4. Investment Strategies That Turn Into Portfolio Nightmares

“Adventure. Excitement. A Jedi craves not these things.”

Yoda, The Empire Strikes Back

There are some stocks that are going to outgain all comers—Apple Computer comes to mind; Google was certainly ruler of all it oversaw for years—but most of the returns that investors can generate now will come from effectively dividing up one’s assets among different asset classes rather than worrying about individual names. Investors in recent years have generally been better off sticking to a broad investment strategy and eschewing individual stocks, which, by themselves, can do a variety of damage to portfolios.

The S&P 500 had a terrible year in 2008, losing 37 percent. But it is possible to construct a “nightmare portfolio” of some of the biggest, well-regarded stocks in the entire investing universe that would have made the S&P’s losses that year look like a rounding error.

Names such as American International Group, the insurance giant that was brought low by exposure to derivatives; or the likes of Citigroup and Bank of America, supposedly safe institutions that borrowed a ton of money and used it to take big positions in poor-quality mortgage loans, or auto giant General Motors, which finally succumbed to heavy debt costs and the loss of competitive edge and was eventually restructured. The financial shares stand out as the most insidious investment of this period. There’s no doubt that the banks were earning a mint during this period, but the delusion that arose was that risk had effectively been managed out of the market through the proliferation of complicated derivatives, mortgage-backed securities, and structured investments. These are notions to run from—the idea that fundamental dynamics that define investing have been repealed due to some sort of great invention that changes everything as we know it.

Perhaps it’s unfair to pick out only the biggest, most obvious losers in 2008. But there were plenty of other stocks that were not forecast to take a walloping, but did so anyway. (We’re making the assumption that most investors would have seen the problems at GM and Citigroup coming, but could not foresee the issues elsewhere. Investors are inherently convinced of the market’s place as a forward-looking indicator, and yet the Dow Jones Industrial Average managed to reach a new all-time peak in October 2007, just two months before the official beginning of the lengthy 2008-2009 recession.¹)

But there was also the likes of aluminum giant Alcoa, which saw its share price fall to $6.23, lowest since 1988 as the economy fell off a cliff. One could even include General Electric, a massive conglomerate with its hands in everything from jet aircraft to financial advisory business to, of course, light bulbs. But that stock saw its credit rating slashed and was forced to cut its dividend amid terrible results in 2008; shares fell 56 percent that year.

In theory, beating the market is possible through effectively understanding when to buy certain sectors based on where in the economic cycle one happens to be, using certain measures of valuation, sentiment, and momentum to understand stock patterns, and through risk management that limits downside when one is taking big risks.

That all sounds nice. The reality is that professional investors have a difficult enough time divorcing themselves from their emotions not to want to chase popular investments for fear of being left behind. And markets can remain irrational long enough to convince nominally intelligent people to take risks that fall outside their stated investment parameters. Extended rallies in the market during periods where volatility indexes were calm (reflecting relatively benign and small daily movements in individual stocks and major stock averages) engendered a belief that investors could increase their risk without adverse consequences. And those who try to time the market, based on one’s understanding of the economy, will find it to be quite the task.

That may sound trite, but sometimes trite makes right. Warren Buffett, chairman and CEO of diversified holding company Berkshire Hathaway Inc., and regarded as one of America’s most prescient investors, said in his 2004 letter to his clients that it should have “been easy for investors to earn juicy returns” over the last 35 years by piggybacking on the success of corporate America. “An index fund that they never touched would have done the job,” he wrote. “Instead, many investors have had experiences ranging from mediocre to disastrous.”²

That’s because for the most part they’ve been buying individual names. And popular literature aside, there are a lot of stocks that fail over time. The Center for Research in Securities Prices, which is run by the University of Chicago’s School of Business, has more than 28,000 stocks in its extensive database going back to the beginning of the 20th century. Of those, just about 12,000 stocks are trading, and of those, only about 3,000 are really liquid, frequently traded names. Eric Crittenden, research director at hedge fund investment company BlackStar Funds, pointed out in a commentary that there are many more stocks that completely tank, losing almost all of their value, than people would expect. Crittenden looked back and found that between 1991 and 2008, the expectation was that 278 stocks would lose at least 75 percent of their value in one year. In reality, there have been more than 2,100, according to Crittenden. He believes that expectations for catastrophic losses are underestimated because people exclude stocks that went bankrupt and took their listing off publicly traded exchanges. “This isn’t in their database—all the delisted bankrupt defunct stocks fall out of the database,” he said. “They look only at stocks that are currently traded today—that’s going to cause a certain amount of survivorship bias.”

