Tuesday, February 27, 2007

It's Great to be Average!

For my first post on this new blog, I want to relate a conversation I had with a friend earlier today. My friend recently invested in shares of EMC (NYSE: EMC), and did so based on information that the company is about to spin off their VMWare division. Although EMC may be a good investment (I don't know), I am questioning the wisdom of buying and selling individual stocks.

The typical investor gets most of his information from the mainstream news media. This information is widely known, and in all likelihood the same information is known to professional traders, brokers, investment bankers and research analysts (unless you are using illegal insider information). If the "big boys" have access to the same information they have probably acted on it and the price you will pay for the stock already reflects the good or bad information you are using to make your trading decision. In other words, the information you plan to use is probably already priced into the stock.

What strikes me as amusing is that in every stock transaction there is a seller and a buyer. The seller sells the stock because he thinks the price of the stock is about to drop. Of course, the buyer buys because he believes the opposite. If you trade a stock you are essentially betting that you understand the market better than the guy on the other side of the deal. However, the guy on the other side of the deal is probably a professional or institutional investor who gets paid to know the market and who specializes in a narrow group of target companies.

While most people never dare to claim that they can beat a professional tennis player in a 1:1 tennis match, and most sane individuals will not try to beat a professional race car driver at his own game, many think they can beat the professional investors at stock picking. Can anyone tell me why that is?

Now the punch line: research shows that most people can achieve better returns on their investments than can a professional investor. The strategy for success is simple: invest in an index fund and don't trade. This strategy essentially guarantees you a return equal to the average market return. Most professional investors under perform the market.

In summary: if you are both picking stocks, the professional investor has an advantage. He has more information and investing is his day job. Even armed with all this research and information, the typical professional investor will under perform the market. You as a private individual have an even smaller chance of beating the market by picking stocks, but by indexing you can assure yourself of average market returns.

Here's to being average.

No comments: