Throughout the past decade or so, one speculatives 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 scholarly articles and popular books published in the 1980s. 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 five to 10% points.
- Just do "what works." In 1996, an obscure money manager named James O'Shaughnessy, he argued that "investor can do much better than the market". By buying a basket of 50 stocks with the highest one-year returns, five straight years of rising earnings, and share prices less than 1.5 times their corporate revenues.
- Follow "The Foolish Four." In the mid-1990s, 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 technical had "minimal risk". Step 1, take the 5 stocks in the Dow Jones Average with the lowest stock prices and highest dividend yields. Step 2, discard the one with the lowest price, Step 3, put 40% of your money in the stock with second-lowest price. Step 4, put 20% in each of the three remaining stocks. One year later, sor the Dow the same way and reset the portfolio according to steps 1 thourgh 4. Repeat until wealthy.
Each of these so-called investing approaches fell prey to Graham's Law. 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 flukes (like the Foolish Four), the mere passage of time will expose that it mode no sense in the first place. On the other hand, if the formula actually did work in the pass (like the January effect), then by publicizing it, market pundits always erode and usually eliminate its ability to do in the future.
All this reinforces Graham's warning that you must treat speculation as veteran gamblers treat thier trips to the casino.
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 confine and restrain it. That's the single best way to make sure you will never fool yourself into confusing speculation wiht investment.
- The Intelligent Investor, Benjamin Graham
