Tina,
Tia Laverne Roberts,
five-year-old
stock genius
In a recent university experiment, three people were given a chance to show their stock picking expertise. They were:
A professional stock analyst
An astrologer
A five-year-old girl (right)
The experiment, devised by Richard Wiseman of the University of Hertfordshire in England, set up three imaginary portfolios, each with stakes of £5,000. The participants chose their stocks, a year went by, and the picks were compared.
The professional stock analyst used all his expertise and computer power to make his choices. The man on the street would choose this person if he wanted his money to grow.
The astrologer used the position of the planets to guide her choices. Common sense says this shouldn't work very well, compared to a roomful of computers.
The five-year-old girl just made random picks. She could be expected to perform about as well as the average, untutored investor relying on instinct.
The results?
The professional analyst's picks went down 46.2%.
The astrologer's portfolio went down 6.2%.
The five-year-old girl came out ahead, with a growth of 5.8%.
How is this possible? Isn't stock picking a science? Can't professional portfolio managers perform better than ordinary, uneducated people? Is our trust in stockbrokers misplaced?
Well, contrary to what you may have been told, fair, open stock markets are not predictable – not by anyone. Not in principle, not in fact.
If this were not true, if stock markets could be predicted, those markets would be neither fair nor open. In fact, the unpredictability of stock markets is proof of their overall fairness.
Hold on a minute. Did you hear me right? Yes, I'll say it again, for emphasis:
The unpredictability of stock markets is proof of their overall fairness.
Why is this true? Why are markets unpredictable by definition? Why can't there be a consistent "winning system," a "sure-fire stock picking strategy," as is so often claimed in articles and books?
Well, there are many reasons. Here are two:
If someone came up with a stock-picking strategy that worked for a time, someone else would surely notice the strategy. That person wouldn't be able to resist telling his relatives, then the stocks targeted by the strategy would go up in price (because of increased demand), thus wiping out the strategy's advantage.
The market is not a bunch of stocks sitting in a warehouse. It is a living organism – people, companies, all competing with each other to maximize their gain. These people are not acting in any predictable way, because predictable people, predictable actions, invariably result in loss. This is true because someone, somewhere inevitably anticipates, and acts on, any predictable behavior. Just like in nature.
There is only one method to gain a real advantage in the stock market, and that method is illegal: insider information. Example? At the same time top Enron executives were telling the public the company was doing fine, they were liquidating their own portfolios. That is how insider trading works – the trader knows something the general public doesn't. And that is why it is illegal.
Here is a very important secret of the stockbroker's trade, a secret stockbrokers pray you don't find out – there is no legal stock picking strategy that can outperform the average, long-term market. This is true logically, scientifically, and it is proven by history.
Why don't the professionals want you to find this out? Because their existence depends on your ignorance – if you found out this dirty secret, you would fire your broker, pick a broad, varied portfolio of stocks, and sit on them. This strategy is called "buy and hold," and it is the approach recommended by most market commentators who are willing to tell the truth.
In many studies performed over decades, the "buy and hold" strategy, as boring as it sounds, is proven to outperform all other (legal) strategies. And there is no reason a "buy and hold" portfolio should perform better than a portfolio overseen by a professional manager, except for two crucial facts:
The expense of brokerage fees.
The risk that the manager will gamble with your money by putting too much of it into too small a market segment, and lose that gamble.
Given that regularly buying and selling stocks is a bad strategy, you may wonder how people make any money in the stock market at all. Well, the reason is simple – the average market increases in value over time. This means if you bought a wide, diverse portfolio and waited twenty years, chances are your portfolio would have increased about as much as a typical market indicator like the Dow-Jones average (a portfolio of typical stocks used to measure market performance).
Which leads to this description of the two primary kinds of investment (and investor):
"Buy and hold" portfolio:
Steady, predictable performance.
Maximum gain in the long term.
Managed portfolio:
Occasionally very exciting.
Wild swings in value compared to the average market.
Added cost of brokerage fees.
Less long-term gain than buy and hold.
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