Wednesday, November 21, 2007

What a millionaire investor knows about investing that you don’t

The majority of academic research finds that the price of a stock is difficult to predict. However, as a group—the market—stocks have gone up about 10%-12% a year over the long term (12+ years). No one can predict stock levels because there are too many unknowns and too many people chasing the solutions to those unknowns. Most investors have about the same information available at any time. The market of thousands of stocks traded by millions of people is a random system. There will be some prices higher than yesterday and some lower than yesterday. Some people see patterns in the changes in prices but they have not become rich with the information. Most of what Wall Street does—analysis of the company fundamentals and timing the ups and downs of their prices—does not improve your earnings over time. Usually the opposite is true. A Random Walk by Burton G. Malkiel, p. 110-185.

Flipping a coin gives anyone a 50% chance of being right. Some people are better at finding the prices that move up. However, they can’t do it all the time. Thus they describe their talent in gambling terms: “I had a hot hand” or “all my calls went the right way.” Some have become rich from their choices. Investors give money to these people in the hope that they can get rich on their coattails. However, by the time the crowd overwhelms the lucky person, luck has moved to another person. The only people who consistently make money and get rich are the people who supply the means of playing this game. Even though shareholders in the five largest Wall Street firms have lost $74 billion of their equity in 2007, a record $38 billion in bonuses is expected to be doled out anyway. What a business!! They get paid for losing our money.

The investors who do well over time are those who buy companies or their stocks at bargain prices and hold them for a long time. Just like a sale on groceries, people like Warren Buffett defy the odds and buy basic product and service providers (like Benjamin Moore, GEICO, and Fruit of the Loom) when their prices are low. Over time, stocks pay dividends and the price goes up with the general economy. Everybody needs paint, insurance and underwear!

It seems simple. However, many investors come to believe they can beat the odds and outsmart everyone else. Some have. Any corporate officer has access to information about their firm and industry that gives them an edge. Thus people who invest in special situations have a much better chance than we do. It is still a chance. Remember Martha Stewart and her friend Sam Waksal, of ImClone infamy.

In the same vein, most wealthy people got that way by being involved in a business they control. There is nothing surprising about this. If you spend your time improving your profitable business, you will be successful. Eventually you will become wealthy. If you give up, you lose.

However, for most investors, investing in the market itself beats 70%-88% (BusinessWeek 11/03) of the people who are hired to do it. That includes pension funds and the largest mutual funds. Many studies have shown that the average investor earns a paltry 2.57% annually compared with inflation of 3.14% and 12.22% for the S & P 500 index. (1984-2002 Investors chase the past performance of those who claim they have beaten the market. This is the business of Wall Street—selling the dream of wealth. Whether a manager makes money for you or not, you are still charged for their salary and expenses. For more information, see our Guide:

When the market seems to be volatile—talk about recession and economy slowdown and big bubble collapse, we want to take our money and hide it in some safe harbor. We think we can wait out the chaos. We say we will get back in when the market direction is clearer. Advisors have traditionally moved money into utilities, staples and health care. A recent study by Vanguard’s IC&R shows these moves to defensive equity fail to save you. Advisors either mistake the exit signs or miss the rally marking the rebound. By selling, you lock in your loss. The portfolio with a proper mix of stocks and fixed income assets is the optimum holding strategy for chaos. You don’t sell your house when home prices rise and fall, do you?

When millionaires think of selling, they look at their funds and ask if the reason they bought them is still valid. Their long-term goals have not changed. There is nowhere else they can put their money to earn 12%. Even in retirement, moving in and out of market sectors for protection is a loser’s game. Millionaires keep their eye on the chart of stock market growth over the last 50 years. See the inset at