How Investment Newsletters “Beat” the Market

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You’ve probably seen the over-sized envelopes in your mailbox: “Get the Prognosticator’s Latest Picks,” “We Were Right About Company ABC – Buy XYZ Before It’s Too Late,” “Lock in Returns of 400% or More…” Inside you find a half-dozen various-sized pieces of paper extolling the virtues of yet another investing newsletter, complete with testimonials, a mockup newsletter (usually missing any actionable information), and a pitch which includes a time-limited, discounted offer with several bonuses, if you act soon. Sound familiar?

If you believe that a low-cost, passive indexing strategy is the best investment philosophy for most investors, you may scratch your head, wondering how these newsletter writers can make such brazen claims. You may even harbor some doubts and second-guessing, wondering if you ought to jump on the bandwagon for those promised double or triple-digit returns. The numbers and testimonials certainly look convincing. They couldn’t print it if it weren’t true, could they?

How do they do it? As much as I endorse a low-cost, passive indexing strategy, I do believe there are some bright and/or lucky individuals out there who can beat the market, for a while. In fact, over any time span you choose, 50% of money managers will outperform the market. And 50% will underperform it. The trouble comes with trying to identify them, in advance. It’s easy enough to identify them in hindsight — just read the advertisements.

The investing landscape is littered with the careers of hot money managers who turned cold. Vanguard, among many others, offers data showing that past performance is no indicator of future performance, and might even be a contra-indicator. In one study, more than 70% of U.S. equity funds that were in the first quartile (top 25%) of performance, dropped out of that quartile in the subsequent three years. (See Portfolio Construction, Table 8.)

So how do those investing newsletters get away with such claims? Here is one strategy: Buy 30 random stocks and record their purchase prices. Wait a while, then check the prices again. The way statistics and markets work, you can be relatively certain that 15 of those stocks will have performed above average. And that 3 of those stocks will have performed in the top 10% of the market. So, start bragging about your stock-picking prowess and the outsize-returns you earned on those three stocks. And don’t mention the 27 others….

In fact, this is so easy, let’s start our own investing newsletter. We’ll call it the Early Retirement Sizzling Stock Selector. So where can we get a basket of 30 stocks? How about the popular Dow Jones Industrial Average? Let’s say we bought a few shares of each component stock in the Dow back at the start of 2011. At the end of the year, we ran some advertising for our newsletter. Well, the top three performers in the Dow last year were McDonalds (up 31%), IBM (up 25%), and Pfizer (up 24%). Wow! Incredible! We are geniuses! Man the presses: “Double-digit returns from safe blue chip stocks are possible even in a weak economy, but you must act now….”

So what’s the catch? The catch is that we had to pick 30 stocks to get our 3 winners, and those 30 included big losers like Bank of America (down 58%), Alcoa (down 44%), and HP (down 39%). And nobody really knows ahead of time which of the 30 Dow stocks will be the winners or losers. The readers of our hypothetical newsletter will have to choose, or guess, for themselves. (Or they could just buy all 30 Dow stocks — otherwise known as passive, index investing.) See how it works?

Here’s a real-life example: In one of my many attempts to accelerate the retirement process, I subscribed for several years to a certain value-oriented investment newsletter. This particular one was highly-ranked by an independent third party as having achieving superior investment returns, out of hundreds of other newsletters, over a period of decades. How could I go wrong?

Here’s what I found: The newsletter covered literally hundreds of stocks. And it issued detailed instructions for buying and selling in virtually every issue. It was essentially running an actively managed mutual fund, and I would have to reproduce that on my own — at monumental time and expense — to have any hope of achieving the same returns. Further, the strategy for buying/selling, though loosely based on valuation metrics, often seemed to boil down to the manager’s gut instincts. So it wasn’t really something I could reproduce at a smaller scale on my own.

The average individual cannot effectively manage dozens, much less hundreds, of individual stock positions, without making it a full-time job. In the end, I abandoned nearly all investing newsletters and active management approaches for simple, safe, reliable passive index investing. And, as a side benefit, I now have a little less to read each month!

But, please don’t conclude that investing newsletters have no value. In fact, I learned something about value investing from the one mentioned above. And I credit another newsletter, Richard C. Young’s Intelligence Report, with much of my early investing education. Dick’s conservative, patient, low-cost, value-oriented philosophy is fundamental to my investing world view.

But the primary value of a good newsletter, or blog, is the regular reminder of investing fundamentals, not the stock picking — which will be difficult, if not impossible, to replicate on your own.

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