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How Clear Is Your Crystal Ball?

"A blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts." Burton G. Malkiel, A Random Walk Down Wall Street, 1973.

How Clear is Your Crystal Ball?

If you were to peek into your crystal ball when deciding on an investment strategy, it would be to see if the market has efficiently priced all stocks trading up to that moment. If the market is efficient, current stock prices fully reflect all information available from every possible source. If important information is not reflected in current prices, the market is an inefficient pricing mechanism and you have an opportunity to generate an abnormally high return by judiciously selecting a few stocks in a strategy to exploit the inefficiency. The issue of market efficiency is the most important factor to consider when creating your investment strategy. Although the academic literature strongly suggests that the market is highly efficient, non-academic studies often suggest otherwise. So, how clear is your crystal ball?

What strategy should I follow if the market is efficient?

Given an efficient market, any guidance about the future you may attempt to gain from studying historical price patterns and previously published financial reports is a waste of time and effort. The implication is that you have no advantage in predicting returns because you do not have access to information not already available to everyone else. Future prices are not predictable but random (cloudy crystal ball), and no actively managed stock selection strategy can be successful. Hence, your investment strategy would be to construct a broadly diversified portfolio to hold for the long term.

What rate of return should I expect if the market is efficient?

Based on historical evidence from 1926 to 2011, Morningstar reports that a broadly diversified portfolio would have generated an average return of approximately 11 percent per year. Today, the investment vehicle for such a strategy would be a mutual fund like the Vanguard 500 Index (MUTF:VFINX) or an Exchange Traded Fund (ETF) like the SPDR S&P 500 (NYSEARCA:SPY). Because 11 percent is an average annual return, the actual return in any specific year would be higher in some years and lower in other years. In addition, some of the individual stocks within the portfolio performed better than 11 percent and some lower. Historical experience also suggests that the longer you hold the diversified portfolio (more than 5 years), the greater the chance becomes that you achieve the average of 11 percent. By following a full diversification strategy, your objective would be to accept the average return offered by the market with no attempt to beat the market.

What strategy should I follow if the market is inefficient?

If the market is inefficient, following a non-diversification strategy based on selecting a few stocks for the purpose of hitting a homerun is your best bet. With such a strategy, you are betting that you can correctly time the buy and sell decision, and that you have the ability to process publicly available information more efficiently than all the other investors in the market. This assumes that your crystal ball is clear.

What does processing publicly available information more efficiently mean?

By whatever technique you use, it means that you are a step ahead of the market. It could mean that you are better at analyzing financial statements and macroeconomic data than other investors. It could also mean that you know more about a specific firm's products and services, or that you have greater insights into global politics than anyone else. Staying a step ahead of the crowd is not easy, but if you can do it you have an advantage that you can exploit. Keep in mind, however, that you are competing with professional investors who have more training, experience, and resources than you.

What kind of inefficiencies have been discovered in the past?

Several studies on "market anomalies" suggest the existence of a few market inefficiencies. One is the "January effect", where stocks generate abnormally high returns in the first two weeks of each year. Other anomalies include a "weekend effect", which says that stock returns are unusually negative over weekends, and a "size effect", which says that small company stocks consistently earn higher returns than large company stocks. These anomalies are so called because empirical studies suggest they exist; if the market is efficient, they would not exist. Developing a strategy based on these anomalies is easier said than done. If all investors are aware that anomalies exist and, therefore, attempt to take advantage of them by buying heavily in late December, selling late in the day on Fridays, or making large purchases of small company stocks, these anomalies would most likely quickly disappear as a result.

Can I, an amateur investor, compete with professional investors?

Actually, you can, if you carefully select the game in which you want to compete. Just like playing baseball, you would have no chance competing against Derek Jeter and his Yankee teammates, but you would have a chance competing against your friends and neighbors who have backgrounds and experiences similar to your own. Just like professional athletes, professional investors have resources and training that you don't have. Knowing the game that professional investors do not play is the game you want to play. Because they control large amounts of money, professional investors usually restrict their attention to large, publicly traded stocks like Apple, IBM, and Exxon. Investing large amounts of money in small stocks is usually a game they cannot play. The small-company game is where you have a chance to compete on a level playing field since this is where your competition is other amateur investors.

How can I recognize small-company stocks?

Three financial metrics are important when identifying small-cap stocks: market capitalization, trading volume, and the percentage of institutional ownership. While no absolute rule exists when using these metrics, a few guidelines will help. First, market capitalization below $500 million will put you in the ballpark of small companies. Companies with market-cap between $500 million and $1 billion are mid-cap, and companies with market cap greater than $1 billion are large cap. Small companies have average trading volume of less than 100,000 shares per day. Large companies like Apple can average 20 million shares traded per day. Finally, institutional investors like pension funds and insurance companies rarely own more than 15 percent of the shares outstanding of small-cap stocks.

What alternatives do I have if I don't want to spend the time and effort to conduct the requisite research for picking stocks?

If you are not willing to spend the time and effort necessary to the conduct requisite research or if you are not comfortable doing this type of research yourself, you should consider a diversification strategy. Investing in an index mutual fund or ETF is quite easy. Even if you hire an investment adviser, you still need to have a view on the strategy you want your adviser to follow. It all depends on how clearly you can see the future in your crystal ball.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.