I hope you don’t fail my basic “Financial IQ Test.”
Unfortunately, most people do.
It’s just one question. And it’s incredibly simple to understand. It should be incredibly simple to change, too.
Let me explain…
When I started out in 1993 as a stockbroker, I quickly learned that customers loved to “bottom fish.”[ad#Google Adsense 336×280-IA]Doctors and lawyers didn’t want to buy the ideas I recommended… They wanted to buy stocks that had fallen a lot in price. “It’s down so much, I can’t go wrong,” they’d say.
These customers had no idea what a horrible strategy that was… And at the time, I didn’t have any statistical proof of how bad the idea was. All I knew is that it didn’t work – I saw that firsthand.
But today, I have the proof for you… And it is undeniable.
“If you’re looking for a great way to underperform the market, look no further,” James O’Shaughnessy writes in his excellent book, What Works on Wall Street.
O’Shaughnessy sliced and diced the stock market in his book, sizing up nearly every possible way to make money in stocks – usually going back over 80 years. And he found that buying what has fallen the most is one of the worst strategies. O’Shaughnessy’s conclusion is:
“Unless FINANCIAL RUIN is your goal, avoid the biggest losers.”
Here’s what O’Shaughnessy did:
He put all stocks into 10 different groups, based on their trailing six-month performance. The top-performing 10% of stocks over the previous six months was Group One, and the bottom 10% of performers was Group Ten.
Here’s what he found:
- $10,000 invested in Group One, using new rankings every six months, would have turned into $572,831,563 from 1927 to 2009.
- $10,000 invested in Group Ten, with new rankings every six months, would have turned into $292,547 over the same time.
Which would you prefer? More than $572 million? Or less than $300,000?
If you’d bought the winners over the preceding six months (the top 10% of performers), you’d have made more than half a billion dollars.
If you’d “bottom-fished” and bought the losers over the last six months (the bottom 10% of performers), you’d have made about 0.05% as much.
In short, you’d have made a fortune doing the opposite of what the doctors and lawyers did.
Longtime DailyWealth readers know I like buying what’s cheap and hated. But you also know I wait for an uptrend. I believe it’s the most important part of the picture. And O’Shaughnessy proved it.
His study shows that buying what was already “up” proved incredibly successful…
“Over six-month and 12-month periods, winners generally continue to win and losers general continue to lose,” O’Shaughnessy writes.
The results by group form an almost perfect “stair-step” downward… Group One compounded your wealth at 14% a year. And Group Ten compounded your wealth at 4% a year. (“Buy and hold” for all stocks was 10% a year.)
Whenever I hear an investor say his main strategy is to buy what has fallen a lot recently, he fails this Financial IQ Test. This person has just proven he has no idea what actually works.
All I’m concerned about is what actually works. And what works is buying what was up, not down. Simply buying what was up over the previous six months turned $10,000 into over $500 million. Doing the opposite performed far worse than the stock market (with much more volatility, too).
Please don’t trade like my old doctor and lawyer customers. Don’t fail this Financial IQ Test. Don’t buy what’s down as a strategy. It not only doesn’t work… it fails miserably.
Don’t go shopping for “deals” in what’s fallen the most over the last six to 12 months. The historical record is painful. It doesn’t work. Instead, do the opposite.
Do what works… History shows you’ll be well-rewarded if you do.
Source: Daily Wealth