A Surefire Way to Lose Money

At this point, you might wonder if Im exaggerating the problems of decision-making and forecasting in the stock market. The answer, I think, can be found by considering the favorite investments of market professionals over time.

Consider a large intemational conference of institutional investors held at the New York Hilton in Febmary 1970. The 2,000 delegates were polled for the stock that would show outstanding appreciation that year. The favorite was National Student Marketing-the highest-octane performer of the day. From a price of 120 in Febmary, it dropped 95 per-

Investors attempt to simplify and rationalize complexity that seems at times impenetrable. Often, they notice facts that are simply coincidental and think they have found correlations. If they buy the stock in the "correlation" and it goes up, they will invest in it through many a loss. The market thus provides an excellent field for illusory correlation. The head and shoulders formation on a chart cuts through thousands of disparate facts that the chartist believes no one can analyze, or buying growth stocks simplifies an otherwise bewildering range of investment altematives. Such methods, which seemed to work in the past, are pervasive on Wall Street. The problem is that some of the correlations are illusory and others are chance. Trasting in them begets error. A chartist may have summed it up most appropriately: "If I hadnt made money some of the time, I would have acquired market wisdom quicker."

Which brings us to the next mle, one that may at first glance appear simple, but is both important and will prove harder to follow than you may think.

RULE 3

Dont make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.

Now, there are people with outstanding gifts for abstract reasoning, who can cut through enormously complex situations. Every field will have its Warren Buffetts or John Templetons. But these people are rare. It seems, then, that the information-processing capabilities and the standards of abstract reasoning required by current investment methods are too complicated for the majority of us, professional or amateur.

* Several studies used different averages or time periods.

11 was one of these experts for six years. Over this period, using the contrarian strategies we will look at, my portfolios outperformed the market in five of the six years I participated from 1987 to 1992, with a combined gain of 156% versus 120% for the market.

cent by July. At the same conference in 1972, the airlines were expected to perform best for the balance of the year. Then within 1 % of their highs, the carriers stocks fell 50% that year in the face of a sha ly rising market. The conference the following year voted them a group to avoid.

Are these simply chance results? In an earlier book, The New Contrarian Investment Strategy (1982), I included 52 surveys ofhow the favorite stocks of large numbers of professional investors had subsequently fared over the 51 -year period between 1929 and 1980. The number of professionals participating ranged from 25 to several thousand. The median was well over a hundred. Wherever possible, the professional choices were measured against the S&P 500 for the next 12 months.*

Eighteen of the studies measured the performance of five or more stocks the experts picked as their favorites. By diversifying into a number of stocks instead of one or two, the element of chance is reduced. Yet, the eighteen portfolios so chosen unde erformed the market on sixteen occasions! This meant, in effect, that, when you received professional advice about stocks, it would be bad advice almost 90% of the time.

Throwing darts at the stock pages, or flipping a coin, would give you a 50-50 chance of beating the market.

The other 34 samples did little better. Overall, the favorite stocks and industries of large groups of money managers and analysts did worse than the market on 40 of 52 occasions, or 77% of the time.

But these surveys, although extending over fifty years, end in 1980. Has expert stock-picking improved since then? More recently, the Wall Street Journal conducted a poll on whether the choices of four well-known professionals could outperform the market in each year between 1986 and 1993. At the end of the year, four pros gave their five favorite picks for the next year to John Dorfman, the editor of the financial section, who reviewed them 12 months later, eliminating the two lowest performers and adding two fresh experts. In 16 of 32 cases, the portfolios unde erformed the market. Somewhat better than the past, but no better than the toss of a coin.*-

Total number of surveys 60

Percent of professional surveys underperforming market

Note: Dividends excluded in all comparisons.

Source: As updated from The New Contrarian Mvestment Strategy

Table 4-1 gives the results of all such surveys that I found through 1993. As the table shows, only 25% of the surveys of the experts "best" stocks outperform the market.

The findings startled me. While I knew that experts make mistakes, I didnt know the magnitude of the errors were as striking or as consistent as the results make evident.

In the past fifteen years, the performance of professional investors has been more carefully scrutinized than ever before. As we saw in chapters 1 and 2, money managers as a group have not outperformed the market. In fact, as the figures show, only about 10% have beaten the averages over this period. The studies through the years clearly demonstrate that professional investors in the large majority of cases were tugged toward the popular stocks of the day, usually near their peaks, and like most investors, steered away from unpopular, unde riced issues, as the subsequent years market action indicated. Also interesting is that although there were dozens of industries to choose from, one industry- technology-was favored so often over the years. And so unsuccessfully! Expert advice, in these surveys at least, clearly led investors to ove riced issues and away from the better values.

Table 4-1

Expert Forcasts of Favorite Stocks and Industries 1929-1993