Why does that matter? Because it gives people the idea that there’s a floor on the losses of all but the absolute worst and leaves people oblivious to the risks in lesser-known stocks. Many of the stocks in question are fad-oriented, names that grow in popularity for a short period of time before tumbling to the depths when it becomes clear that they don’t have the earnings or demand to justify their high valuations.

But instead of using index funds and allocating funds in a disciplined fashion to various asset classes, many investors chase those fads—when, as we shall see, early investors in industries that eventually changed the fabric of society often ended up poorer because of so many failures in the early days of various companies in those industries.

The “Experts” Fallacy

Many of you have probably at one point or another allocated some of your money to funds that were expected to do well because they were highly rated by fund ratings company Morningstar or because of past results. But it doesn’t take much for an investor to destroy all of the previous gains he had worked to accumulate over previous years.

The most famous example of this is probably Bill Miller, chief investment officer at Baltimore-based Legg Mason, whose signature fund, Legg Mason Value Trust, beat the S&P 500 for 15 consecutive years, a record few can match. As the bull market wore on through the 1990s and the middle of the last decade, Miller’s legend grew as he was one of a few to stay ahead of the S&P 500 year-in and year-out. In that time, he built the kind of reputation that attracted more and more investors to his fund, which eventually peaked in size at about $20 billion in assets. In 2003, his 44 percent return crushed the S&P 500, ranking him in the top 1 percent of all large-cap blend funds for that year.

But the good times couldn’t last forever. Miller suffered through middling years in 2004 and 2005, but he still stayed ahead of the S&P 500. In 2006, Miller’s fund returned just 5.9 percent, and that year marked the second in a row that he trailed the average fund in his category, but this time, he failed to beat the S&P 500.

It got worse in 2007, when his 6.7 percent loss ranked him in the bottom 1 percent of all similar funds, according to Morningstar data. That year, the market managed a 5.5 percent gain, and Miller’s style—contrarian value investing, as Barron’s put it—proved horrific in a market dominated by rising inflation and strong economic growth. The environment in 2007 favored high-growth cyclical stocks such as the oil and gasoline names, as well as commodity-related shares. Those stocks soared, and Miller’s holdings languished.

Everything came crashing down in 2008, however. The S&P 500 tanked in 2008, falling 37 percent, but Miller made those losses look like a safe haven. His fund plunged 55 percent, and the manager that had made all other managers look silly for more than a decade ended up ranking as one of the worst in his category over the previous ten years.

This slump was bad for long-term investors in the fund, as it becomes harder for someone later in life to make up for substantial losses in one’s portfolio (for someone at the beginning of his investment horizon, a loss on a relatively small amount of assets can be recouped more easily). For newer investors enticed by Miller’s track record, this was a disaster for them, too. It was at the peak of Miller’s performance that the most assets were attracted by his fund—and those people who got in then, expecting big gains from a money manager who could put all others to shame, have been battered all over the place. But there are very few professionals who can consistently stay ahead of the market for an extended period of time who are also accessible by individuals.

In his book, The Little Book of Common Sense Investing, published in 2007, former Vanguard chairman John Bogle points out three funds that have been in existence since 1970 that have managed to outperform the S&P 500: Davis New York Venture, Fidelity Contrafund, and Franklin Mutual Shares. Because investing is a zero-sum game (that is, someone’s 20 percent gain comes at the expense of someone else shouldering a big loss), there are bound to be a few winners. Still, it’s notable that according to Morningstar data, at the end of 2009 Davis New York Venture sported a ten-year annualized return of just 0.84 percent (for investor returns, which factors in the drag on performance as a result of inflows, outflows, and taxes).

Many individual investors do the same as Mr. Miller in a quest to beat the averages. The litany of professional investors struggling to come out ahead of the market, and the reality that most fail to do this for more than a few years running, should be evidence enough for most individuals to reconsider what is a somewhat futile quest to outdo that which cannot be outdone without great pain. Yet regular folks who manage their own accounts tend to concentrate on their stock picks rather than on effective cost controls or risk management. The popular media and advertisements for the discount brokerages cater to this attitude that it’s easy to figure it all out. The late 1990s were littered with commercials from the brokerages urging investors to get into the game, and lately those ads have made a roaring comeback.

This populist approach was appealing to investors amid a climate where they were being forced to depend more on their own resources to build a retirement nest egg. Social security had started to be viewed as the small, supplemental portion rather than a mainstay, and company pensions were receding as the favored retirement vehicle. With the 401(k) and individual retirement accounts becoming more important, investing became like home improvement—the province of do-it-yourselfers.

