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Issue VIII

June 1996


Sharp Investing



How to Beat the Market
like a Rented Mule

Beating the stock market over the long run is simple to understand, but not an easy process to carry out. Just ask the 90% of professional investors that underperform the market over the long run. That it is a simple process is evidenced by the higher percentage of relatively unsophisticated amateur investors able to consistently outperform the market (thought to be as high as 20%). Have you ever wondered why the pros, with their extensive knowledge, experience, staff, and access to vast amounts of information fail to beat their largely unsophisticated amateur brethren? Here is the short answer: professionals work for businesses which are sales driven, not market performance driven. The conflicting motives result in underperformance for 90% of these companies. The longer answer is detailed in a previous edition of Sharp Investing (Mutual Funds, Friend or Foe?, Issue III, March 1995).

How then does one beat the stock market? If most pros can't do it, how could you or I hope to beat it? Until the last ten years, most academics believed that luck was the only way to beat the highly efficient market called the "efficient markets hypothesis". However, in recent years computing power has allowed researchers to "data-mine" stock market data, which means we use powerful computers to detect patterns and trends in the data. This has resulted in some strategies that have consistently outperformed stock markets all over

the world as long as the data has been available. Of course, this is no guarantee that they will continue to work well in the future but it's the best chance of achieving long term superior performance. There is always an element of randomness that cannot be controlled, but you can stack the odds in favor of beating the market over the long run.

Having spent the past four years reading academic research and conducting my own research, I've concluded that there are three main ways in which to stack the odds of beating the stock market over the long run that are supported by rigorous scholarly research.

They are, in order of importance:

1. Understanding and controlling human nature
2. Understanding and taking advantage of certain market characteristics
3. Controlling portfolio expenses

This issue of Sharp Investing will deal with understanding and controlling of human nature. In September the second and third areas will be covered. Sorry about the three month cliffhanger but I couldn't manage to fit the topic into one issue.

Human nature works against investors in a variety of ways. People tend to overweight recent events and underweight past events. This is known as being short-sighted or not putting things in historical perspective. We all do it to some degree. Ever been in a car wreck and spend the next month flinching at every bump in the road? You are no more likely to be in another wreck than before, but the recent event has way too much influence on your short term behavior.

People also tend to find comfort in consensus opinion. Rare is the independent thinker that is not affected by the current opinion of the day. People tend to think alike, and be attracted to the same things, and dislike the same things. Not everyone

thinks alike, but many do when it comes to investing. When in the market, most people are driven by two sides of the same coin, fear and greed. Controlling these natural biases within yourself and understanding that most investors cannot control these biases provides the single most powerful tool to outperform the stock market.

The biggest reason more amateurs than pros beat the market comes from how each deals with human nature and their different profit motives. The amateur profit motive is performance maximization, so the successful amateur strives to suppress the biases of human nature. Conversely, a professionals' profit motive is sales maximization, which means they embrace human nature in order to attract investors. What attracts investors? Things that are part of their basic human nature: greed, consensus opinions, attractive scenarios, fear, overweighting of recent events, etc. Long term performance goals are subordinated to the short term sales goals in most cases of institutional investing.

What you are about to read is a very simple strategy that takes advantage of market inefficiencies created by human nature. However, it is quite difficult for most to implement because it means controlling one's own tendencies to fall into the same investing traps as most of the rest of the market.

Sharp Investing is a quarterly publication focused on investment education. For a subscription contact
Sharp Investments, at:

13160 SW Butner Road
Beaverton, OR 97005
Phone 503-520-5000

Fax 520-0530 email:
Sharpinv@aol.com
Daniel R. Sharp
Registered Investment Advisor




www.sharpinvestments.com

1. Gambling fever: This is perhaps the most well known human foible when it comes to investing. A lot of people will take on risk for risk's sake alone, contrary to the rational investor assumed in most financial models. A rational investor demands higher return for higher levels of risk, where
gambling generally means a lower chance of return for the risk undertaken. A quick look at the proliferation of legalized gambling in this country attests to this fact. Many of these people are attracted to the stock market because of the random short term nature of the market. They do about as well in the market as in the casinos, being that the odds are about the same for both if an investor is a short term trader. I think everyone realizes that a gambling mentality is not a good characteristic to bring into the investing arena.

