Why Investors Fail to Beat Market Returns

Investors have very short memories.” – Roman Abramovich

My friend Marty is a typical investor.

He got into stocks in 1986, and sold out after the market crashed in 1987. He stayed out for several years, and then got in for a big ride as the tech boom accelerated. When stocks were trading at more than 50 times earnings, I urged him to get out. He waited until after the crash. The result: He was down almost half his original investment. He has been in and out of the market ever since, jumping from one investment advisor to another.

“I am embarrassed by my performance,” he admitted the other day over breakfast. “I am afraid to tell my wife how little we have left in our stock account.”

“What are you doing, stock-wise?” he asked me.

“I pretty much got out of individual stocks a while ago,” I told him.

“Why didn’t you tell me?” he said.

“Two reasons,” I said. “First, I’m not an expert on investing. And second, you don’t listen to me anyway.”

He mulled that over.

“So do you think I should sell now?”

“I really don’t know,” I told him. “But I do have a suggestion for you.”

He was interested.

“I suggest you read a new book that’s just been published by Regnery Press. It’s written by a friend of mine. His name is Mark Skousen. He’s an economist and an investment advisor.”

“Sounds heavy,” he complained.

“It’s not. It’s actually a fast, easy read. And I think you’ll like the title. It’s called Investing in One Lesson.”

I went on to tell Marty a little bit about the book…

In the first chapter, Skousen recalls a comment Peter Lynch made about the investing public. Lynch ran the Fidelity Magellan Fund, the most successful mutual fund in the 1970s and 1980s. But he said that despite the fund’s great success during that period, the majority of its shareholders lost money.

Why? Because they tried to time the market and never stayed fully invested. Whenever the market fell, they would panic and get out. Then they’d try to get back in after the price turned around. As a result, they were always chasing the price.

Recent studies, Skousen points out, confirm Lynch’s story. Since 1987, the average mutual fund has gained 13 percent a year (compounded). Yet the average fund investor has earned only 3.5 percent.

The reason is always the same. Individual investors can’t seem to stick with winning programs or funds. They get confused and flustered by the financial news and bail out too soon. Then they come back in too late. And then they do it again.

The problem, Skousen says, is that investors misunderstand a fundamental truth about the stock market: “The business of investing is not the same as investing in a business.”

In Automatic Wealth I made the same point. The stock market, I said, is not just an agglomeration of financial spreadsheets, of profits and losses. It is a global, computerized casino where huge institutions (pension funds, mutual funds, managed accounts, etc.) respond instantly and automatically to hundreds (even thousands) of different matrices. And where millions of individual investors respond to any news about this institutional activity and about what other investors are doing.

It is very complicated. No wonder, Skousen says, that if you look at the Forbes richest 400 list, very few made their money from the stock market. Most “made their fortunes through creating and expanding their own businesses.”

You have to respect an investment expert who gives entrepreneurship its due.

It shouldn’t be a surprise, Skousen says, that stockbrokers often do better than their clients. Or that managers of mutual funds do better in their individual portfolios. “That’s because investing is their business.”

If you want to invest like the best fund managers (and beat the averages), Skousen has an answer. It is a “very simple strategy – a shortcut, if you will – that will keep you out of trouble and help your portfolio grow without devoting your life to investing.”

As a businessman who doesn’t have time to become an expert in the stock market, I was interested to discover Skousen’s strategy. Though I haven’t been investing in individual stocks, I have been investing in no-load index funds. And I’ve been happy to earn a long-term return on those funds that’s been equal to the market’s long-term average of 9 percent. With the businesses I’m involved in growing at double-digit rates (and a real estate portfolio too), that’s satisfied me.

But Skousen’s strategy is better. He explains exactly why investing in a stock is not the same thing as investing in a business. He explains why technical investing is fatally flawed for most investors. And then he makes a persuasive case for a particular type of investing that has consistently beaten the averages.

It has elements of contrarianism in it, which I like. Contrarian investing lets you play the market against the mass of misguided, uninformed individual investors. It also has a good dose of fundamentalism in it. I like that, too, because, over the long run, the market has proven to regress to the mean. (Price-to-earnings ratios, for example, eventually influence the long-term pricing of the market.)

Skousen focuses on a certain class of stocks that are usually immune from fad buying. These stocks, he points out, represent less than 20 percent of all stocks that trade on the various exchanges. They are so neglected that they are not terribly affected by institutional moves and individual hysteria. And their prices are reliably connected to underlying value.

Can you guess what class of stocks Skousen is talking about?

If not, buy the book immediately and see if you aren’t persuaded, as I was, that he has found a smart way to approach the stock market. If you can guess what he’s talking about, read the book anyway. It will confirm your confidence in this stock class and expand your understanding of the market.

I won’t give away Skousen’s strategy here, because I want you to get the full effect of the argument he puts forth in this good book. As I told my friend Marty, it is a fast read – like a John Grisham novel. But it’s full of solid sense and helpful facts that will give you the confidence you need to follow his program.

I have bought a dozen copies for friends of mine who invest in the market. It will be in their stockings this Christmas. It might be a good idea not only to get a copy for yourself, but also for some of the people on your gift list. If you go to Amazon now, you’ll have your books in time for the holidays.

[Ed. Note: Get Michael Masterson’s insights into becoming successful in your business and personal life, achieving financial independence, and accomplishing all your goals on his new website. You’ll find updates on all of Michael’s books, news on upcoming ETR events, Michael’s blog, and room to send in your comments and questions. Check it out today.] [Ed. Note: Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]