The difference is that investing is a bit higher on the curve in terms of knowledge needed than home improvement or landscaping. It’s not quite on the level of medicine (one wouldn’t operate on his own body), but it is more complex than simple house repairs (and after all, a plumber can always fix an overzealous handyman’s mistakes). There’s no do-over for retirement.

But for about two decades, investors weren’t punished for excess, working through a long period of moderation where inflation cycles were short and downturns even shorter. Market gyrations were relatively safe to ride through, and that left investors who had until now little experience in the market with a sense of invincibility, one that’s been punctured, time and again, in the last decade.

It’s all just enough information to make people dangerous. Instead, one might ask, how can I spend my time figuring out proper asset allocation and understanding what my cost is? Jack Ablin, chief investment officer at Harris Bank in Chicago, and author of Reading Minds and Markets, says investors who already devote hours to trading have plenty of time to shift away from this to taking a more holistic approach. “You should take the time you would have done trading and apply it to this,” he says. “Not only will you be able to make more consistent, more valuable decisions, you’ll have some time left over,” he said. Here, again, he credits the 24-hour, seven-day-a-week trading culture propagated in the media for the obsession with short-term movements in markets that dooms so many individuals. “Markets move a lot slower than people think and more deliberately...the markets news shows have to be on every minute of the trading day, and will often give investors a false sense of urgency.”⁴

It isn’t just the shows themselves; it’s the advertising, which usually promotes whatever widget a particular company can offer that supposedly sets it apart from the rest, and focuses on the do-it-yourself-style empowerment principle. One such ad for E-Trade Financial that does this features a talking baby going on about his stock-picking prowess.

Another 2009 commercial for TD Ameritrade notes the charting capabilities available for individuals on its Web site, even though trusting charts, particularly in the absence of other information, is a rather perilous way to invest. Burton Malkiel, in his seminal A Random Walk Down Wall Street, has pretty harsh words for those who devote their time to chart patterns, because ultimately the charts will at some point fail to act in the preconceived pattern that is anticipated. This commercial features fresh-faced individuals noting things like, “look at that head-and-shoulders pattern!” in a ridiculously chipper voice, jabbering on about “pattern matching,” as if finding such market patterns can be used as the basis for trading or investing, and if charts can’t betray you down to your last dollar.

These advertisements don’t point out how transaction costs will destroy most investors’ attempts to beat the market over the long haul, but then again, they really don’t concentrate on the idea that people should be saving for decades down the road anyway. They’re primarily concerned with here and now, and anything that will entice you to do more trading, which boosts their revenue without making anything better for you. Charts and expected outcomes have a way of failing people; Long-Term Capital Management found that out in 1998 when the hedge fund brought the financial world to a standstill as a result of complicated bets that were designed to take advantage of movements in assets that ended up going the opposite from everything that was expected.

Steak Versus Meat Loaf

Without a doubt, endless repeating of bromides about diversification and cost containment would make for boring television. Sex sells, and stocks bouncing up or down are a sexier story than telling someone to save their pennies, invest in index funds, and be patient. (If winning the great game of buying and selling stocks is the sizzle, being patient isn’t even the steak, it’s dried-up meatloaf as far as marketing is concerned.)

This is why people would rather pick stocks, because there’s an element of surprise to it. But popular financial business media makes this the centerpiece of its content, regardless of whether it is CNBC or Fox Business or various investing magazines. (Disclosure: I have appeared on Fox Business several times.)

Again, the best advice that one can get—saving money, diversification, paying attention to long-term goals—has an “eating your vegetables” quality to it, and it is understandable that financial media will not simply repeat the same advice, time and again. Yet the industry still remains caught up in the “stocks you should buy now” phenomena, with all of the razzle-dazzle associated with it. One of the primary reasons for this is the exclusivity factor. Everyone has heard the mantras about saving and being cautious; not everyone has heard that a particular IPO is going to soar through the roof when it starts to trade; not everyone has heard about a prominent analyst upgrading a company’s outlook that will put a jolt into the shares; not everyone has heard that there’s a load of bearish action on one company in the options market. Having access to these “secrets,” so to speak, is exciting, and it fuels interest in company shares. Very few investing chat rooms survive long talking merely about diversification strategies, but message boards focused on particular stocks on popular Web sites such as Yahoo thrive, with rapid-fire commentary (most of it crude, uninformed, and grammatically speaking, an epic disaster) throughout the day.

