The Greater Fool Theory and Investing

Stock pickers success has nothing to do with skill and all to do with luck. To succeed in reaching your long term financial goals own the market, globally diversify and rebalance. The final piece is to remain disciplined to your strategy. The formal phrase is the investment policy statement. You will not know if you succeed unless you have a goal and a strategy. Remember predicting the future is for fools.

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You are Picking StocksPicking stocks refers to both the practice of buying individual stocks because you believe they are mispriced, or purchasing actively managed stock mutual funds, where the fund manager attempts to beat a designated benchmark. If you are engaging in either of these activities, you are a participant in the GFT.

Individual and institutional stock pickers assume they can find mispriced (typically underpriced) stocks, hold them and sell them at a profit. If anyone could do this, you would think it would be Bruce Berkowitz, the much lauded manager of the Fairholme Fund. With much fanfare, on Jan. 12, 2010, Morningstar issued a press release naming him the “Domestic-Stock Fund Manager of the Decade.” It noted this was a new award recognizing fund managers who have achieved superior risk-adjusted results over the past 10 years and have an established record of serving shareholders well.”

How did the “Domestic Fund Manager of the Decade” perform in 2011? According to data provided by Morningstar Direct, his fund suffered a staggering loss of 32.4 percent!

Greater fools thought that Berkowitz had the Midas touch that would continue indefinitely. They assumed there would always be buyers at a higher price for stocks picked by him. They were wrong.

If you purchase any actively managed mutual fund, you are engaging in the GFT. One study (reported here) showed the Vanguard Index fund beat 75 percent of designated mutual funds before taxes for the period 1982-1991. The same study found that its after tax return beat 65 out of 71 mutual funds. When you buy these actively managed funds, you are the greater fool.

Stock picking and over weight in gold are two big mistakes investors make. Many are driven by fear and media hype. The best strategy is a risk adjusted globally diversified portfolio. This takes out the guess work as well as the anxiety.

Please comment or call to discuss how this affects you.

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