Jim Cramer's Shame Meter Is Broken

10/12/2010 08:29 pm ET | Updated May 25, 2011
  • Dan Solin Author of the Smartest series of books

I don't watch Jim Cramer's aptly titled Mad Money. A reader sent me CNBC's summary of his October 6, 2010, show, which he thought would be of interest. He was right!

Cramer outlined a recommended trading strategy. It was quite simple. You should sell stocks that had "flown too high," "let them cool off" and then buy them back at lower prices. According to Cramer, this is a "tested strategy" that had served him well for 30 years.

Here's the part that really got my attention: "And if there were proof that buy-and-hold -- or simply buying an index fund, for that matter -- generated the kinds of returns earned from actively managing your money," Cramer would "offer a mea culpa immediately."

Hold on to your hats.

Cramer offers no data indicating his trading strategy is "tested." All of the available data indicates it is nonsense.

Cramer doesn't tell investors how to implement this strategy. How is an investor to know when a stock is "too high" or when to buy back in? The movement of stock prices is random, often driven by tomorrow's news, which no one knows.

Cramer's dismal stock-picking record illustrates this problem.

An article in Barron's found that Cramer's stock picks underperformed the DJIA, the S&P 500 and the Nasdaq over the two year period studied.

A website that tracks the performance of investment gurus found that Cramer's stock picks were right 47% of the time, which is slightly less than you would expect from the toss of a coin.

Cramer conveniently ignores this data, and offers "proof that he is correct." He brags that he called the market lows, when the Dow was "flirting with 6,000," and advised his viewers to buy stocks.

Cramer fails to note that, on March 21, 2008, he wrote an article for New York Magazine stating that the market had reached a bottom: "[N]ot just for the stock itself, which happens to the venerable Bear Stearns, but for the whole stock market, and for the long-suffering housing market too." Viewers who followed this advice, saw their portfolios plunge by 39.7% over the ensuing 254 days. His observation about the "long-suffering housing market" hitting bottom was simply dead wrong.

Sometimes stock pickers are right and sometimes they are wrong. When they are right, it is due to luck and not skill.

This was precisely the finding of an independent study, which concluded that 99.4% of the 2,076 active fund managers studied over a 32-year period demonstrated no genuine stock picking ability.

Another study, published in the prestigious Journal of Finance, looked at the performance of 819 actively managed funds over a 45-year period. The study found that actively managed funds underperformed their passive benchmarks by approximately 1% a year, due to their trading costs and high management fees.

The import of this study is stark. Investors pay more than $10 billion in fees to actively managed funds. Yet the fund managers do not have the skill to equal their benchmarks. Investors would be better off buying funds that simply tracked the index.

Still not convinced?

Another study discussed here looked at hiring and firing decisions of active managers made by more than 3,700 retirement plan sponsors over a nine-year period. These managers were responsible for managing $737 billion of assets.

Generally, the managers were hired based on their past performance, much the way investors are told to pick mutual funds.

So how was the performance of these "skilled" active managers after they were hired? On average they were close to or below their benchmarks. "Hot hands" are a function of luck. Luck does not persist.

There is a wealth of additional data indicating that index-based investing consistently beats active management over the long term. It is summarized here.

There is a method to Cramer's "madness." He wants you to trade. Trading increases the revenues of his corporate sponsors. It also decreases your returns.

Here's my challenge to Cramer: Show me any peer review study demonstrating your trading strategy has merit. Since you represented your strategy has "served you well for 30 years," provide me with a list of your trades over that time period. I will crunch the numbers and publish the results.

Otherwise, I look forward to your promised mea culpa. It's not spelled "boo-ya."

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