Rich's Unified Theory Of Investing

10/25/2010


Twenty-one years is a long time to think about anything, and I really should have a unified theory of something at this point in my life. So, in the interests of good headlines and better investing, I give you the most universally applicable truism I’ve picked up since joining Dow Theory Forecasts in 1989:

With investments and other things, you get paid for doing what others don’t want to do.

Much of the support for this theory is common sense. Your retirement will be more comfortable if you save instead of spend. Your investment returns are likely to be higher if you do your homework, fully research your options, and assume more risk. But some of the less obvious corollaries also hold practical implications for investors. Among the highlights:

Investors don’t like discipline. There is no shortage of systems that work on Wall Street; the one surefire way to lose is by jumping from one approach to another based on what’s working at the moment. Yet that is precisely what many investors do. A recent Morningstar study found that U.S. equity funds delivered an average annual return of 1.6% for the 10 years ended December 2009. But investors in those funds realized only a 0.2% annual return, reflecting ill-timed moves in and out.

Similarly, stock-picking investors have a hard time sticking with an approach temporarily out of favor. By using a blend of different approaches, our Quadrix® stock-rating system aims to deliver consistent outperformance. No system can work all the time, and we are always seeking to improve our approach. But the discipline imposed by Quadrix is one of the reasons Dow Theory Forecasts is among a select group of newsletters that outperformed the stock market for the five, 10, and 15 years ended June, according to the Hulbert Financial Digest.

Investors don’t like to be humble. When your system is working, attributing the strong returns to your innate stock-picking ability is fun. Crediting a bull market or a system that happens to be in favor is a killjoy. Yet confusing brains with a bull market is among the most dangerous mistakes you can make. In fact, many academics argue that investor overconfidence is the root cause of all speculative bubbles.

Investors don’t like to buy value stocks. A large body of research shows that stocks with low price/earnings, price/cash flow, and price/sales ratios tend to outperform. Meanwhile, shares of the most widely admired companies tend to underperform value stocks. Buying a value stock typically means buying into a poor story, whereas widely admired companies tend to have great stories. History suggests the average investor attaches too much importance to great stories — and too little to low valuations.

Investors don’t like to buy stocks trading near 52-week highs. Academics and our own research have shown that stocks trading near 52-week highs tend to outperform over the next year. Yet many investors, told to buy low and sell high, see stocks at 52-week highs as names to avoid. Because investors are so uncomfortable buying stocks near 52-week highs, they are reluctant to act on good news regarding these stocks — and such stocks therefore tend to be systematically undervalued.

Investors don’t like to cut their losers, or let their winners ride. Because investors feel the pain of losses more than the joy of gains, they tend to sell winners too early (to lock up gains) and hold on to losers too long (to avoid taking losses). Remember, the price you paid for a stock is nearly irrelevant except for taxes; what matters is whether a stock represents one of your best ideas going forward.


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