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Four Ways to Beat the Market


The bad news is, two of those are out of most investors' reach.


You can't beat the crowd by being the crowd. Yet, time and again, this is exactly what most investors attempt to do.

The investment manifestation of this is called momentum investing -- buy high to sell higher. Yet the foundation of this approach is anchored in a self-delusional belief that one can time the market; ride the wave then jump off the board just as the wave crests.

Sometimes this fantasy works -- but all fantasies work for a while. Sadly, however, all fantasies must meet reality (just like what happens in Vegas tends to stay in Vegas). From an investing perspective, that moment occurs when an investor zigs when he should have zagged, and all the hard-fought-for profits evaporate in what seems like a few nightmarish moments.

So, why -- with the evidence so heavily against being the crowd to beat the crowd through market timing (and/or supposed superior individual stock selection) -- do investors adhere to such a certain failed approach? The answer comes from a famous passage in John Maynard Keynes' most important text, The General Theory of Employment, Interest and Money:

"…human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.

"The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money -- a further reason for the higher return from the pastime to a given stock of intelligence and resources.

"Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

In that last sentence, you have the psychological rationale for momentum investing: Go with the crowd -- they must know something. Besides, if I'm wrong, who will criticize me when just about everyone else is wrong? Misery sure loves company.

This thinking is also the anchoring principle behind closet indexing -- that delicately disingenuous game played when sector weightings are tilted by 1%-or-less increments (for example: I love energy, so I'll overweight it by…1%!). Talk about conviction of one's beliefs.

Well, what's the alternative, you might ask? And what does all this have to do with the market conditions at hand?

Investment Strategy Implications

In my weekly memo to clients invested in a small hedge fund that I manage, I posted the following closing comment:

"Markets such as the one we are experiencing have an extreme quality to them. Since most investors are momentum/follow-the-crowd types, market extremes are areas that test the contrarian mettle in all of us. Buy low, sell high is always easier said than done."

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No positions in stocks mentioned.
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