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This Stock Tip Will Incinerate Your Savings

"Buy the rumor, sell the news."

You probably learned that bit of market "wisdom" early in your investing career. We hope you spend the rest of your investing days doing your best to forget it.

This occurred to us when we read two equally comical stories in major national newspapers:

  • McDonald's "rose upon news that the company's 'Hamburger University' has a very promising freshman class coming in."
  • "Petrobras Energia Participaciones plunged nearly 20% yesterday in Argentina after a two-week buying spree that was apparently helped by a string of U.S. media mistakes about its ticker symbol. ... Petrobras Energia has a parent, Petroleo Brasileiro, known as Petrobras. Business commentators who were trying to recommend Petrobras used the symbol PZE ... instead of the correct PBR."

In the interest of disclosure, we admit that one of those headlines isn't about a real event -- it's from the satirical newspaper The Onion. One of them, though, was reported in the business world's paper of record, The Wall Street Journal. (We'll tell you which is which soon.)

But first
As investors, "buy the rumor" is anathema to us -- we believe in long-term, buy-to-hold investing, while "buy the rumor" is short-term stock-trading embodied. Yet as bad a real-life practice as it is, thousands of folks buy a rumor every day in the public markets -- occasionally with entertaining results.

In his superb Your Money & Your Brain, Jason Zweig tells what happened on Oct. 1, 1997, when WorldCom's announced bid to acquire MCI Communications sent MassMutual Corporate Investors' stock up 2.4% on 11 times normal trading volume.

Why? Investors acting fast on the rumor bought shares of ticker MCI -- the symbol for MassMutual. (MCI's ticker at the time was MCIC.) Whoops.

This is hardly isolated to the past. We'll go out on a limb to say that every single market day, a hurried trader confuses Vale (NYSE: RIO  ) with Rio Tinto (NYSE: RTP  ) , or Allegheny Technologies (NYSE: ATI  ) with insurer Alleghany (NYSE: Y  ) , or even Hewlett-Packard (NYSE: HPQ  ) with Helmerich & Payne (NYSE: HP  ) . Heck, just go over to the Yahoo! Finance page for Appell Petroleum (APPL), and you'll find 10 news stories for Apple (AAPL).

Why?! Why is this happening?!
Of course, if you're going to buy the rumor, you need to act fast. With institutions having access to products such as the Dow Jones Elementized News Feed, if you're not lightning-quick, you'll get creamed as a trader.

The catch-22, of course, is that you can't be as fast as you need to be, and if you try, you'll probably only embarrass yourself by mistakenly buying the MassMutuals of the world.

That's actually great news for you, if you can accept it as truth and modify your mind-set. As James Montier wrote recently, "[T]he paradox of investing today is that the very thing that creates the opportunity (the myopia of investors) prevents most from exploiting the obvious time arbitrage opportunity."

Easier than shock therapy
The thing about traders is that they'll cause a stock price to jump up, down, and all around without any regard for the quality and prospects of its underlying business. You can profit from this because when it comes to buying a stock to hold for years, only two data points matter:

  1. The price you pay.
  2. The quality and prospects of the underlying business.

If you identify quality companies with strong prospects ahead of time and wait for traders to sell them to you at a low, low price, you will do very, very well. That's how Fool co-founders David and Tom Gardner run their Motley Fool Stock Advisor service, and their picks are ahead of the market by 41 percentage points on average.

They also advise individual investors to:

To that last point
Finally, it's time to reveal that McDonald's has no promising class at Hamburger U. The true story is that supposedly sophisticated investors spent two weeks buying the "wrong" Petrobras. As Mel Brooks said: "Tragedy is when I cut my finger. Comedy is when you walk into an open sewer and die."

So stop buying the rumor and focus instead on owning great businesses for the long-term. If you're looking for some additional recommendations, click here to sign up for David and Tom's Stock Advisor free for 30 days.

This article was first published April 18, 2008. It has been updated.

Neither Brian Richards nor Tim Hanson owns shares of any stocks mentioned. Apple is a Stock Advisor recommendation. Petrobras is an Income Investor pick. The Motley Fool has a disclosure policy.

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