What Next?

December 02, 2003

The best advice for most investors is to ignore all claims, from whatever the source, about any ability to outperform on a risk-adjusted based on stock-selection or market timing skills.

There is an overwhelming body of evidence on the track record of the stock recommendations of Wall Street investment firms that demonstrates that these firms do not have the ability to use fundamental and/or technical analysis to deliver market-beating results. Financial economists would cite the Efficient Market Hypothesis to explain the results. New York Attorney General Eliot Spitzer "uncovered" another explanation that contributed to the poor results-Wall Street firms touted stocks because their employers did or were hoping to do investment banking with the companies.

In an attempt to generate new business the investment firm of Charles Schwab developed its own stock rating system. Since the firm does not engage in investment banking activities, Schwab boasted that its ratings would not be tarnished by any biases. Its system is based on a computer-driven model that divides about 3,500 stocks into five categories rated A (most likely to succeed) through F (poorest prospects).

How would an investor have fared using Schwab's system? Let's make thefollowing assumption. Given the track record of other stock-rating services, and being skeptical of claims about any ability to identify undervalued stocks, an individual investor awaits the first year results of the ratings before drawing any conclusions. The system, which premiered in May 2002, performed exactly as Schwab hoped it would. Although stocks in all five categories were down on average, stocks rated A and B declined about half as much as the broad market, while D-rated stocks fell twice as much, and F-rated stocks were down three times as much. Schwab of course touted those results. So our skeptic becomes convinced that Schwab has built a better mousetrap and begins to use the system. Thanks to the November 13, 2003 edition of the San Francisco Chronicle, we find what is probably just about Schwab's worst nightmare. From May 6, 2002 through Oct. 20, 2003, Schwab's F-rated stocks have done the best, with an average return of 30.09 percent. The D-rated stocks were second best, with a 25.4 percent increase. Stocks rated C and B were next, with an identical 23.3 percent average increase. In last place were the A stocks, which rose 22.4 percent. Now what is our intrepid investor to do? And keep this in mind: While strategies have no costs, implementing them does. The returns listed above do not include any trading costs. Of course, any investor using Schwab's would incur not only commissions, but bid-offer spreads as well. To add insult to injury, access to Schwab's ratings may be contingent on the payment of a service fee or the amount of assets held in a Schwab account.

The best advice for our investor is to ignore all claims, from whatever the source, about any ability to outperform on a risk-adjusted based on stock-selection or market timing skills. Wall Street's research did not fail because of any bias; instead it failed because Wall Street analysts don't have any ability to add incremental insight, allowing them to exploit market mispricings. And of course, neither does Schwab. Schwab, and most individual investors, are making the same mistake-they confuse information (e.g., a company has great prospects) with information that they can exploit. The following quotation provides a very important insight:

"The most general implication of the efficient market hypothesis is that most security analysis is logically incomplete and valueless. The logical incompleteness consists of failing to determine or even consider whether the price of the stock already reflects the substance of the analysis. A very optimistic forecast of a company's future earnings is no justification for buying the stock; it is necessary that the analyst's forecast be significantly more optimistic than other forecasts. Such marked differences of opinion are the basis of abnormal gains and losses. A proper analytical report will include evidence of the existence of such a difference and support for the analyst's own views."1

In other words, advice must include both the information about the company and an explanation of why that information is not already incorporated into prices. Only information that is not already incorporated into prices can be used to exploit mispricings. Bernard Baruch put it this way: "Something that everyone knows isn't worth knowing." It is also important to understand that capturing incremental insight is very difficult, if not impossible, to achieve. The reason is that security analysts are competing with so many other smart and highly motivated people researching the same stocks. It is this tough competition that makes it so difficult to gain a competitive advantage. Imagine an art auction where you are the only expert among a group of amateurs. In that circumstance, it might be possible to find a bargain. On the other hand, if you are one of a group of mostly experts, it is far less likely that you will find bargain prices. The same is true of stocks. Competition among all the professional active managers ensures that the market price is highly likely to be the correct price. As Rex Sinquefield, the co-chairman of Dimensional Fund Advisors, points out: "Just because there are some investors smarter than others, that advantage will not show up. The market is too vast and too informationally efficient."2

It is important for investors to understand that there are only two ways you can exploit information. The first is if the market is not aware of the information (not very likely unless it is inside information, upon which it is illegal to trade). The second is if you can somehow interpret the information better than everyone else. The question then is: Just how tough is the competition? We can turn to Benjamin Graham for his insights. Graham felt that the results of security analysts depended more on the level of their competition than on the level of their skill. The tougher the competition, the tougher it is to beat the market. Today, the vast majority of trading-80 to 90 percent- is done by institutional investors. It is they who set the prices of securities. Investors are not competing against individuals, but are competing against other professionals. Nobel Laureate William Sharpe provided the following insight:

"After all, the market's performance is itself an average of the performance of all investors. If, on average, mutual funds had beaten the market, then some other group of investors would have lost to the market. With the substantial amount of professional management in today's stock market, it is difficult to think of a likely group of victims."

The bottom line is that the best advice is not to become one of the victims.



1. James Lorie and Mary Hamilton, The Stock Market: Theories and Evidence.

2. Financial Advisor (March 2001).



Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know,"  "The Only Guide To A Winning Investment Strategy You Will Ever Need," "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," and "The Successful Investor Today: 14 Simple Truths You Must Know When You Invest." Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.


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