For the three years I was the writer and editor of the Wall Street Journal’s MarketBeat blog, I found the Web site got the most interest during the meltdown days of 2008. Readership spiked during the Bear Stearns blow-up in March 2008, and again during the entire August-to-December period of 2008 when Lehman Brothers went down, AIG became a ward of the state, and prominent financial institutions Washington Mutual and Countrywide Financial collapsed. The readership was often highest when writing about options-related activity in shares of those stocks, along with the perennial favorites, Google, Apple Computer, Research in Motion (the maker of the BlackBerry wireless device), Dendreon (a biotech company that was developing a prostate cancer treatment), Crocs Shoes (a favorite momentum play), and a few others. The volatile nature of these stocks kept interest high, and market enthusiasts still look to names of those types as trading opportunities. Citigroup, for instance, remains one of the most actively traded stocks on the New York Stock Exchange on a daily basis, and Google and Apple are usually among the daily leaders for volume on the Nasdaq Stock Market.

Several prominent investors interviewed for this book told of their appearances on CNBC and a desire to make broader points about market activity or approaches for retirement, but the channel gears itself towards whatever happens to be hot on a particular date. The channel might argue that it has changed its approach, but that’s hard to believe when you see noontime anchor Tyler Mathisen teasing the next segment by noting that eBay had hit a new 52-week high and asking, “Should you buy it now?” CNBC is not alone among this kind of investing advice—magazines for time immemorial have been touting the next hot mutual fund and the stock to buy now, because repetitive pronouncements of the prudence of diversification wears thin rather quickly, and this does not sell many issues.

Nobody exemplifies the short-term trading mentality more than Jim Cramer, who is willing to ramble at length about a litany of companies that most have only a passing interest in. Oddly enough, the advice Cramer espouses in his 2005 book Real Money: Sane Investing in an Insane World, is relatively sound for the investor who shares a similar passion for investing as the manic former hedge fund manager. He suggests that people devote only a portion of their assets to speculation, while the rest probably should be invested in stable assets and low-cost vehicles like index funds. As far as buying stocks, Cramer suggested in that tome that the investor who wants to diversify should have positions in 10 to 15 stocks (ideally at least five), and should spend one hour a week doing homework on those names. So that’s 10 to 15 hours a week. For some—like Cramer, who has an adrenalin level probably only matched by people running from hired killers—this is easy, and those who want to try to use diversification and a bit of speculating through purchases of single stocks should probably be reading that book rather than this one.

But many don’t have that kind of time, and without it, it’s impossible to get the kind of edge one needs to beat the market—something Cramer himself admits. “Investing can be a hobby, but trading can’t,” he wrote, noting that his wife, Karen, “is a fabulous trader,” but “has failed miserably as a part-time trader.” He says that those who cannot treat it as a job should look to professional management or some other way of investing their assets.

Furthermore, one essential truth that’s been discovered by many a researcher is this: Professionals who devote their lives to the task have a hard time beating the market, and the average person tends to do even worse, particularly lousy at picking stocks. Those who trade more tend to compound their problems by layering in extra costs: In 2000, Berkeley professor Terrence Odean and U.C. Davis professor Brad Barber wrote a paper that examined trading costs among retail investors, looking at nearly 67,000 households with brokerage accounts, and found that the average household was outperforming between 1991 and 1996. They managed an annualized gross return of 18.7 percent compared with “an investment in a value-weighted index,” which earns a mean return of 17.9 percent.⁵ Not so bad, right? But once you factor in the overhead—the difference between bid/ask spreads, along with commissions—the trader’s performance fell short, earning an average 16.4 percent annually.

That’s not to say one should give up on investing altogether, or accept the idea of buying and holding and hoping things work out for the best. Many people did that in the last 20 years, and they ended up losing money at the point when they could least afford it. Others just made bad decisions at all the wrong times—the buy-and-hold investors who pay cursory attention to their portfolio run a greater risk at panicking at the wrong time. They’re jarred awake to find the market is diving, they haven’t examined their portfolio in months, and they sell shares amid a frenzy only to see bargain-hunters scoop up undervalued holdings that then go on to profit from strong rallies that follow.

Plausible Fads

One of the essential contradictions in investing is the desire we have for big returns and little risk. It’s the thinking that drives the creation of, and demand for, products like mortgage-backed securities and complicated derivatives, assets that will supposedly be all things to all people. It’s what drove so many people to blindly trust Bernard Madoff, because unlike other secretive managers, Madoff promised normalcy when all others promised the moon, and that (along with the exclusivity promised only to well-heeled, well-connected folk) drove the interest in his investments.

