in the First Place

Many investors, however, either don’t expect or just plain can’t tolerate the short-term discomfort of the stock market, and they’ll do just about anything to try to avoid it. Some, on the one hand, will ignore stocks altogether, not wanting to deal with the short-term risk involved. Instead, they’ll put their money into bonds, Treasury bills, or even just keep it in a CD or savings account. After all, while those options don’t have nearly the upside of stocks, you can’t lose money with them. Or can you?

While stocks are generally thought of as riskier investments than bonds or T-bills, David Dreman (the great “contrarian” investor you’ll soon read about in Chapter 5) found flaws in that logic. The reason: inflation. If, for example, all of your money is in a savings account that is earning 2 percent interest per year but inflation is at 3 percent per year, the relative worth of your money isn’t increasing by 2 percent annually; it’s actually declining.

Since World War II, the threat of inflation to fixed-income investments has been very real. In his book Contrarian Investment Strategies, Dreman notes that when adjusted for inflation, stocks returned an average of 7.5 percent from 1946 to 1996; when also adjusted for inflation, however, bonds had an average annual return of just 0.86 percent, gold actually declined by 0.13 percent per year, and T-bills returned just 0.42 percent annually. Looked at another way, the average annual T-bill return before inflation was 4.8 percent during that period, about two-and-a-half times less than what stocks returned before inflation—not great, but not bad considering that T-bills are essentially risk-free; after inflation is factored in, however, stocks returned about 18 times as much as T-bills per year. Based on information like that, Dreman concluded that inflation was a far greater risk to long-term investors than short-term stock market volatility.

Now, while some will try to avoid short-term market discomfort by avoiding stocks altogether, others, of course, believe they can have their cake and eat it too—that they can skirt the stock market’s short-term anxiety and still reap the long-term rewards. But much more often than not, they will end up with all the short-term discomfort and none of the long-term gains.

Part of the reason is that, as we discussed earlier, most investors who try to time the market end up buying high and selling low. But there’s also another important reason that is critical to understand—the nature of when and how the stock market makes its gains. In a 2007 article for CNNMoney, Jeanne Sahadi touched on this concept. Citing data from Ibbotson Associates, Sahadi said that if you had invested $100 in the S&P 500 in 1926, you would have had $307,700 in 2006—a pretty staggering gain. But if you had been out of the market for the best-performing 40 months of that lengthy 972-month period, you would have had just $1,823 in 2006. That means that 99 percent of the gains over that 81-year period came in just 4 percent of the months.

The principle holds over shorter periods, as well. If you invested $100 in 1987, you’d have had $931 by the end of 2006, Sahadi noted. But if you were out of the market for the 17 best trading months of that 240-month period, you’d have ended up with just $232. In this case, 84 percent of the gains came in 7 percent of the months.

The bottom line: While the market rises substantially over time, much of its increases come on a relatively small portion of trading days—and no one knows for sure when they’re going to come. If you jump in and out of the market based on short-term fluctuations, you’re bound to miss some of those big days—and you can’t get them back.