Why do you suppose the brokers on the floor of
the Stock Exchange always cheer at the sound of the closing bell - no matter
what the market did that day? Because whenever you trade, they make money -
whether you did or not. By speculating instead of investing, you lower your own
odds of building wealth and raise someone else's.
According to Benjamin Graham “An investment
operation is one which, upon thorough analysis, promises safety of principal
and an adequate return.” Note that investing, according to Graham, consists
equally of three elements:
1. You must thoroughly analyze a
company, and the soundness of its underlying businesses, before you buy stock;
2. You must deliberately protect
yourself against serious losses;
3. You must aspire to “adequate”, not
extraordinary, performance.
An investor calculates what a stock worth,
based on the value of its businesses on the contrary a speculator gambles that
a stock will go up in price because somebody else will pay even more for it.
Like casino gambling or betting on the horses, speculating in the market can be
exciting or even rewarding (if you happen to get lucky). But it's the worst
imaginable way to build your wealth.
On the other hand, investing is a unique kind
of casino - one where you cannot lose in the end, so long as you play only by
the rules that put the odds squarely in your favor. People who invest make
money for themselves; people who speculate make money for their brokers. And
that, in turn, is why Wall Street perennially downplays the durable virtues of
investing and hypes the gaudy appeal of speculation.
While investing in share market, throughout the
past decade or so, one speculative formula after another was promoted,
popularized, and then thrown aside. All of them shared a few traits - This is
quick! This is easy! And it won't hurt a bit!
Here are a few of the trendy formulas that fell
flat.
Cash in on the calendar
The "January effect”, the tendency of
small stocks to produce big gains around the turn of the year was widely
promoted in professional articles and popular books published. These studies
showed that if you piled into small stocks in the second half of December and
held them into January, you would beat the market by 5 to 10 percentage points.
That amazed many experts.
What caused the January jolt? First of all,
many investors sell their inferior stocks late in the year to lock in losses
that can reduce their tax liability. Second, professional money managers grow
more cautious as the year draws to a close, seeking to preserve their
outperformance (or minimize their underperformance). That makes them reluctant
to buy a falling stock. And if an underperforming stock is also small and
obscure, a money manager will be even less eager to show it in his year-end
list of holdings. All these factors turn small stocks into momentary bargains;
when the tax-driven selling ceases in January they typically bounce back,
producing a robust and rapid gain.
The January effect has not withered away, but
it has weakened. According to finance Professor William Schwert of the
University of Rochester, if you had bought small stocks in late December and
sold them in early January, you would have beaten the market by 8.5 percentage
points from 1962 through 1979, by 4.4 points from 1980 through 1089, and by 5.8
points from 1990 through 2001.
As more people learned about the January
effect, more traders bought small stocks in December, making them less of a
bargain and thus reducing their returns. Also, the January effect is biggest
among the smallest stocks but the total cost of buying and selling such tiny
stocks can run up to 8% of your investment. Sadly, by the time you're done
paying your broker, all your gains on the January effect will melt away.
Just do ‘what works’
In 1996, an obscure money manager named James
O'Shaughnessy published a book called What Works on Wall Street. In it, he
argued that “investors can do much better than the market”. O'Shaughnessy made
a stunning claim: From 1954 through 1994, you could have turned $10,000 into
$8,074,504, beating the market by more than 10 fold-a-towering 18.2% average
annual return. How? By buying a basket of 50 stocks with the highest one-year
returns, five straight years of rising earnings, and share prices less than 1.6
times their corporate revenues. As if he were the Edison of Wall Street,
O'Shaughnessy obtained U.S. Patent No. 5,978,778 for his “automated strategies”
and launched a group of four mutual funds based on his findings. By late 1999
the funds had sucked in more than $175 million from the public - and, in his
annual letter to shareholders, O'Shaughnessy stated grandly: "As always, I
hope that together, we can reach our long-term goals by staying the course and
sticking with our time-tested investment strategies."
But “What works on Wall Street” stopped working
right after O'Shaughnessy publicized. Two of his funds stank so badly that they
shut down in early 2000, and the overall stock market (as measured by the
S&P 500 index) walloped every O'Shaughnessy fund almost nonstop for nearly
four years running.
In June 2000, O'Shaughnessy moved closer to his
own “Long term goals” by turning the funds over to a new manager, leaving his
customers to fend for themselves with those “time-tested investment
strategies”. O'Shaughnessy's shareholders might have been less upset if he had
given his book a more precise title - for instance, What Used to Work on Wall
Street…… Until I Wrote This Book.
Follow ‘The Foolish Four’
In the mid - 1990s, the Motley Fool website
(and several books) hyped the daylights out of a technique called “The Foolish
Four”. According to the Motley Fool, you would have “trashed the market
averages over the last 25 years” and could “crush your mutual funds” by
spending “only 15 minutes a year” on planning your investments. Best of all,
this technique had "minimal risk-". All you needed to do was this:
1. Take the five stocks in the Dow
Jones Industrial Average with the lowest stock prices and highest dividend
yields.
2. Discard the one with the Iowest
price.
3. Put 40% your money in the stock with
the second-Iowest price.
4. Put 20% in each of the three
remaining stocks.
5. One year later sort the Dow the same
way and reset the portfolio according to steps 1 through 4.
6. Repeat until wealthy.
Over a 25-year period, the Motley Fool claimed,
this technique would have beaten the market by a remarkable 10.1 percentage
points annually. Over the next two decades, they suggested, $20 000 invested in
The Foolish Four should flower into $1,791,000. (And, they claimed, you could
do still better by picking the five Dow stocks with the highest ratio of
dividend yield to the square root of stock price, dropping the one that scored
the highest, and buying the next tour.)
Sure enough, instead of crushing the market,
The Foolish Four crushed the thousands of people who were fooled into believing
that it was a form of investing. In 2000 alone, the Four Foolish stocks
Catarpillar, Eastman Kodak, SBC, and General Motors - lost 14% while the Dow
dropped by just 4.7%.
As these examples show, there's only one thing
that never suffers a bear market on Wall Street: stupid Ideas. All mechanical
formulas for earning higher stock performance are “a kind of self-destructive
process - akin to the law of diminishing returns”. There are two reasons the
returns fade away. If the formula was just based on random statistical nukes
(like The Foolish Four), the mere passage of time will expose that it made no
sense in the first place. On the other hand, if the formula actually did work
in the past (like the January effect), then by publicizing it, market pundits
always erode - and usually eliminate - its ability to do so in the future.
All this reinforces Graham's warning that you
must treat speculation as veteran gamblers treat their trips to the casino:
· You must never delude yourself into
thinking that you're investing when you're speculating.
· Speculating becomes mortally
dangerous the moment you begin to take it seriously.
· You must put strict limits on the
amount you are willing to wager.
Just as sensible gamblers take, say, $100 down
to the casino floor and leave the rest of their money locked in the safe in
their hotel room, the intelligent investor designates a tiny portion of his
total portfolio as a “mad money” account. For most of us, 10% our overall
wealth is the maximum permissible amount to put at speculative risk.
Never mingle the money in your speculative
account with what's in your investment accounts; never allow your speculative
thinking to spill over into your investing activities; and never put more than
10% your assets into your mad money account, no matter what happens.
For better or worse, the gambling instinct is
part of human nature. So it's futile for most people even to try suppressing
it. But you must continue and restrain it. That’s the single best way to make
sure you will never fool yourself into confusing speculation with investment.
Extracts from: The Intelligent
Investor by Benjamin Graham