This applies to the stock market as well. Big dollars have been lost over time in short-lived fads, where a particular sector becomes overvalued on lofty expectations for something more than can be delivered. The last true fad was the 1996-1999 period, when Internet stocks proliferated due to cheap credit and on expectations that the invention itself would revolutionize various industries by increasing productivity and improving communication.

The thing is, the Internet did all of these things, and yet, most of the stocks devoted to online retail—business-to-consumer activities—disappeared. Networking companies and those that provided security software thrived, such as CheckPoint Software Technologies, but Webvan, Pets.com, Furniture.com, Kozmo.com, and others all went away. Some did well, such as Amazon.com.

There have been other fads grounded in even stranger ideas. Bowling stocks became popular in the 1950s when automatic pinresetting machines became the standard, and investors became convinced that this diversion was set to become the country’s biggest pastime. This did not work out so well. Solar energy stocks dominated the action among day-traders expecting an explosion in demand for photovoltaic tubes and other products designed to capture the sun’s rays. Those stocks soared between 2003 and 2007 before falling under the weight of unrealistic expectations in the latter part of the last decade. There was a brief flurry of interest in stocks of vending-machine companies in the 1960s, while shares of movie theater companies also boomed for a while before dropping off the face of the earth around the same period of time. Such fads, particularly vending machines and bowling shares, are usually brief, and flame out quickly.

The more insidious manias, however, are those that either represent a rethink of the traditional role of a particular sector in the economy, or introduce a new technology that really does cause an alteration in the lives of people. Compared with a fad stock such as Crocs, maker of goofy looking shoes, the Internet is a much bigger, all-encompassing story that is easy to believe, and changed American life in a way that, say, bowling companies or the makers of Crocs shoes do not.

All at once, the market, being a discounter of future growth but also trafficking heavily in fears, wants, and hopes, overstates the case for the worth of a particular sector. To an outside observer, the Nasdaq Composite Index’s ascent—it doubled between May 1999 and its peak in March 2000, just ten months—doesn’t make any sense. To those participating in this historic boom in technology shares, it wasn’t to be questioned, just enjoyed. A decade later, the index is still having trouble reaching half the value it enjoyed at its peak. Many of the bellwether shares of that fateful period have long since been absorbed into other companies.

Some of the memorable companies that sprang up during this period were a health Web site led by former attorney general C. Everett Koop, along with Pets.com, a pet-oriented retailer with a well-known mascot, a sock puppet. In retrospect, these companies were easy to understand—they were mostly e-retailers, selling goods in a particular niche over the Internet. That’s a perfectly fine business model, but not one that was able to become profitable on a large-enough scale to satisfy investors in their stock. (One could see the steady demise of such names—a popular site called Kozmo.com offered to deliver just about everything to one’s house, like movies and video games...eventually one had to start buying ice cream, and then the minimum delivery charge rose, and so on and so forth until the company died, victim of an unsustainable model.)

Some companies of this type thrived, obviously—Amazon.com exists to this day, and eBay is going strong as well. But Amazon was a rare case, and the stock languished for years before making a comeback about a decade after its pinnacle. eBay thrives mostly because it’s the leader in what is essentially the world’s biggest yard sale—and they’re just a facilitator, not bothering to weigh themselves down with such overhead as inventory. Most disappeared; though many remember the sock puppet.

The more worrisome kind of fads, if they can be called that, is when well-regarded large-cap stocks or sectors start to dominate the equity market, and their value rises to a level considered incompatible with the growth potential of those companies. These manias are more terrifying, because they are based on a few semicoherent principles of investing. Well-known, generally strong investments are put on a pedestal, regarded as impervious to the whims of the market, so great is their dominance.

Things get even more perilous for investors who blindly put money into established companies (rather than new ones, which most understand is a speculative endeavor), anticipating few problems. Following the technology bubble, there were a group of shares that were thought to be impervious to the pain being experienced by most of the stocks in the market.

Even though many recognized the speculative nature of the market, some, such as Microsoft, semiconductor maker Intel, software giant Oracle, networking colossus Cisco Systems, and perhaps a few others, were considered those that couldn’t go wrong. And without a doubt, those shares were better investments than many of the other names that experienced their heyday in the late 1990s.

