Every financial magazine, CNBC, newspapers, most mutual fund companies and the stock brokers have perpetuated the following acts as a way to benefit investors, to help them “beat the market”. The reality is that beating the market predictably and sustainably is, as shown by THIS interview with Prof. Eugene Fama, nearly statistically impossible, what’s more, just trying to do it is the common cause for investors’ anxiety, fear and stress.

So, why do they promote these ideas? Sadly but true: to benefit themselves. Think about it. The media lives through advertising dollars, so they produce stories that generate them viewers/readers; the more people that watch their shows or buy their magazines, the more money they can make because the cost of advertising with them increases with their number of viewers/readers. On the other hand, mutual fund companies and stock brokers perpetuate these myths because its their way to make money. You’ll see why in a moment.

Myth #1:  Stock Picking Works. What’s stock picking? Simple: Selecting stocks (or paying somebody to do it for you, say a mutual fund manager or a stockbroker) that are believed to do well in the future. The reality, as confirmed by Nobel Price winner Harry Markowitz and academics as Eugene Fama and Kenneth French, is that stock picking has to do more with luck than skill (for more about it, please watch the video from my previous post). Think about it this way, if mutual fund companies had a way to know which stocks to buy to predictably and consistently beat the market how many mutual funds do you think there will be? (Answer: One, at most per fund company!) Why then there are more than 19,000 mutual funds in the U.S. alone? (Answer: Because even Mutual Fund companies don’t know which stocks to buy to beat the market). By pure statistical luck about 10% of mutual funds will beat the market every year, the problem is, nobody knows in advance which funds will do it.  Interestingly enough, the managers of those “market beating funds” are the ones that appear in magazine covers, or are featured in CNBC or Bloomberg.  What’s more, those funds are the ones that usually under perform the indexes in the following years (more on this in Part 2).

Myth #2: Track Record Investing Works. What’s track record investing? Either you or your financial planner choose a mutual fund because “it has had great returns”. The truth is, again, confirmed by THESE academic studies, that past performance has nothing to do with future performance (note the relationship with Myth #1). Based on that, the SEC mandates that every advertisement that claims past performance about investments has to include the following disclaimer: “Past performance is no guarantee of future results”. So, why do people keep doing it? In my opinion, pure greed. Greed from the investor to achieve above market returns and greed from the financial planner/stock broker to make more commissions or to justify the fees they charge to the investor.

Myth #3: Market Timing Works.
What’s market timing? Either you or your stock broker/financial planner decide when to “get in” or “get out” of the market. The critical question here would be: Get in (or out) based on what? Known risks? (e.g. The economy is in bad shape) Bad news for you: It is already on the price of the stock. Unknown risks? Worse news for you: How do you know what you don’t know? Let’s take another look at probability. The great John Bogle (more on him on future posts) puts it this way in his latest book (Enough. True Measures of Money, Business, and Life. Wiley, 2008. Buy it HERE):
…If the odds or making the right decision are, because of costs, even less than 50-50, the odds of making two right decisions are even less than one to four. And the odds of making, say a dozen correct timing decisions -hardly excessive for a strategy that is based  on market timing- seem doomed to failure. Over, say, 20 years, betting at those odds would give you just one chance out of 4,096 to win (even when we ignore the negative impact of transaction costs)…

So, you have a 1 in 4,096 chance of making 12 correct market timing decisions in a row (without including transaction costs).  Would your savings be worth the shot?

How many of these myths do you believe in?  What’s more: Are your investments based on them? Would you like to invest in a different way? Contact me today to schedule a free of charge & objective evaluation on your portfolio.

Soon I will post Part 2 of this post, and believe me, you don’t want to miss it, I will talk about how these year’s winners become next year’s losers, transaction costs and their effect on returns, and much more.

The opinions expressed are those of Miguel Gomez-Garcia as of 4/3/09 and are subject to change based on market and other conditions, others may have different views on the topics presented. Past performance is not a guarantee of future results.