Jim Cramer's Mad Money Effect: A Winning Strategy?

If you’re having fun investing, then there’s a good chance that you’re not properly diversified, you’re trading too much, and you’re taking too much risk.

—Gregory Baer and Gary Gensler, The Great Mutual Fund Trap.

Millions of people each year visit the Las Vegas casinos. With the exception of a very small percent of professional gamblers, the rest are there for the entertainment value. Knowing that the odds favor the house, while they hope to win, they expect to lose. The expected loss is, in effect, the price of the entertainment. That entertainment includes not only what happens at the gaming tables and the roulette wheels, but also the great singers, comedians, and magicians, spectacular shows like Cirque du Soleil, and amazing performance acts like Siegfriend & Roy. And there are also great restaurants.

While perfectly willing to spend their hard earned dollars on entertainment, the visitors know that it would not be prudent to “invest” their savings at the gambling tables—they are able to separate entertainment from investing. Unfortunately, once they return home, this is not always the case.

Jim Cramer, ex-hedge fund manager, has become one of the most recognizable faces in the investment world. And his show, Mad Money, in which he dispenses rapid fire investment advice, has been wildly successful for CNBC—it is their most watched show with almost 400,000 daily viewers. But has it been as successful for investors who follow his advice? Three Ph.D. students at Northwestern’s Kellogg School of Management sought the answer to this question.

At first glance, the answer would appear to be yes. After Cramer recommends a stock volume soars. For example, the researchers found that on the smallest quartile of stocks volume is almost nine times more than on the day after his recommendation (and stays above normal for about four days, with the effect decreasing with time). The increased demand led to an overnight rise in prices of about 5 percent for the smallest stocks (where they can have the greatest impact) and about 2 percent for the entire sample of the 246 unconditional recommendations examined between July 28, 2005 and October 14, 2005. Unfortunately, the profits turn out to be as illusionary as the tooth fairy—run-up in price completely reverses within twelve trading days. The original gains turn into nothing more than market impact costs. In other words, after costs Cramer’s picks have negative value to investors who act on the buy recommendations. However, the market is so efficient that there may be people that are benefiting from Cramer’s picks.

While the demand for Cramer’s stock picks increases, there is also an increase in the volume of short selling (bets that the stock will fall). In the opening minutes of the day following a recommendation short sales increase to almost seven times their normal levels, and they remain elevated for three days. Who are these short sellers? Likely candidates are hedge funds who are exploiting the naivete of individual investors. Through their actions, short sellers are helping to keep the market efficient.

There is another group that benefits from Cramer’s recommendations and the actions of naive investors. Market makers in the stocks of the recommended companies benefit from the greatly increased trading activity.

One other point is worth noting. The authors found that the stocks that Cramer recommends have excess returns for the three days prior to his actual recommendation. They provide two logical explanations for this behavior. The first is that Cramer is simply recommending stocks with short-term momentum (of which there is evidence, although after trading costs the positive momentum is difficult, if not impossible, to exploit ). The second explanation is that there is leakage of information as to which stocks he will recommend.

The Moral of the Tale

The moral of this tale is that while it is fine to render unto Caesar’s Palace your entertainment dollar, you should not be rendering unto Wall Street your investment dollars. While Cramer might be providing entertainment (if you enjoy screaming, chair throwing, ringing cash registers, and shouts of booyah!), those following his recommendations are like lambs being led to be sheared by more sophisticated institutional investors.

Both CNBC and Cramer attempt to make investing entertaining so you will pay attention. That is the winning strategy for them. It is also the winning strategy for brokerage firms and market makers because your actions make them money. But it is not the winning strategy for you. Investing was never meant to be entertaining. Instead, investing should be about giving yourself the greatest chance to achieve your goals with the least amount of risk. Research shows that investors harm themselves, on average, with every trade they make that results from paying attention to what is nothing more than “noise” (which Cramer certainly makes a lot of). The prudent strategy is thus to build a globally diversified portfolio and have the discipline to adhere to it, ignoring the noise of the market, whether it comes from Jim Cramer or any other prognosticator. As Steve Forbes, publisher of the magazine that bears his name stated: “You make more money selling the advice than following it."

_{Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).}

_{His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.}

Comments

[Dan Carty]

If you do some homework and apply some rules to Cramers picks (like I do with my "Cramer Portfolio Strategy"), the returns are very good. This is just another one of those studies that attempts to knock Mad Money down. I think the show is useful as it provides Ideas - one does not have to buy or sell anything. It is to be used as part of an overall strategy. Using Mad money, to date, I have earned almost 18% (actually from September). So Mad Money does add value from my perspective. Dan Carty (tradersinsights.com).