But these four stocks—the Four Horsemen, as some referred to them—were drastically overvalued, and their performance reflected it as earnings sagged in the middle of the decade. After attaining peaks in 2000, the stocks have largely been what investors call “dead money,” stocks that can’t possibly justify their valuation and therefore trade sideways, or drift lower, for several years. Since the beginning of 2001, Microsoft has recovered, rising about 14 percent. However, Cisco is off by 41 percent, Oracle has lost more than 21 percent of its value, and Intel is down about 33 percent. In that time, the S&P 500 has given up about 18 percent, making only Microsoft an outperformer during that time period.⁷

Looking at a better buying opportunity—the market’s trough in late 2002—produces more acceptable results for the other two names. Between October 2002 and late April 2010, both Cisco and Oracle had more than doubled. Intel was a relative laggard, rising 66 percent, and Microsoft rose 41 percent, but that lagged the S&P 500’s 46 percent gain. It’s not as if all of these companies aren’t sound businesses, earning tons of money, and providing employment to thousands. But their prowess earned them the unfortunate status as a stock where decisions didn’t need to be made, other than to find a nice spot to tuck away one’s share holdings until waking up for retirement in 20 or whatever-odd years. And if you’ve engaged in that strategy, vainly holding onto those stocks from the top of the market under the supposition that they would be bound to come back, you’re still fighting an uphill battle.

This isn’t the first time a group of specific stocks was anointed the status of Teflon investment. In the 1970s, there was another, larger group of names. They were called the “Nifty Fifty.”

This share group was sort of the original list of “buy-and-hold” stocks. They were called “one-decision stocks” because investors were told they could buy the stocks and hang onto them forever. This was in the 1960s and in the early 1970s, and for a time, names such as CocaCola, IBM, and General Electric were justifiable as portfolio stalwarts.

To proponents of this strategy, these stocks were the kind of investments that would be money good for forever and a day simply because of their size and earnings prowess. This notion, of course, is ludicrous. Once stocks hit a certain level of valuation, and cannot justify their high prices, all that’s left is the greater fool theory—that someone will always find the stock compelling at an even higher price. Really, that’s what stock investing is—finding someone who will value your investment at something greater so you can sell it. When that fails to happen (and it can fail to happen for a number of years), you’re sunk.

Well, things got messy in the mid-1970s during a period of substandard growth and rising inflation. The years between 1968 and 1982, when stocks were essentially flat, were good ones for active investors who knew when to capture the market’s ups and downs. Those who let it ride on stocks that were supposed to be safe were disappointed mightily. Not all of the Nifty Fifty were bad companies—Coke and IBM are clearly going strong today, employing tens of thousands of people and dominating their markets. But returns were elusive for some time.

Some companies, such as Xerox or Polaroid, started to have trouble, while others were discovered to not have been immune to the vagaries of the stock market. The Nifty Fifty was buoyed for some time by investor enthusiasm for these names, despite their lofty valuations, noted Jeff Fesenmaier and Gary Smith of Pomona College in Claremont, California.⁸ Certain stocks were laughably overvalued, such as Avon, which traded at 65 times forward earnings expectations.

There is disagreement as to what stocks were definitely in the Nifty Fifty. There are several lists that existed during that particular time, and a list used by Jeremy Siegel, Wharton School of Business professor, does not match that of other lists. Fesenmaier and Smith note that the stocks in question were generally those that were overvalued by most conventional measures, yet were excused from typical valuation because of the long-term potential of these companies, and their place of importance in the U.S. economy.

There were lists maintained by brokerages Morgan Guaranty and Kidder Peabody, and the Pomona professors found that there were 24 stocks that appeared on both of these lists. All were accorded very high valuations during the early 1970s. “With the spectacular exception of Wal-Mart, the glamour stocks that were pushed to relatively high P/E ratios in the early 1970s did substantially worse than the market, in both the short and long run,” they write. Wal-Mart Stores has posted strong returns over the next 37 years; in fact, from 1972 through 2001, just two other stocks posted a better annualized return, according to the University of Chicago’s Center for Research in Security Prices; the others are SouthWest Airlines and Boothe Computer, later bought by Robert Half International.

Most of the others, even McDonald’s, Walt Disney Co., or oil service giant Schlumberger, were pedestrian performers when compared with the S&P 500 over the next 20 years. (Some of the names are mind-boggling: Schlitz Brewing is in the group, for instance, along with fellow beer producer Anheuser-Busch. Sure, everyone drinks beer, and continues to drink beer, but until the entire country develops an alcohol problem, their market share is going to be limited, which is the kind of thing that should have been easy to spot.)

