Everybody's Got a System

By Scott Lummer
Chief Investment Officer, mPower

This week's question is:

I read about stock picking strategies in various magazines and web sites. They seem to have a better track record than the S&P 500 index. My company allows us to buy individual stocks in our 401(k). Can you recommend one of these strategies?"

The first time I traveled to Las Vegas, I was sure I had figured out a way to win at blackjack. After all, I was a math major, and had read several books on concepts that would help me beat the house. And after the first night, I was doing really well. Celebrating my good fortune by buying everyone in the casino deli a 50-cent shrimp cocktail, I was drawn into a conversation with two grizzled Vegas veterans. When I told them the source of my newfound riches, one of them looked at the other and said, sarcastically, "Everybody's got a system." The other smiled knowingly.

That was over two decades ago, but I still remember the look in their eyes as they pondered yet another rookie with a "can't miss" strategy. Over time, I came to realize that "can't miss" strategies can and do miss -- how else could those fancy buildings in Vegas pay their monstrous electricity bills? (It's not with the profits from $3.99 buffet dinners!)

Well, I've now been following the capital markets long enough to qualify as a grizzled veteran. I hear about many investing strategies that seem logical on the surface. And although I'm tempted to believe them, because like all investors I would like to find the Holy Grail of philosophies, I usually end up with the same degree of cynicism that my two "friends" showed that night in Vegas. I'm not going to tell you that it's impossible for you to outperform the S&P 500, but you should be aware of the difficulties and risks you face.

First let me share with you three characteristics a system must have in order for you even to consider using it.

1. It has to have a historical track record -- and I'm not talking about just the last 3 weeks.
2. There has to be an explanation of why the results occurred. For example, a few years ago the popular press seemed enamored with the "Super Bowl effect". Some researcher found that if you invested in stocks in years when the NFC team won, and in money markets in years when the AFC team won, you would outperform the market. Of course there was no logical explanation of why this occurred. And it hasn't really occurred over the past two years (how have money market investments performed relative to stocks since January of 1998?). I know the Super Bowl strategy sounds silly, but the foundation of many other tactics is not much more solid.
3. Here's the tough criterion: there has to be a reason why the strategy will continue to work even after everyone knows about it. In the '70s and early '80s, the money managers who invested in stocks immediately after the Fed cut interest rates earned impressive returns. However, since the mid-'80s, when that strategy was discussed publicly, it hasn't done very well. Today, the stock price reacts in anticipation of the Fed announcement.

Very few strategies fulfill all three criteria.

You also should be aware of your competition. In attempting to find a system, you are battling tens of thousands of professional money managers. Your typical opponent has at least 15 years of investment experience, a CFA designation (which results from a rigorous training program), and a staff of well-trained analysts. Oh -- and he or she is pretty smart as well; aware not only of your system, but also of 200 variants of it that perform differently in various types of market conditions. It's kind of like going to an island to hunt for buried treasure with a faded map, and seeing thousands of Indiana Jones's with Global Positioning Devices on the boat with you.

There are a couple of other dangers to think about. Recognize that almost any investing strategy attempting to beat the market will involve some costs. The more active the strategy, the more expensive it will be. And the costs are usually reduced by volume -- what is cheap to someone managing a $5 billion portfolio will be costly if you are investing "only" a few hundred thousand dollars. Although a concept might work for professionals, the commissions can chew you up. Moreover, some investing tactics add significant risk to your portfolio. Investing heavily in a style (like small-cap growth companies) or a sector (financials) can reduce the diversification in your portfolio, and cause huge dips when the strategy doesn't work out.

One last thought, although maybe it's obvious. If you had a really great investing strategy -- one that you were sure would do well, would you publicize it in a magazine or on a web site? I wouldn't.

Now on the other hand, if you have an original idea -- tell me about it. If I like it, I'll even spring for a shrimp cocktail!

