Any finance class will quickly teach you that the speed with which efficient markets absorb public information makes it nearly impossible to find a bargain stock. This notion, fittingly dubbed the "efficient markets theory," is the philosophy driving many committed index investors. But how do the teachers feel about this bit of wisdom?
A research paper recently covered at CNNMoney.com surveyed finance professors, finding that many took their own teachings to heart. About two-thirds didn't try to beat the market, investing instead in index funds, and steering clear of picking individual stocks. Almost 15% had never purchased a single stock!
But a minority of these professors, the active traders, did pick stocks, and did try to beat the market. However, rather than using the sophisticated models and theories about risk and asset pricing that they taught their students, the study reports that these professors looked at a firm's fundamentals (such as P/E ratio) and the momentum in its stock price -- how it performed recently, compared to 52-week highs and lows. In other words, they were chasing performance!
Do as I say ...
The researchers fittingly wonder why finance professors spend so much time researching sophisticated risk models if those models are "glaringly unimportant" in the real world. Finance professors who want to beat the market ignore their own (well-researched) advice and just chase the hot stocks.
I don't mean to pick on finance professors. I also don't mean to say that dedicated investors can't beat the market with a well-researched portfolio of chosen stocks. Instead, I find this a fascinating example of something we all do from time to time -- ignoring the fundamentals we know to be true.
... not as I do
Consider asset allocation. At one time or another, most of us have sat down and figured out how much money we want to invest in bonds, stocks, international investments, commodities, and Star Wars figurines. That handy pie chart represents the amount of risk we're willing to take with our money.
But what if one of your chosen assets performs poorly? Let's say you hopped on the real estate investment trust bandwagon, purchasing shares of the Vanguard REIT ETF (AMEX: VNQ), the iShares Dow Jones U.S. Real Estate ETF (NYSE: IYR), or iShares Cohen & Steers Realty Majors ETF (NYSE: ICF). You smiled to yourself as your REIT grew during the housing bubble.
Then, one day, you realized your REITs had grown far beyond the tiny slice they originally occupied in your asset-allocation pie chart. Components like Vornado Realty (NYSE: VNO), Prologis (NYSE: PLD), and Host Hotels (NYSE: HST) had boomed, pushing your ETFs higher. Never mind, you told yourself, hoping to ride the bubble all the way to an early retirement. Not until the market crashed did you realize that you'd taken more risk than you planned. As a result, you lost a lot more than you might have, if only you'd rebalanced your portfolio somewhere along the line.
Lessons learned
You've probably heard some money-management maxims so many times that they hardly register anymore. Let this be a reminder that even the hoariest cliche contains an important grain of truth. You should save for a rainy day, pay yourself first, and avoid putting all your eggs in one basket. In the same spirit, don't chase performance.
For more Foolish wisdom, find out:
- how to focus on absolute performance;
- why you shouldn't chase performance; and
- picks for 2008's best stock.