There’s a common factor between these stocks and the recent run in the banking names, or even the telecommunications run-up in the late 1990s: All of these strategies have a veneer of plausibility behind their ridiculous valuations, and in that respect, it makes them more dangerous than the manias that surround oddball sectors or inventions that are new to the market. A lot of us recognized the silliness of some Internet ventures, but how do you tell someone that IBM is a bad investment? How do you suggest that Xerox, with its ubiquitous copy machines, is a poor investing idea? It’s not speculative—at the time, it was a well-known brand that had a lot going for it, including steady earnings and name recognition. But that doesn’t mean it was going to maintain a real value.

The Nifty Fifty were said to be able to justify their high value because the stocks in question were high-growth names and leaders in their respective industries. “The usual moral of the Nifty Fifty story is that investors became too enamored with growth stocks in the early 1970s and pushed the prices of their favorites to unjustified heights,” the professors wrote. Sound familiar? The run-up in banking stocks in 2006-2007 was said to be justified because cheap credit and rising real-estate values would underpin earnings for those companies for years to come, and, after all, they were large companies that were leaders in their markets. Telecom companies, in the late 1990s, were thought deserving of their valuations because the entire world needed to be linked via cable or some other device. The early 1980s featured a strong run in oil and gasoline companies benefiting from the tight oil supplies that briefly boosted the price of crude oil to $100 a barrel.

But these strategies, eventually, were all brought low, or as a columnist in Forbes put it at one point, “People didn’t stop buying the Nifty Fifty until every one of those stocks was taken out and shot.”⁹

What’s the lesson from all of this? It’s that you cannot expect to garner strong returns because you’re buying a stock that’s considered beyond the pale in its long-term outlook. It’s much too simple a philosophy, resting on the idea that stocks will always justify higher valuations because of anticipated growth, when even the safest of stocks can become overvalued and remain that way for a number of years, such as Pfizer did in the early part of the 2000s, or as Microsoft or Intel did around the same time, or JP Morgan Chase and the other banks in the latter part of the decade. Psychologically, it holds appeal because it promises outperformance but only with assets that are viewed as having an innate quality—but such investments don’t exist. Stocks can be rewarding as an asset class, but they are not devoid of risk, and you should hesitate to invest in any area of the market—be it a sector or a group of companies anointed as market saviors—and consider it a substitute for buying the entire market, much less corporate debt, government bonds, or other safer assets.

Gone to the Dogs

There are other strategies that combine an investor’s psychological desire for safety and predictability with the possibility of a “secret” way to beat the market. One of the best-known is the so-called “Dogs of the Dow,” popularized in the 1980s by Michael O’Higgins, who runs O’Higgins Asset Management. This involves, at the beginning of each year, buying the ten stocks included in the Dow Jones Industrial Average that have the highest dividend yield, which is calculated by taking the stock’s price and dividing it by the annual dividend. (A stock with a $30 price and a $3 dividend therefore has a 10 percent dividend yield, which is very high. Usually dividend yields are lower, anywhere from 2 to 5 percent.)

This strategy has worked in the past, particularly during a long bull market. That’s because the stocks in the Dow that were priced lower than the other members of the index were sound companies, and likely to continue to pay their dividends even though investors on the whole believed they had less value than the growth stocks. Again, one comes back to the plausibility argument: These are well-regarded stocks, and this strategy depends on looking at this group of solid companies and betting on those that are said to be undervalued when compared with others—how could something like this go wrong?

But this strategy has not been in existence long enough for investors to know whether it truly stands up to the rigor of several market cycles. It cannot be denied that over a 70- or 100-year period, stocks outperform bonds more often than not. And maybe after that amount of time, the Dogs strategy will beat the market. However, the Dow Dogs are facing their first extended bear market after more than two decades of getting fat off a relatively steady market environment. And in recent years, it’s been getting socked—illustrating how a couple of bad years of underperformance, particularly after an investor has been using the same strategy for years, can hurt one’s portfolio.

In 2008, the Dogs of the Dow included Citigroup and General Motors, a pair of companies that had lost substantial value in the marketplace, and thus sported high dividend yields. The problem? Those companies cut their dividends to nothing and the stocks continued to get hammered. Citigroup lost 77 percent of its value in 2008; General Motors dropped 87 percent, and a few of the other Dow Dogs also weren’t so good, leading to a 38.8 percent decline for the Dogs in 2008, worse than the Dow itself, which dropped 32 percent. (In 2008, just two of the Dow’s 30 names ended the year higher—Wal-Mart and McDonald’s, and neither were Dogs that year.)

Things didn’t fare much better in 2009. The Dogs finished the year with a 16.9 percent average gain, while the Dow itself rose by 22.7 percent, and the S&P 500 did even better, so this strategy falls short.

