Why Investors Are Their Own Worst Enemies

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Brendan: Another one of the interesting things, I think, in the book, is a lot of times, investors are in a way their own worst enemy. You have the "hot" stocks that are going up to astronomical valuations; maybe they get a little bit ahead of themselves.

Green Mountain Coffee Roasters (UNKNOWN: GMCR.DL  ) was one. Netflix (NASDAQ: NFLX  ) was ahead of itself for a while, but then, on the flip side of the coin, I think a lot of investors get worried when there's a lot of bad news out there -- maybe about the macro economy, maybe the fiscal cliff -- starts to bring stocks down a little bit.

You think investors need to not use their emotions in that way, but exactly the opposite. Could you tell me what you mean by that?

Jack: Exactly. How do people pick their investments, typically? They pick what's worked best, or they go into a market after it's been going up a lot. When were the most people investing in stocks? The late 1990s.

I do several things in the book, but one is I look at market investing after long periods of bad performance, long periods of good performance. I actually did 32 different test cases, and 31 out of 32 cases you did better coming in after the bad period as opposed to the good period. The probabilities are very strong for doing just the opposite.

It's also for picking the best sector to invest in; you pick the best S&P sector. You will do better picking the worst S&P sector -- almost invariably you do better -- and it's because it's the best, it means that prices are going up. You'll encourage new supply, demand will go down, you'll get more competitors coming in. People have already bought it. They probably overbid the sector because everybody's shifting from what's not working to what's working.

Human emotions result in price movements which get things out of line. Then, if you follow that because that's the best performer, you are essentially picking something that is bad value and more likely to revert.

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