Where Outperformance Comes From

There's a saying that there's always someone on the other side of your trade, and that someone may know more than you. I thought of this last week while reading the biography of Joseph Kennedy.

Kennedy's wealth came from a mix of genius and a sheer lack of morals. Take this story: The repeal of prohibition in 1933 was bound to benefit companies that made supplies needed to make alcohol. One was a bottling company called Owens-Illinois. Rather than investing in directly in Owens-Illinois, Kennedy purchased shares of a company called Libbey-Owens-Ford. "Libbey-Owens-Ford was an entirely separate company, which manufactured plate glass for automobiles, not bottles, but its name was close enough to the bottle glass company to fool unwary investors," writes biographer David Nasaw. On news of the repeal, Kennedy and his partners traded shares back and forth between each other, pumping up trading volume to draw attention. That caused other investors to buy shares "on the mistaken belief that they were buying shares of Owens-Illinois, the bottle manufacturer." After a surge, Kennedy dumped Libbey-Owens-Ford with a $1 million inflation-adjusted profit and invested the proceeds in his original target, Owens-Illinois.

Almost half of Gen Yers -- those between age 20 and 32 -- say they "will never feel comfortable investing in the stock market," according to a 2012 study by MFS Investment management. They use words like "casino," "crapshoot," and "rigged" to describe the market. They know someone is on the other side of each trade, and that someone -- like Kennedy -- may know more than them.

But there's something every mom-and-pop investor can do to gain an edge on the person on the other side of the trade: be willing to wait longer.

That's it. There are few things more powerful in investing than the realization that the biggest gains tend to accrue to the person who waits the longest. If you bought an index fund 20 years ago and checked your account statement for the first time this morning, you could legitimately call yourself one of the top investors of modern history, having outperformed three-quarters of professional fund managers. You can say this only because you were willing to wait longer than everyone else who trades, fidgets, rotates, sells in May and goes away, and make (small-f) fools of themselves while you let compound interest work.

Most outperformance in the stock market doesn't come from Kennedy-like mischief, but instead from something simple called time arbitrage. It's exploiting the gap between your time horizon and mine. If you're worried about the next six months, but I can be patient for the next six years, I have an edge over you. You may sell shares today because you don't want to have another down month, and I'll be happy to buy them from you to focus on my up decade. That's all time arbitrage is. With a diversified portfolio, anyone can do it, because patience doesn't require inside information, fancy math models, or high-frequency trading algorithms. All you have to do is wait. It works best with an indifference to short-term volatility that borders on obliviousness.

Companies didn't report much information in the 1930s, but archive documents show Libbey-Owens-Ford earned somewhere around $1.1 million in profit in 1933. By 1985, profits were more than $70 million. Getting tricked by Kennedy didn't matter much if you were willing to wait.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 06, 2014, at 4:07 PM, BruceBenson wrote:

    To the millennials, who are my kids, I tell them to save and invest for financial independence sometime later in their life. They like that notion and how to go about it: buy and hold and build towards the goal during their early working life.

    I don't talk about investing for retirement, because that is meaningless to them (and me). I did read somewhere that Gen Y more often start to invest for the long term in their 20s. I, like most of my boomer buddies, started more often in our 30s. So I do think they've learned something.

    But, let's quit talking about retirement as the end goal. That seems too far off and not particularly interesting to our youth.

    Financial independence (work for awhile, then go do what you want to do) seems to be a great motivator. It works even if one's purpose is to get rich quick. It is essentially the same goal -- the magnitude and timing is all that is different.

    Unfortunately, too many people want to be Kennedy, go strike it rich on one big gamble. Or they think the rich got that way on big gambles (ok, a lot did -- and some got caught). My kids understand the notion of the "Millionaire Next Door" and are looking for interesting lives without having to worry, too much, about money. For a lot of folks, this would be just right, so buy and hold for the long term would satisfy a lot of folks.

  • Report this Comment On May 12, 2014, at 7:40 AM, DavidCLevine wrote:

    Over the long run, the best way to improve returns is to minimize commissions, fees, and taxes. Paying lower fees is like earning higher returns.

    Short-term trading is either an informational game or 50%/50% bet at best. Neither gambling nor informational advantages make for successful long-term investment strategies.

    I've written a book to help educate and protect investors: The Financial "Fix" www.thefinancialfixbook.com. There is virtually no discussion of stock picking.

  • Report this Comment On May 12, 2014, at 2:35 PM, rjboyajian wrote:

    I agree that waiting is a wonderful way to make money in the market. However, in order to be successful in waiting, you must be in a diversified fund (ETF will do fine) and dollar cost average your contributions. The Boggle Method in so many words.

  • Report this Comment On May 12, 2014, at 5:00 PM, ffbj wrote:

    Good information and really one of the few things going for non-professional investors. Not too crazy about the example though. I mean 1.1 million in 1933 was equal to around 20 million when Libby Owens was sold. So only 3x times increase in profits in 50 years... I bet if you compared the charts of the 2 companies you would have done a lot better in Owens Illinois.

    Not important though since, the purport of the article is still the same. Btw I thought that since you went there you should have pointed out similar examples, such as people thinking they were buying Twitter, and other such examples that happened recently, as a way to strengthen your argument that investors make dumb mistakes to this day. Except Boggle hates ETF, comment on that last comment. Buy an index fund that tracks the market: So sayeth Boggle.

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