Analysis of Basic Investment Principles

This is an analysis of the basic investment principles, together with the modifications that I think are necessary to improve accuracy.

The stock market outperforms real estate and bonds.

This statement is true for passive investors. But people who actively manage their investments affect the profitability of those investments. For example, a private equity firm such as Kohlberg, Kravis, and Roberts ( Merchants of Debt by George Anders) can put a company in such a financial bind that managers must favor debt reduction over empire building.

Ordinary investors cannot do this with stocks, but they can actively manage real estate to make it outperform stocks. For example, if you own your residence you are managing a real estate investment. The sweat equity you put into your home and the tax advantages of home ownership will increase the profitablility of your home.

Technical analysis is worthless.

Jesse Livermore (Reminiscences of a Stock Operator by Edwin Lefevre) made several fortunes in short-term trades because he could read the tape better than anyone else. He lost his fortune every time and ended up killing himself.

When a technical factor provides an edge, the edge soon disappears. Nicholas Darvas (How I Made $2,000,000 in the Stock Market by Nicolas Darvas) used a system involving price patterns and stop orders. This worked for him, but the patterns he favored do not occur now, and the use of stop orders is so prevalent that purchases and sales triggered by stop orders are executed far from the stop level.

The Value Line Investment Survey uses "earnings surprise" as a factor in predicting relative stock performance in the next twelve months. An earnings surprise occurs when reported earnings differ from predicted earnings. Nowadays, any earnings surprise causes an immediate price movement so large that it eliminates any future forecasting significance of the surprise.

Perhaps you are not persuaded by these examples. If you have confidence in your ability to read charts, you should be able to recognize a chart which is a random walk. Examine these charts to see if you can.

When you have finished examining the charts, see the labeled charts and my (erroneous) analysis of these charts.

Fundamental analysis is worthless.

Professional fund managers underperform market indices, but this does not mean that it is impossible to pick stocks that outperform the indices. For example, Warren Buffett (The Warren Buffet Way by Robert G Hagstrom) has such an outstanding track record using fundamental analysis that it is highly unlikely he is just lucky. He has an uncanny ability to find companies with a product or service that is likely to dominate the market, and to recognize managers that will put profitability before growth.

A simple argument proves that fundamental analysis can be useful. If it were worthless, then professionals would do as well as the market indices -- no better and no worse. But in fact they do worse, and it doesn't matter why.

An example of how a fund manager thinks occurred when index funds were first introduced. An index fund underperformed the index that it was emulating. When asked how this was possible, the fund manager said that some of the stocks in the index were not purchased because they were not investment grade.

Earning higher returns entails higher risk.

This is true for a single investment holding, and is the principal reason that stocks outperform real estate and bonds. But diversification and cost averaging can reduce risk in a stock portfolio to less than that of a single holding in real estate or bonds, without sacrificing performance.

Diversification and cost averaging reduce risk

Diversification means having investments that move independently of each other. Just diversifying a stock portfolio is not enough. To increase diversification, you should have part of your funds in stocks and part in real estate.

Cost averaging is easy to do if you are diverting part of your income into stocks. Just invest periodically whenever you have enough cash to make another purchase. But cost averaging is more difficult if you receive a large sum of money through an inheritance, gift, or other windfall. You should not invest it all at once, because the market might be about to start a substantial decline. But you do not want to wait too long, because the stock market is likely to be more profitable than cash equivalents. Some sort of a compromise is needed.

The market has an upward bias.

To see if this is true let's look at a long term chart, and while we're at it let's see if there is any other evidence of non-randomness.

The market moves in exaggerated trends.

If the market were a random walk, filtering for trends of any minimum length would result in an average trend length of twice the minimum. I tested three stocks and three market indices to find out if they move in exaggerated trends. They do. The detailed analysis is at trends.

It is true that trading solely on trends, unless a very large filter size is used, is unprofitable because of the costs of commissions and bid/asked differentials. But if you are going to buy or sell anyway, for whatever reason, it makes sense to go with the trend.

Going with the trend might be seen as paying tribute to technical analysis. In effect, the trend is the current leg of a point-and-figure stock chart. However, technicians are not concerned with the length of a trend, they are concerned only with the endpoint of the trend.

The best stock market investment is an index fund.

Buying individual stocks is better than buying shares in index funds because the increased volatility of individual stocks makes it easier to manage your portfolio for tax purposes. And even though each stock is more volatile than an index fund, in a well diversified portfolio the overall volatility can approach that of an index fund.

Buying individual stocks also provides opportunities to select stocks with strong uptrends. Because of the persistence of trends, such stocks are likely to outperform the market in the short term.

Furthermore, rare individuals are capable of picking stocks that outperform the market in the long term. These people would be wasting their talent if they purchased shares in an index fund.

Buy and hold is the best strategy.

There are valid reasons for selling a stock. You might need the money, or you might want to sell to establish a tax loss. If you are trying to pick stocks that outperform the market, a third reason for selling is that you have lost confidence in a stock.

Leonard Azar, 309 Oxford Street, Brookings, OR 97415 -- (541) 469-2429 -- e-mail