Wall Street is a tremendous pressure cooker. Literally billions of dollars change hands every single day. Most of that money is managed by institutions -- organizations that invest other people's money. Largely because of that, Wall Street runs by a set of unwritten rules that are different from the ones you must follow as an individual investor. If you know these rules, you can exploit their weaknesses for your personal advantage and end up ahead.
Not only that, but the way these unwritten rules work in practice, your shot of beating the market actually improves the less time you spend trying. Of course, market-beating investing is not an entirely passive business. You will have to tend your portfolio like a gardener. There will often be weeds to pull and excessive growth to cut back. In general, though, planting the right seeds and simply letting nature take its course is often the best way to long-term success.
Unwritten rule No. 1: The short term is all that matters
Institutional investors' biggest problem is that they're managing other people's money. Ultimately, those other people control the purse strings, and they can yank their cash out if the institution fails to live up to their expectations. As a result, Wall Street institutions live and die by their benchmarks against their respective indexes and peers.
The reason is simple. If a mutual fund falls behind those benchmarks, money starts to flow out of the fund. If too much money cashes out, the fund is often forced to sell its positions, often at an inopportune time. Selling stock at the wrong time often exacerbates the underperformance problem, which leads to even more money cashing out. It's a vicious cycle, and it's one of the primary reasons why so many gigantic funds like Fidelity Blue Chip Growth
Because of their excessive focus on short-term results, these institutions tend to panic-sell whenever the news is at all bad. Take Amazon.com's
How you can exploit it
Since the institutions focus so heavily on the short term, any weakness in a company's results or outlook triggers a mass exodus from its shares. Fortunately for you, that round of panic-selling gives you the opportunity to absolutely crush the market. When a stock drops so far so quickly, there's a very good chance that it will fall below what it's really worth. As an individual investor not bound by the short-term timeframe, you can then buy it on sale. From that point, you simply wait for the panic to subside and for the stock to return to its fair value, giving you some extra returns for your patience.
This is precisely the strategy that we employ at Motley Fool Inside Value, and it's exactly why lead analyst Philip Durell's picks have overall outperformed S&P 500 index trackers like Vanguard's 500 Index Trust
It's also why the Inside Value portfolio contains companies like insurance giant Endurance Specialty Insurance
Unwritten rule No. 2: Too much of a good thing is bad
While underperforming its index and its peers causes too much money to leave a fund, doing too well can cause the opposite problem. Believe it or not, in the mutual fund world, there is such a thing as having too much money. Remember all the money pulled out of the funds that underperformed? For the most part, it gets immediately reinvested -- in the funds that recently outperformed their benchmarks or peers.
So why is this bad? For the most part, cash handed to a mutual fund must be invested. After all, would you pay someone 1% of your money every year to have it sit in a savings account at your local bank? Of course not! So these same funds that panic-sell on bad news are forced to buy even more stocks if they're doing well. And which companies do they buy? Ones that have done well, of course -- stocks they already own that have strong recent price performance numbers.
Just as panic-selling can cause a stock to drop below its true value, too much buying can cause it to rise far above that worth. By using that same Inside Value calculator, you can not only tell when a company is probably underpriced and worth buying, but you can also tell when it's likely overpriced and in need of being pruned.
That sort of calculation led me to dump specialty real estate operator AmREIT
With a clear understanding of that fair value, you could have comfortably sold during Cisco's several-month run-up, prior to the crash. There was no need to hurry and no need to spend every waking minute watching the market. In fact, by spending less time following the stock, it would have been far easier to take that objective stance and determine that it was time to sell.
The Foolish bottom line
It's quite possible to beat Wall Street if you understand its unwritten rules and learn to exploit the weaknesses those rules create. Best of all, because those rules focus on short-term price moves rather than long-run value, you need not be a market junkie. Instead, you can crush the market in your spare time, with long-term thinking and the power of value.
Do you like the idea of investing to beat the market without spending every minute of every day following stock movements? Subscribe to Inside Value today to start your journey. Join today, and not only will we knock $50 off your subscription price, but you'll also receive a copy of value pioneer Benjamin Graham's seminal work, The Intelligent Investor, as well asStocks 2006, the Fool's guide to the investing year ahead, absolutely free.
This article was originally published on Feb. 2, 2006. It has been updated.
Amazon and Dell are Motley Fool Stock Advisor picks. Dell is also a Motley Fool Inside Value pick.