Anyone with even a nodding familiarity with the stock market has heard of the Random Walk Theory, or has heard the arguments of John Boggle and others of his persuasion about the merit of index funds. Basically, the argument goes: Everything that can be known about a stock is immediately filtered into its share price, and even professional money managers typically fail to beat the market. Therefore, the argument goes, it is silly to invest in individual stocks or even in anything other than a broad-based index mutual fund.
The argument sounds persuasive, and if you don’t like to do your own homework, it’s a good one. Dollar cost average your funds into a broad-based mutual fund over a period of many years, investing the same amount no matter what the market does, and you can be virtually guaranteed that your returns will ultimately beat those of bonds and bank accounts.
The argument fails, however, for those who enjoy learning about the market and researching stocks. It fails because it makes the false assumptions that the markets are always efficient and that the individual can never beat the professional. One stock that illustrated the fallacy of the first assumption in recent times was Michael’s (a large arts and crafts store that has since gone private). Michael’s headquarters happened to be located in the same city where a sniper was on the loose, shooting people at random. On that news alone, the stock took a large drop. It didn’t take a genius to figure out that the sniper would be caught and that Michael’s profits would not be seriously hurt even if he wasn’t. So much for efficient markets.
As to the argument that the individual can never beat the professional, it is less true than ever before, due to the immediate access individuals now have to market developments. In fact, individuals have a marked advantage over professionals, because they can invest in very small companies, which often have the largest positive moves, but which mutual funds are prohibited from investing in because they would wind up controlling the company if they bought even one share for each holder. Moreover, money managers have blind spots that may prohibit them from seeing a great opportunity.
At the present time, the vast majority of money managers are men, and they bring the biases of most men to their purchases. With apologies for what I realize is a gross generalization that is not always true, let us return to the example of Michael’s. If I were to ask 300 random men about the potential of the arts and crafts business, most of the non-artists among them would underestimate it. Go into Michael’s some time, and you will notice that the vast majority of patrons are women. Now ask women the same question. Every woman I know has bought silk flowers, stenciling supplies, decorative painting supplies, or some other craft supply within the last 6 months, for herself or for her children. Who do you think has a better chance of accurately assessing an arts and crafts supplier’s future potential?
Finally, individuals have a better chance of beating the market because they need not face monthly or quarterly performance reviews. I may know that an adult diaper maker is about to double its business, but I don’t know when. I can buy and hang on, without having to explain myself in the shorter term. Moreover, I don’t have to sell such an un-sexy idea to my supervisors, so I can leave emotional reactions to a product out of the equation.
If you want to go it alone, read everything you can get your hands on about the factors that affect stock prices. Buy with great care and sell only in the event of a fundamental change in the company’s prospects. If you do it right, you will conclude that over time, you can beat the market.