2. Long term investing: You own a business, not a stock. You wouldn't buy a whole business and then sell it a few months later for 5% more. Why would your strategy be any different with investing in minority parts of a business? A buy and hold strategy has proven to lowers costs, reduce taxes, lower risk, increase return, allow the positive bias of the market to work in the investor's favor as well as letting an investor sleep better at night. I don't know of a single long term successful investor that beat the market any other way than boring old buy and hold. As a long term investor, a person still has to keep close tabs on new information and changes in company or market fundamentals but can completely disregard the day to day fluctuations in price that mean absolutely nothing in the long run. Think of the stock market as a interested buyer that comes by every day and offers you a price for your business. Some days he feels good and offers you more for your business, some days he feels bad and offers you less. But until something changes in your business or the economy, you ignore this guy and tend to business.

3. Value Investing: Value investing is the art of selecting securities that are selling for less than their intrinsic economic value. Value stocks are frequently unpopular, out of favor companies with some sort of perceived problem that makes them repulsive to most investors. Conversely, growth stocks are popular, high growth stocks that are priced at a premium and have usually performed well recently. In this issue I will discuss the psychological implications of value investing. In the next issue I will discuss the economic implications of value investing.

As a human, are you attracted to something with a bright future, exciting prospects, a good story, and something most others covet also? Or are you attracted to something with an uncertain future, boring prospects, not much of a story, and something no one else wants? Of course you, like millions of other investors, are attracted to the

former. However, successful investing almost always demands you do the opposite of your basic human nature.

Have you ever been to an auction? People that bid on unwanted, unloved items often are the only bidders and consequently may pick up a bargain. However, items that get a lot of attention and bidders often sell for an inflated value in a frenzy of competitive bidding. The recent Jackie Onassis auction proves my point quite nicely.

Stocks work exactly the same way. Stocks that are popular, glamorous, and have great prospects are widely followed and purchased, garner lots of attention, and are attractive to the vast majority of investors, who love consensus. Stocks that are unpopular, boring and have poor prospects are neglected, get little attention, and are repulsive and uninteresting to the majority of investors. For example, this winter when Microsoft stock moved from 100 to 105 dollars per share (5% gain) one day it earned a headline in the paper's business section "Microsoft Soars!". At about the same time, Kmart stock had moved from 5 1/2 to 11 dollars per share (100% gain) without a single reference to how well it's stock price performed recently.

Therefore, growth stocks have very high expectations and value stocks have very low expectations. Is it easier to exceed high expectations or low expectations?

Studies show that investors tend to overweight recent events in regard to forecasting future growth rates of investments. Companies that have had a large recent amount of good news tend to sell at a bit of a premium to the true value, and companies that have had a large recent amount of bad news tend to sell at a bigger discount than they should.

Investors flock to the popular securities, keeping the price a little higher than warranted, and avoid the unpopular, which lowers temporary demand and the market price below where it should be. Almost all of the growth companies will eventually fail to meet the ever increasing high expectations and start the move towards becoming a value company. Investors think every growth company is the next Microsoft, but they are the rare exception. The rule is eventual disappointment. Conversely, most of the value companies eventually will exceed the low expectations and begin the transition back to a growth company. Some will go bankrupt or never exceed the low expectations, but again, this is the exception.
While popularity can change overnight, unpopularity usually takes a good part of a market cycle to reverse itself. Buying a value stock means possibly having to wait for several years in order to see the reversal. The reward? Value stocks have returned 18% over the last 60 years, compared to 10% for the market in general and 7% for growth.

