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3 Components Needed for Beating the Market

3 Components Needed for Beating the Market

Time to look back

2004 is over, now we are in 2005. This is time to seriously look at performance of your personal investment, such as mutual fund, or individual stocks holdings, etc. Does your fund beat index last year? Does it beat index over past many years? How are you doing with your own stock investment comparing to SP&500 index?

If the answer is "great", well congratulations. You have your own way of beating market and making big money already.

If the answer is "not so great", or "failed to beat index". You have got a problem. You need to look deeper into the investment strategy you used or your fund used. You can not pretend that there is no problem when in fact there IS a problem. I know there are just so many people out there that can not face this. Let's face it, Almost everyone, include myself have ego that we JUST do not want to admit failure or mistake or any hint of it. Here comes the 1st Component below.

Component # 1 - ego, gut, perseverance

Value investing or investing in general is all about psychology, ego, attitude, and gut.

Investing is serious business. It is our money, our life savings at stake. Sometimes biting the bullet with pain to trash the ego is worth the pain if that makes you more money. Ego is one thing that we must avoid in stock market investing business in order to make big money ahead. You can not hide, you have to compare your own performance of past many years to SP&500 index. Of course, I am not saying that you should be comparing every month. It is OK to make some mistakes, here and there for certain months. However, it is NOT ok if the performance year over year has been bad. You have got to change if that is the case.

Although ego is something you should all avoid, perseverance is something you must treasure if you want to be that marathon winner. When you finished your due diligence and you have calculated your risk reward ratio and intrinsic value, go for it and stick with it. Do not be scared of negative comments or negative press, even if the source is from a famous author or from your close family. Value investing is lonely business. I know this for years. I have been criticized over past many years for numerous reasons, for not beeing able to sell at top, for not beeing able to buy at bottom, for picking a risky bankruptcy related stock, or for buying a low float small cap stock , blah blah. You know what? in the end, my investment performance is better than most of folks out there in the market, including those "pro" mutual fund managers.

I have got comments like this before: "Blast, I like your method, I know you are making big money. But, I can not do as you are doing. I can not hold. Especially bad news hit, I just have to sell, and my performance sucks".

Well, if he/she do not have gut to hold like I hold during bad time, she/he can not make big money with value investing. One can be all right in paper, right with value calculation, right with timing of purchase. However, if you can not fight against panic during minor negative news, you are out in the investing marathon.

Component # 2 - right method

Many investment methods are flawed, period. This is especially true for many short term oriented trading methods. Many mutual funds preach long term holding for their fund investors, but the fund managers themself engage in short-term trading like mad men. Performance of many momentum based growth funds or tech funds looked horrible for past 5 years. The reason for that is very simple: the investing method itself. Growth investing or short term trading sometimes can be very speculative and dangerous.

Wall street has famous theory that "the more risk, the more reward". Therefore, yeah, growth funds are risky, but if you want to have more reward, you have to chase risky stuff.

Wrong. The truth actually is "the more risk, the less reward".

I know I am going to be hammered by saying above non-conventional statement. I put out below example to back up my point.

Las Vegas is world famous place for gambling. As an average investor, you visit Las Vegas looking for opportunities to make big money with $50,000 investing capital. Let's assume the theory "the more risk, the more reward" is correct. Where are the riskiest opportunities out there in LV? Of course, Gambling. The potential reward can be astonishingly high. Black jacket, slot machine all have huge potential with 1000% or even more within minutes. You can make millions if you are lucky with your $50,000 principal at slot machine. Actually, it is FACT there are small group of gamblers who made millions in gambling in LV.

However, If you are sensible person, you know the answer. As high as the potential reward can be, the most likely result from gambling with $50,000 principal at LV is WIPEOUT. You lose all your hard-earned money.

If you are a rich investor with multi-million dollar capital looking for investment opportunities in Las Vegas. Certainly casino company stocks and bonds or private offering might be worth looking. However, the sad news is that no matter for stocks or bonds or private offerings, the investment reward is only around 10% to 20% yearly. Well, maybe it is not so sad at all. 10% or 20% of return is certainly a lot safer than gambling. Which reward is better, 10% - 20% return or wipeout?

Well, I know you may want to protest against my above example. Stock market can not be as bad as Casino, right?

