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Money Talks

By Dr. Gregg Dimkoff
Professor, Grand Valley State University
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As I write this article, the Dow Jones Industrial Average Index has risen about 65 percent since bottoming out March 9 last year, while the broader NASDAQ Composite Index is 89 percent higher. It’s unlikely we’ll ever see another period of such extreme stock market gains. Did you miss out on the returns? Or miss out on most of them? If so, you aren’t alone. Investors have to share some anatomy with a brass monkey to jump into stock markets when prices are sinking like a rock. Instead, most of them are scared, and are selling everything. As is so often the case, individual investors tend to move their money back into the stock market only after a major bull market. In other words, now.

Today’s investors face a much more difficult task trying to make money in the stock market than at any time over the past year. Stock market prices may have risen to reflect the confidence that the financial market meltdown ravishing global economies in the fall of 2008 has mostly ended, and that the recession is ending. If so, future stock market returns may revert to the decades-long mean, about 8-10 percent per year, and picking winners will be much more difficult. What’s an investor to do? Which stocks are most likely to at least match — if not outperform — market returns?

A Google search of “how to buy stocks” turns up over one million hits. You can get “expert” advice from day traders, plumbers and probably even eight-year-old kids having fun with us. One site says it’s relatively easy to buy stocks once you’ve done the necessary research. Good luck with that. To do the research well, you’ll need college degrees in finance, accounting and economics, and on top of that, be lucky. Luckier than the vast majority of stock analysts — people who make their livings researching stocks — who had buy or strong buy recommendations on Enron only 30 days before the company declared bankruptcy. If the professional researchers can’t get it right only 30 days before Enron’s financial Armageddon, what chance do you have? Slim to none.

Some Internet sites give you what seem to be useful rules for filtering out stocks likely to lag market returns. Examples of such rules are to stick to stocks with a history of above average earnings growth, strong balance sheets, great managers, some sort of market dominance, a debt-to-equity level below some stated maximum value, positive cash flow, and on it goes. Again, it would be most helpful to have those three college degrees before you begin.

In fact, the ability to select stocks consistently outperforming market indexes is about as rare as winning the Lotto. It happens, but only to someone else. Even most professional investors, stock analysts and mutual fund managers cannot do so year after year. Does that stop them? No, they are driven to try, and perhaps more importantly, they are paid to try. As you may have read, the best way to get someone to keep exhibiting the same behavior is to make the reward for doing so random. Because stock returns often exhibit randomness, we keep trying to pick winners.

A considerable amount of academic research shows that individual investors don’t stand much of a chance trying to pick individual stocks that will outperform the market. Studies show individuals earn only a small fraction of the return generated by stock markets. They churn their holdings too much, they get spooked during bear markets (selling low), then get back in when prices have recovered (buying high), they unsuccessfully try to time markets, they don’t diversify adequately, they put too much money in their employer’s stock, and they are suckers for penny stocks — stocks selling for less than $1 per share — hopeful a price increase of only a few pennies will generate a huge percentage return. All of these activities destroy returns.

The best advice I can give you about picking individual stocks is don’t even try. Give up the idea. Life isn’t that easy. You might be surprised by how many financial advisors and stockbrokers either are prohibited by their employers from putting their clients’ money in individual stocks, or won’t do so because they see the futility of doing so. Instead, their objective is to diversify their clients’ investments to reflect client risk tolerances and time horizons using mutuals funds and exchange-traded funds (ETFs). ETFs achieve diversification like mutual funds but are traded continuously throughout the day and kick off much less income tax liability than mutual funds.

Choose three-five diversified mutual funds or ETFs. Focus on matching the funds to your risk tolerances, try to find funds outperforming their peer funds, and try to choose funds whose annual expense charges are less than 1 percent. The Wall Street Journal includes a mutual fund section at the end of each calendar quarter. You can check out a fund’s performance relative to its peer groups and annual expense charges. If you don’t feel comfortable doing this yourself, and most people don’t, find a good financial advisor.

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