Just because you have money in the stock market, that doesn’t make you an investor as defined by Benjamin Graham. Graham made an important distinction between an investor and a speculator. In a prior post, we looked at the traits of an actual investor.
Basically, an investor looks for safety of principal and an adequate return. A speculator in everybody else.
Although speculating isn’t illegal, there are some dangers that you should be aware of. For instance:
- You may be speculating, but you think you’re actually investing.
- You may speculate seriously rather than as a hobby.
- You may speculate with more money than you can afford to lose.
Here are three of the speculative strategies that people have used in the past, along with their results. They’re here to serve as warnings of the potential pitfalls.
The January Effect
The refers to the tendency for small stocks to produce big gains at the beginning of the year. Studies in the 1980′s showed that if you bought stocks in the latter half of December and held them until January, you’d beat the market by 5 to 10%.
What caused the great return? Many investors sell their underperforming stocks late in the year to create a loss that can cut their tax bill. At the same time, money managers want to maintain their outperformance by refusing to buy a poor stock.
These factors make small stocks a temporary bargain. When the selling stops in January, they bounce back and produce a quick gain. From 1990 to 2001, if you followed the January Effect, you would’ve beaten the market by 5.8%.
However, as more people learned of and implemented this method, they became less of a bargain, which led to lower returns. Furthermore, since the cost of buying such stocks added up to about 8% of your investment, this cost immediately canceled out any gain you had to begin with.
Doing What Works
Money manager James O’Shaughnessy wrote a book called What Works on Wall Street. In it, he claimed that from 1954 to 1994, you could’ve grown $10,000 into more than $8,000,000 using the following investing method:
- Buy the 50 stocks with the highest one-year returns, five straight years of increased earnings, and a price less than 1.5 times its revenues.
Based on this strategy, he launched four mutual funds. Unfortunately, the strategy stopped working after he publicized it. Two of the funds were so bad that they shut down completely in 2000. On top of this, the S&P 500 outperformed all his funds almost nonstop for the four years between 1996 and 2000.
The Foolish Four
The Motley Fool claimed that you could beat the market by spending just 15 minutes a year planning your investments. Here were the steps they suggested:
- Take the five stocks in the DJIA with the lowest prices and highest dividend yields.
- Ignore the one with the lowest price.
- Put 40% of your money in the stock with the second-lowest price.
- Put 20% in the three remaining stocks.
- After one year, sort the DJIA the same way and repeat steps 1 through 4.
- Repeat till you’re rich.
Over a 25-year period, they claimed that this technique could beat the market by over 10% each year. How did it actually do? Poorly. In 2000, the Foolish Four lost 14%, while the DJIA lost just under 5%.
Moral of the Story
Speculating strategies for better performance nearly always lead to diminishing returns. If the formula is based on random luck, then time will show that it made no sense to begin with. And even if the formula actually worked in the past, publicizing the formula usually decreases its effectiveness in the future.
So if you do want to speculate, set aside a tiny portion of your money in a separate fund, and never mix your speculative and investment pursuits.
Do you speculate in the market? If so, how much?
Photo by Katrina.Tuliao