It depends. Although casino gambling does not provide real investment opportunities as stock market provides, sometimes stock market can be even worse than casino due to insider manipulation, cheating books, etc. Over the past couple of years, I have heard so many negative news from stock market: Enron, Worldcom, mutual fund scandals, market timing, etc. But I have not heard of news of slot machine cheating by Las Vegas Casino company. Casino does not need to cheat to make money, the odds are against gamblers. Although stock market does offer real investment opportunities for businessman-like investors, stock market is also a place for gamblers to place their bet just like a Casino.

In stock market, the odds are against speculators.

Well, I know you may have more questions. Why Casino bonds or stock offerings or even private offering is only offering 10% to 20% returns?

Casino business is just another business. Numerous academic study has shown that in US history of past many decades, majority of companies can not maintain more than 20% of return on equity over the long run. Many companies are operating under loss, a negative return on equity. If you read books on Warren Buffet method of Philip Fisher method, you will know that they are experts in identifying those small group of high return on equity stocks. But for most companies, they are not as good as the stocks in which Buffet or Fisher invested.

Competitive economics is also at play here. If a company can make more than 20% of return consistently, the competition will heat up and more smart businessmen will enter this field to drive down the return.

If you think of value investing as special kind of business, you will realize how hard it is to maintain 20% return for the long run, as Warren Buffet achieved over past 50 years. Very few investors can do that. Value investing business is just as competitive as other business. Let's face it, if value investing is not competitive and easy to make big money consistently, many smart business guys out there in US will liquidate their own company and start their investment firm instead.

Component # 3 - right tools - new way to find great picks

Peter Lynch mentioned many methods to get the stock leads and identify the big winners in his book "One up in Wall Street". Tips from wife, tips from friends can land you the great stock idea. Although his methods are very valid, there are new ways to find that great pick in this internet stage: Software Data Mining.

It is quite fortunate that I am a data mining expert myself. If you are good at data mining, you can do yourself well too. You can design and fine-tune your data mining tools to get the leads you want and make big money by getting ahead of crowds.

A successful value investor really has to find great pick ahead of big guys and move fast in order to make big money. In this internet stage, big guys such as mutual funds or hedge funds really have no advantage over small guys or small firms such as BlastInvest. At BlastInvest, we do stock data mining with our in-house software just as good as those big guys, if not better. Sarbane Oxley new law also helped individual investors and small firms like BlastInvest a lot because most of public companies now disclose information to public and to big institutions simultaneously through conference calls or press releases. Insiders now also have to report insider buying and selling within couple of days of transaction instead of several months before. Whenever insiders buy or sell, You need to know that immediately within a few days. You want to buy when insiders buy and you may want to sell when insiders are selling too.

Don't despair if you do not know how to program software yourself. There are lots of tools and services out there to help you out. Here I want to talk about the most useful tools out there.

(1) Valuation screening tool. You need at least one tool for screening against value metrics for you. Yahoo stock screening is very useful tool and it is free.

(2) Insider buying tool. This is must-have tool to get you the latest insider buying stocks. There are many offering there, fee-based or free. We offer free insider-buying weekly service as well at BlastInvest.

(3) Strategy screen. Validea.com offers an interesting stock screening tool that can screen based on methods of Ben Graham, Warren Buffet, or Peter Lynch. It has limitations too. I have used it and found that its Warren Buffet tool is not working well and its Ben Graham strategy screening is only looking for "defensive" type of stocks, not the "enterprising investor" type of stocks. My BIRTP newsletter is really geared toward "enterprising investor" type of stocks rather than "defensive investor" type of stocks. Heck, still Validea is best kind of tool available at affordable price in this category.

Final thought

If you follow up with my above 3 components of value investing, you are on your path for financial freedom.

However, if you can not do as I stated above, do not naively believe that you can make big money alone in stock market mainly by hunch. Buy the stock screening tools if necessary, get the professional help from real experts and consider my newsletter BIRTP as well.

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* Article by Henry Lu of BlastInvest LLC, a premium investment newsletter publisher in Connecticut. Visit http://www.blastinvest.com for FREE "how-to" investing assistance, web services and more.

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3 Components Needed for Beating the Market

Stocks & Mutual Fund