The morale: A great company is not always a great investment, and a poor company is not always a poor investment. Too many investors fail to recognize this.

4. Spend time on what works, not what is fun: Procrastination is the practice of reordering tasks from the important to the appealing. Everyone would rather spend time doing something fun and exciting rather than something boring and mundane. Which is more exciting, picking out a hot new stock or grinding through all the details of portfolio management such as asset allocation, diversification, dollar cost averaging, calculating limit orders, etc.? Everyone loves to pick stocks! Investment newsletters know this, and fill their newsletters with name after name of the latest hot stocks. Investment books also tout "stock-picking" strategies. People at cocktail parties talk about hot stocks. Pick, pick, pick! Most investor's spend all their time on this one area. Does it pay off? There are dozens of academic studies that show stock picking is an almost completely random process. Throwing darts or spending months studying a portfolio candidate yield almost the same exact results. Conversely, portfolio management has been shown to yield impressive results. It's just not as fun. Is your goal to have fun or to make money? Picking stocks is almost pure luck. Managing stocks is almost pure skill. For every hour an investor spends analyzing a particular stock they should spend another ten managing their current portfolio. It means the difference between being in the market for fun, and being there for profit.

5. Let go of your losses, hold onto your gains:
Have you ever done this? You buy a stock. It goes down hard and quick on some piece of bad news. You hang on through the death spiral in hopes of eventually breaking even. Your ego is on the line and as long as you don't turn those paper losses into real losses, there is still a chance to break even. How about this? You buy a stock and it goes up quickly. You quickly sell to lock in the gains and the bragging rights. Then you spend the next five years kicking yourself as the stock goes up, up and up.

Do these two examples sound familiar? It is basic human nature to behave this way. It is also the exactly the opposite way to success. Cutting your gains short and holding your losses is not the fast track to superior performance. Success comes from cutting your losses and letting your gains run long. Here's how:

Stock picking is an almost completely random process. Putting your ego into your particular picks is like being disappointed with yourself because of the way the weather turned out. It would make more sense to put your investing ego into portfolio management since that is the area in which an investor actually has control. 50% of stocks will go down in the very short run, 40% in two years time, and 30% over a 3 to 5 year time period, as the long term positive bias of the market works its magic. Therefore even a long term investor can count on being wrong 3 times out of 10. Robert Sharp, author of Calculated Risk, records that 4 of every 10 stocks he picked went down, but by cutting his losses quickly and dispassionately he managed to average 28% annual capital gains (not including dividends) over his investing career. The investor's concern should be for the whole portfolio, not for the single stock that disappoints. If the price decrease is due to new information that dims the prospects of the stock, get out, take your losses, and reinvest the remainder in a new security. If the stock moves down randomly without any fundamental change in the company, it may be time to buy more of the stock. The work is in determining if the movement is random or purposeful.

On the other end, winning stocks should be left alone much longer than they usually are. Would you sell a business that had just started to take off and prosper? I can think of five good reasons to sell a winning stock. One: You need the money.

Two: You find an unfavorable change in company fundamentals. Three: You find an unfavorable change in market fundamentals (a dangerously overvalued market). Four: The stock rises so much it seems tremendously overpriced in relation to it's historical cycles. Five: The stock rises so much your portfolio becomes dangerously under-diversified (say more than 1/3 of your total portfolio).

Never sell a winning stock because of the temporary supply/demand bumpy ride. If the
company fundamentals continue to grow, the stock price will eventually follow. At some point your stock may catch the popularity wave and become priced way, way above what fundamentals would indicate. In this case it becomes a judgment call because it is so difficult to predict popularity. In some cases the King Solomon approach (selling half and holding half) may be the wisest decision. All other things being equal, holding in this situation further defers commissions and taxes and sometimes popular stocks will continue to rise beyond all belief.

Next issue we will tackle the analytical aspects of beating the stock market over the long run. Those that can master the psychological aspects detailed here should have great success with or without extensive knowledge or special financial skills.
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