rediff.com

NewsApp (Free)

Read news as it happens
Download NewsApp

Available on  

Rediff News  All News 
Rediff.com  » Business » How they made millions in the stock market

How they made millions in the stock market

August 30, 2007 14:16 IST

It's easy to think of the greatest investors of all time and imagine people who, either through some sort of gift of birth or years upon years of diligent study, had a complete understanding of the economy and the stock market. These Wall Street gurus surely must have had an uncanny ability to get into the market at just the right time and cash out just before things went south, the type of investors who would have foreseen the market's recent slide and gotten out just in time.

It would make for a great story, the notion of these prescient, unbeatable investors. The problem is it's simply not true. Sure, some people have been fortunate enough to make a lot of money with good (perhaps "lucky" is a better word to describe it) timing.

Slideshows:
12 safe-haven stocks
Most attractive small caps

But the vast majority of those who have beaten the market over the long term haven't done so by predicting when it will go up or down. In fact, many of them--Peter Lynch, Warren Buffett and James O'Shaughnessy, to name a few--made their fortunes not by getting out of the market at times like these but by staying in it. When other investors or the media were panicking, these investors didn't let emotion sway them from their proven strategies.

A great example of how ignoring "buzz" and sticking to a solid strategy can lead you through tough times is James O'Shaughnessy, one of the Wall Street winners upon whom I base my "guru strategies"--computer models that each mimic the philosophy of a different investing great.

Before the tech stock bubble burst in 2000, O'Shaughnessy had been taking some big hits in the media because of his continued focus on non-tech stocks. While his performance lagged during the tech boom, he avoided the bust that followed. O'Shaughnessy's RBC US Growth Fund, meanwhile, has outpaced the S&P every year since 2002.

David Dreman, another guru upon whom I base one of my models, has also made a fortune by sticking to his guns. While other investors fled in droves from both tobacco giant Altria, which took a licking amid lawsuit concerns in 2000, and Tyco, which had to deal with an embarrassing CEO fiasco a couple years later, Dreman snatched up shares of both down-and-out businesses. By sticking to his unpopular belief that those firms had value, he ended up enjoying huge gains.

Dreman is a student of investor psychology, and believes that people often overreact to bad news in the market. Crises can thus be a major buying time for him. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he has said. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower." His advice: "Buy during a panic, don't sell."

Sticking with stocks

At time like these, it's also important to remember the historic staying power of the stock market. Citing a study performed by Roger Ibbotson, Rex Sinquefield and Ibbotson Associates, the American Association of Independent Investors notes that if you were to have bought into the S&P 500 at the beginning of each year and sold at the end of each year from 1926 through 2004, you would have lost money in 29 per cent of those years.

Slideshows:
Seven buy-now bond funds
Ground-floor stocks: Biggest new issues

But if you were to have bought at the start of each year and sold after two years, your chance of posting a loss would have dropped to 16 per cent. If you held for 10 years, you'd have lost only 3 per cent of the time.

The stock market also climbs higher than other investment vehicles over time. Citing the same researchers, the AAII notes that in the 10-year period that ended at the end of 2004, the S&P averaged 12.1 per cent annual return, beating long-term corporate bonds (9.5 per cent), long-term government bonds (9.8 per cent) and treasury bills (3.9 per cent). When you stretch the time frame out to the previous 20, 30, 40 or 50 years, the spread between stocks and other investments generally gets even greater.

Hedge fund guru Joel Greenblatt, author of The Little Book That Beats The Market, has also compiled data involving risk and investing time frames. Greenblatt developed a simple and intuitive strategy that looked for stocks with high returns on capital and high earnings yields.

According to Greenblatt's 17-year back test, this approach would have delivered dramatic stock market outperformance (30.8 per cent per annum), but it did not outperform the market year in and year out. In fact, he points out that the portfolio of stocks underperformed 25 percent of the time if followed for only one year and 17 percent of the time if followed for two years.

But if followed for three or more years, the strategy has a 95 per cent chance of beating the market. The point here is that even the best strategies don't always work in the short term and most investors don't give an approach enough time to prove its value.

Don't try to time the market

While the market is a great bet to post strong gains over the long term, you can run into problems if you try to switch between cash and stocks to maximize gains and limit losses.

The big problem here is that you never know reliably in advance of when big market moves will occur, a notion that many of the gurus I study agree with.

Slideshows:
Ground-floor stocks: Biggest underwriters
12 could-be buyout stocks

"I don't remember anybody predicting the market right more than once, and they predict a lot," Lynch said in a PBS interview several years ago. He also likened investing in stocks with a one- or two-year horizon to "betting on red or black at the casino," adding, "What the market's going to do in one or two years, you don't know. Time is on your side in the stock market."

All of this is not to say these gurus invested without regard to price. In fact, many, including Lynch, had metrics for identifying stocks that were undervalued based at least in part on their prices. Lynch compared a stock's price/earnings ratio with its growth rate, while O'Shaughnessy and Kenneth Fisher compare price with sales, for example.

But they used these price-based measures to find stocks that were selling at a good price based on the company's underlying fundamentals--not based on what other investors or pundits thought of them.

Like Dreman, many of these gurus actually saw price drops as opportunities to up their investments. Asked in that same PBS interview whether average investors should follow a "buy-and-hold" strategy, Lynch responded, "They should buy, hold and when the market goes down, add to it. Every time the market goes down 10 per cent, you add to it, [and] you would have better returns than the average of 11 per cent, if you believe in it, if it's money you're not worried about [in the short term]."

Buffett also saw price drops as an opportunity, like he did in shares of Coca-Cola after the 1987 market crash. While many investors jump on the bandwagon of stocks that are "hot" at the moment, Buffett finds that to be folly. "Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before?" he once remarked.

"Investors should remember that excitement and expenses are their enemies," Buffett said in a 2004 letter to shareholders. "And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

Those comments were general in nature, but it's worth noting that amid all of the recent turmoil, Buffett's name has been raised as a possible buyer for pieces of Countrywide Financial, one of the firms that has taken the biggest hits in the market's current slide.

The point here is not that you should buy on the cheap and then blindly hold individual stocks in perpetuity. It's that you need to find a proven way of identifying strong companies whose stock prices are likely to rise over time, and that you stick to that method in good times and bad.

You sell not when a stock's price, or the market in general, dips, but when the stock no longer meets the criteria you used to select it (i.e., low debt, strong earnings, high return on equity, etc.). That's how my guru strategies have far outpaced the market since I created them four years ago, and how the Wall Street greats I've mentioned compiled their fortunes.

And, if you have the discipline, it's how you, too, can beat the Street over the long run.

John Reese, Forbes