Scott L. Lummer, Ph.D., CFA, mPower's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He wants to know what's on your mind, so feel free to send him your questions about the stock market! He'll answer as many as he can in his weekly column.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Everybody's Got a System

By Scott Lummer
Chief Investment Officer, mPower

This week's question is:

I read about stock picking strategies in various magazines and web sites. They seem to have a better track record than the S&P 500 index. My company allows us to buy individual stocks in our 401(k). Can you recommend one of these strategies?"

The first time I traveled to Las Vegas, I was sure I had figured out a way to win at blackjack. After all, I was a math major, and had read several books on concepts that would help me beat the house. And after the first night, I was doing really well. Celebrating my good fortune by buying everyone in the casino deli a 50-cent shrimp cocktail, I was drawn into a conversation with two grizzled Vegas veterans. When I told them the source of my newfound riches, one of them looked at the other and said, sarcastically, "Everybody's got a system." The other smiled knowingly.

That was over two decades ago, but I still remember the look in their eyes as they pondered yet another rookie with a "can't miss" strategy. Over time, I came to realize that "can't miss" strategies can and do miss -- how else could those fancy buildings in Vegas pay their monstrous electricity bills? (It's not with the profits from $3.99 buffet dinners!)

Well, I've now been following the capital markets long enough to qualify as a grizzled veteran. I hear about many investing strategies that seem logical on the surface. And although I'm tempted to believe them, because like all investors I would like to find the Holy Grail of philosophies, I usually end up with the same degree of cynicism that my two "friends" showed that night in Vegas. I'm not going to tell you that it's impossible for you to outperform the S&P 500, but you should be aware of the difficulties and risks you face.

First let me share with you three characteristics a system must have in order for you even to consider using it.

1. It has to have a historical track record -- and I'm not talking about just the last 3 weeks.
2. There has to be an explanation of why the results occurred. For example, a few years ago the popular press seemed enamored with the "Super Bowl effect". Some researcher found that if you invested in stocks in years when the NFC team won, and in money markets in years when the AFC team won, you would outperform the market. Of course there was no logical explanation of why this occurred. And it hasn't really occurred over the past two years (how have money market investments performed relative to stocks since January of 1998?). I know the Super Bowl strategy sounds silly, but the foundation of many other tactics is not much more solid.
3. Here's the tough criterion: there has to be a reason why the strategy will continue to work even after everyone knows about it. In the '70s and early '80s, the money managers who invested in stocks immediately after the Fed cut interest rates earned impressive returns. However, since the mid-'80s, when that strategy was discussed publicly, it hasn't done very well. Today, the stock price reacts in anticipation of the Fed announcement.

Very few strategies fulfill all three criteria.

You also should be aware of your competition. In attempting to find a system, you are battling tens of thousands of professional money managers. Your typical opponent has at least 15 years of investment experience, a CFA designation (which results from a rigorous training program), and a staff of well-trained analysts. Oh -- and he or she is pretty smart as well; aware not only of your system, but also of 200 variants of it that perform differently in various types of market conditions. It's kind of like going to an island to hunt for buried treasure with a faded map, and seeing thousands of Indiana Jones's with Global Positioning Devices on the boat with you.

There are a couple of other dangers to think about. Recognize that almost any investing strategy attempting to beat the market will involve some costs. The more active the strategy, the more expensive it will be. And the costs are usually reduced by volume -- what is cheap to someone managing a $5 billion portfolio will be costly if you are investing "only" a few hundred thousand dollars. Although a concept might work for professionals, the commissions can chew you up. Moreover, some investing tactics add significant risk to your portfolio. Investing heavily in a style (like small-cap growth companies) or a sector (financials) can reduce the diversification in your portfolio, and cause huge dips when the strategy doesn't work out.

One last thought, although maybe it's obvious. If you had a really great investing strategy -- one that you were sure would do well, would you publicize it in a magazine or on a web site? I wouldn't.

Now on the other hand, if you have an original idea -- tell me about it. If I like it, I'll even spring for a shrimp cocktail!

Scott L. Lummer, Ph.D., CFA, mPower's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He wants to know what's on your mind, so feel free to send him your questions about the stock market! He'll answer as many as he can in his weekly column.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.