So how does this affect long-term performance? It’s not all that great. Headed into 2010, the three-year performance of the Dow Dogs is minus 6.6 percent, compared with a loss of 0.1 percent for the Dow. For the 15-year period ended December 31, 2009, Dogs had a return of 9 percent, compared with an 11 percent gain for the Dow industrials, a 10.4 percent return for the S&P, and a 10.3 percent return for Vanguard’s Index 500 fund. Yes, 9 percent is good—but it falls short of what an investor could have garnered by buying the entire average, or by purchasing the Vanguard Index 500, which has a low expense ratio.¹⁰

O’Higgins, for his part, was undaunted, telling Beth Kowitt of Fortune magazine in January 2009 that there are “many years where you don’t do well with it,” but “those are generally the times when you should stay with it,”¹¹ because the strategy will turn around in the following years. Again, this may be true for an extended bull run, one that lasted through the middle of this decade, but an uncertain market such as this does not afford such comfort, and it exposes investors to the risk of underperformance, once again, if companies continue to struggle with dividends. It also advises passivity on the part of the investor: “Just leave everything alone and things will magically work out.” And as we’ve seen, that’s a loser of a strategy.

Historically, very few companies cut dividends. Between 2004 and 2007, Standard & Poor’s Index Services reported between 29 and 32 cuts each year, compared with, on average, about 1,400 yearly increases. But 2008 was different, with 163 dividend cuts compared with 1,091 increases. Through September 2009, it was even-steven—479 cuts, 479 increases.¹² Eventually, that ratio will probably snap back, and more dividends will be increased than decreased, but amid an ongoing bear market, where companies seek capital preservation, one cannot be sure that dividends will continue to rise automatically.

Furthermore, the Dow Jones members are not impervious to pain in coming years. (It’s notable that one of the companies added when General Motors was mercifully eliminated from the Dow was Cisco Systems, the networking giant, which does not pay a dividend.)

The problem with strategies such as this is that they’re eminently believable, and the fact that they don’t rest on a speculative investment such as biotechnology shares or penny stocks nobody has heard of makes them sound safer to a long-term investor. But it still raises the question as to why anyone would bother using this as their way of getting an edge. These are well-known names; investors aren’t discovering anything hiding under a rock, so the advantage of being early to a name just doesn’t apply with well-established giants like GE. This really just leaves the idea of hope that a supposedly safe investment will yield upside surprises for an investor doing the barest of homework (really, investing in the Dogs doesn’t involve any work—just looking at the chart from the previous year). It’s shorthand for real work. And if it’s shorthand you want, there are index funds: They won’t outdo the market, but the only underperformance comes from one’s own trading costs, and you can’t kick yourself for trying a strategy that destroyed your portfolio when everyone else got rich off passive investing.

There are such things as safe investment strategies in the equity market. A portfolio of stocks picked from a pregenerated list is not one of them.

Boiling It Down

• Research shows that most investors, even professionals, are lousy stock pickers. Those who are good spend hours a day doing it. You’re better off looking elsewhere.

• Be wary of fad investments that seem plausible—like those based around new industries that are having a big impact on the economy. Many investments in those industries will not pan out.

• Some investment strategies work only part of the time.

• Avoid the temptation to ride a herd into one investment, or a successful investor.

Endnotes

¹ National Bureau of Economic Research, Business Cycle Expansions and Contractions, http://www.nber.org/cycles.html.

² http://www.berkshirehathaway.com/letters/2004ltr.pdf.

³ Data from Legg Mason Capital Management Web site, http://www.leggmason.com/individualinvestors/products/mutual%2Dfunds/annualized_performance.aspx.

⁴ Author interview.

⁵ Terrance Odean and Brad M. Barber, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, Vol. LV, No. 2, April 2000.

⁶ Gerald P. Dwyer Jr. and Cora Barnhart, “Returns to Investors in Stocks in New Industries,” September 2008, Working Paper Series, Federal Reserve Bank of Atlanta.

⁷ Reuters.

⁸ Jeff Fesenmaier and Gary Smith, “The Nifty-Fifty Re-Revisited,” Pomona College, Claremont, California, http://www.economics.pomona.edu/GarySmith/Nifty50/Nifty50.html.

⁹ Fesenmaier and Smith.

¹⁰ Dogs of the Dow, www.Dogsofthedow.com.

¹¹ Beth Kowitt, “Dogs of the Dow for 2009,” Fortune, January 28, 2009, http://money.cnn.com/2009/01/28/magazines/fortune/investing/investor_daily.fortune/index.htm.

¹² Standard & Poor’s Index Services.