In a previous post I explained how it is possible for superior investors to beat market averages by focusing on long-term value instead of short-term stock prices. This is the exception to efficient market theory. This can make it tempting to become a stock picker. Confidence can be dangerous. Before you jump in believing that you can beat the stock market average, understand that most people who try to do this will fail. It’s not possible for most people to be above average. Add to this the trading costs and volatility that come with individual stock picking, and most stock pickers will make less than the stock market index. Another problem is that it takes a very long time to tell if you have a talent for judging to true value of companies. An investor could just be lucky for 10 years and then suffer disastrous losses because he really doesn’t know what he is doing. By the time you have invested long enough to know whether you are a good stock picker, much of your investing life...

According to proponents of efficient market theory, it isn’t possible to do better than market averages by picking your own investments. New information gets incorporated into stock prices almost immediately making it impossible to profit from this information. On the other hand, there are a handful of people like Warren Buffett who have outperformed stock market averages for so long that it couldn’t possibly be a fluke. Both sides in this argument make a strong case. But who is right? As usual, the answer is somewhere in between. Price vs. Value At any given moment, the price of a stock is determined by the crowd of people making bids to buy and sell shares. If some good news comes out, the stock’s price will shift upward due to the change in bids coming from the crowd. The crowd isn’t necessarily right, though. A stock’s true value, which is based on the company’s future prospects, could be $20 even though the crowd sets a price of $10. But this doesn’t necessarily mean that yo...

Why does the stock market give higher returns, on average, than bonds or interest on cash? We can observe that this has been true in the past, but why is it true? There are many ways to answer this question, but I’ll pick just one. Everything else being equal, people tend to prefer lower risk investments. Most people would take a sure 5% return over an investment that has a 50/50 chance of giving either 0% or 10%. It’s just sensible to reduce risk if you can do it without giving up anything else. All investments have some type of risk. With an individual stock, the main risk is that the company will produce lower than expected profits. Stocks are riskier than bonds and interest on cash. So, stocks have to offer higher returns than bonds and cash to attract investors. Suppose that most people believe that the stock market will give lower returns than bonds for the next decade. This would cause people to sell stocks and buy bonds leading to stock prices dropping and bond pr...

I finally got around to doing my incomes taxes. I’ve been using QuickTax for several years now, but there are so many other choices now that I almost chose something cheaper. In the end, I decided to stick with the annoying software I know instead of some new, likely annoying, software. For the most part, QuickTax works well as long as you know what you are doing. There is no substitute for understanding the tax system and knowing how different deductions, income, and transactions will affect your total taxes owed. QuickTax will help with getting some choices right, but it can’t save you from everything. Upgraded Versions My main criticism of QuickTax is the constant attempts to get people to upgrade to more expensive versions of the product. I get along fine with the “Standard” version, but the confusing product feature lists make it seem like you need to upgrade to “Platinum” if you have any dividends or capital gains. Even while going through the built-in interview proc...

I like pennies. More specifically, I like old pennies, and other old coins for that matter. I’m not much of a collector, but I have a few coins that are worth $5 or $10 each. A Winnipeg MP, Pat Martin, is expected to introduce a bill to eliminate the Canadian penny. See this Wikipedia entry for US efforts to eliminate the penny. Despite my fondness for old coins, I don’t like getting pennies in my change. Pennies are worth too little now to consider them to be money. We give a penny and take a penny, but it doesn’t really amount to anything. Handling pennies is like worrying about a decimal place in your weight. “I weighed 175 pounds yesterday, but today I weigh 175.1 pounds! Let me just take these pennies out of my pocket. There we go. I’m back down to 175 again.” The truth is that pennies should have been eliminated decades ago. We’ve waited so long that we really should eliminate the nickel and dime as well. We could get along just fine if cash transactions were rounded to t...

A reader, Jay, left comments on my market timing experiment asking specifically about strategies that buy after a market drop, and sell after the market rises. The theory behind these strategies is to buy low and sell high. I ran some experiments to test this approach. As in previous experiments, the investor decides each month whether to be invested in the S&P 500 or not. The goal is to avoid months where stocks drop in value. I ran the experiments on S&P return data from December 1990 to March 2008. The first thing I tried was to assume that the investor would be invested in the stock market at the beginning and would proceed as follows: 1. If the money is in the stock market, and if stocks are priced at least 5% higher than they were one, two, or three months ago, then sell. Otherwise, stay in the market. 2. If the money is in cash, and if stocks are priced at least 5% lower than they were one, two, or three months ago, then buy stocks. Otherwise, stay out of the mark...

I hope that everyone who read this morning’s version of this post (see below) figured out that it’s an April Fools’ joke. All I did was examine past S&P 500 returns and concoct the silly “zone theory” to exactly pick out which months had negative returns and avoid them. Following this theory really would have returned 28% per year. But, anyone could make money knowing future stock prices in advance. Zone theory was tuned perfectly to past data, and there is no reason to believe that it would work in the future. There is also no reason to believe that you can predict what will happen next month by looking at a stock chart for the past few months. What will happen depends on information that just isn’t in the charts. So, forget about zone theory and other crazy market timing theories and invest for the long term without obsessing on short-term fluctuations. Market Timing Breakthrough! After wasting so much time trying to show that market timing can’t work, I stumbled across an amazin...