Why You Should Beat Wall Street

For decades, it's been known that most mutual funds underperform passive index funds. To me, that seems counterintuitive. How can a completely brain-dead strategy like buying every stock in the S&P 500 -- or an exchange-traded fund like SPDRs (AMEX:SPY) -- outperform legions of the smartest people on Wall Street?

If you answered, "Because Wall Street is secretly controlled by an evil cabal of demonic gnomes from the seventh dimension," then you may enjoy some of the discussions on our Overstock.com board.

But there are other plausible explanations. In 1965, Warren Buffett himself theorized that conformity, in many different forms, was responsible.

Buffett's explanation
On Wall Street, you can make mistakes, as long as they're the same mistakes that everyone else is making. Buffett noted that there's little personal gain from taking a stand on a novel idea, and lots to lose if that idea is a bust. The safest place is standing in the middle of a crowd.

So, most portfolio managers conform to the consensus on the right money management practices, the right degree of diversification, and the right stocks to buy. The judgment of the group replaces the judgment of the individual. Instead of finding the best investments, Wall Street buys the stocks that everyone agrees aren't terrible. And there's little motivation for any individual to break this cycle of mediocrity.

Buffett does note that investment advisors are still providing an important service by promoting a long-term outlook and preventing clients from making truly disastrous investment decisions. But if you're looking for outperformance, don't look to Wall Street.

Back to the future
Aside from Wall Street having a long-term outlook, Buffett's impressions are still valid today. The suited legions still haven't figured out that what Buffett learned long ago: Avoid the most popular stocks, because they'll be priced to perfection.

Cisco Systems (NASDAQ:CSCO), Amazon.com (NASDAQ:AMZN), and eBay (NASDAQ:EBAY) are the best of the late-1990s Internet companies. Each one has become completely dominant in its niche. Yet two of these companies are below their prices of seven years ago, while the other one shows only mediocre returns. It's really hard to make money buying the expensive stocks that everyone wants to own.

Buffett, on the other hand, purchased American Express (NYSE:AXP) during the salad-oil scandal and Coca-Cola (NYSE:KO) a few years after the "New Coke" fiasco. These were great businesses, but truly hated stocks. Yet they turned out to be some of the most successful investments in the career of a man known for excellent investments.

The Foolish bottom line
Now, as a small investor, you not only can but should beat Wall Street. Why? Just remember:

1. You have the freedom to pick the best stocks for your portfolio, not just the ones that everyone else is buying.
2. Your job doesn't depend on conformity, so you can seek out the stocks that nobody else wants -- the stocks that are so hated by everyone that they trade way below their fair value. The same stocks that offer the market's best returns.

So don't be overwhelmed by the stream of news, noise, and information from Wall Street. Nonconformity really can put you ahead of the pros.

If you're looking for help identifying value-priced stocks, our market-beating Inside Value service uses many more of Buffett's strategies to find these opportunities. You can take a look at all of our research and recommendations by joining the service free for 30 days.

Fool contributor Richard Gibbons is an evil gnome secretly trying to control his own bladder. He owns shares and calls on Overstock.com, but does not have a position any of the other stocks discussed in this article. Coke is an Inside Value pick. Amazon and eBay are Stock Advisor recommendations. The Motley Fool has a disclosure policy.