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As investors, you have all been on the receiving end of sales pitches from brokers, friends and investment advisors about stocks that they claim will deliver spectacular returns. These stories not only sound persuasive and reasonable but are also backed up by evidence—anecdotal, in some cases, and statistical, in others—that the strategies work. When you try to implement them for your investments, though, you seldom can match their success on paper. All too often, you end up with buyer's remorse, poorer for the experience and promising yourselves that you will not fall for the allure of these stories again. All too often, you forget the lessons of past mistakes and are easy prey for the next big stock story.
While there are literally hundreds of schemes to beat the market in circulation, they are all variants of about a dozen basic themes that have been around for as long as there have been stocks to buy and sell. These broad themes are modified, given new names and marketed as new and different investment strategies by salespeople to a new generation of investors. There must be something in these stories that appeals to investor instincts and to human weaknesses— greed, fear and hubris, to name but three—to give them the staying power that they do. This book is an exploration of the appeal of these stories, why so many investors fall for them and fail with them, and what it may take to win with each of them.
As you will see, with each story, there is a kernel of truth that makes it believable and a base in financial theory that allows proponents to claim to have a solid rationale. Each chapter begins with an examination of the basis for each investment story and the theory that would justify its adoption. Why bother with the theory? Not only will it give you perspective on what makes each story work, but it will also allow you to identify potential weaknesses with the story.
If you have been on the receiving end of one of these investment stories, you probably have also been told of studies that back them up and you are offered evidence of their potency. It should come as no surprise, given the source, that most of these studies give you only a portion of the truth. As you will see in this book, every investment strategy ever devised has succeeded for some periods and with some stocks, but the complete picture requires an assessment of whether it works over long periods and with a wide cross section of stocks. That is why you will see a review of the existing empirical evidence, drawn from both believers and skeptics, on each strategy and some of the potential problems with each.
With every investment strategy, investors also grapple with the question of what adopting that strategy will mean in terms of investment choices. If you adopt a strategy of buying "low" PE stocks, you have to judge what represents a low PE ratio and what types of stocks have low PE ratios. If you believe that your best investments are in small companies, you have to decide how to measure the size of companies —sales, market capitalization, etc.—and what level would represent a small company. You will be presented with rules of thumb, that a PE of 8 is cheap or that a company with a market capitalization less than $100 million is small, but these rules of thumb can be dangerous as markets themselves change over time. To provide a frame of reference, this book examines the distribution of various measures— PE, price-to-book ratio and market capitalization, to name a few— across the entire market. This should then allow you to get a sense of differences across the market and to develop portfolio standards.
The best test of any strategy is to apply it to the market and to peruse the portfolio that you would have ended up with as a result of following it. This book attempts to do this with each of the broad strategies examined, and you can ask yourself whether you would be comfortable investing in the stocks that make up this portfolio. If you are not, it is a warning sign that this strategy may not be appropriate for you. If you are a careful investor, putting this portfolio under a microscope will allow you to study the strategy for weaknesses and examine what you can do to minimize the damage.
It is worth emphasizing what this book is about and what it does not try to do. It is not about promoting or debunking investment strategies, since there are plenty of analysts and brokers who do the former and lots of cynics, many from academia, who do the latter. But it is about providing a full picture of each investment strategy so that you can make your own judgments about what works and what does not. It is not about answering every investment question that has ever been asked; no one can have the foresight to do this. But it is about providing you with the ammunition to ask the right questions when confronted with promoters of these strategies. It is not a book for pessimists who are convinced that picking stocks is an exercise in futility, but it is a book for optimists who want to figure out how to make active strategies pay off and how to use them prudently. It is not about things you cannot and should not do while investing, but it is about things you can and should do as an investor to improve your odds for success.
As long as there have been financial markets, there have been mountebanks and frauds luring investors into get-rich schemes that ultimately fail. In the aftermath of these failings, you are often tempted to turn to the courts and to governments to protect you from yourself. The best antidote, though, to an unscrupulous sales pitch about "stocks that cannot lose" or to a "get rich quickly" scheme is a skeptical and informed investor. I hope this book helps you become one.