04/01/2008 10:47 pm ET Updated May 25, 2011

Smart Advice for the HuffPost Investor: Investment Pornography -- Are You A Victim?

"Investment pornography" is generally attributed to the respected financial journalist Jane Bryant Quinn. She defined it in the following quote:

You know the stories: The Top Ten Mutual Funds to Buy Now, How to Double Your Money This Year, personality profiles that read like fan magazines. Stock-touting pieces that praise any path to profits. We've all done these stories, in one form or another. It's investment pornography -- soft core, not hard core, but pornography all the same.

I define it as any effort to convince investors that there is a reliable way to "beat the markets."

Many investors fall prey to investment pornography. They believe they have found the path to investment success. Upon examination, their strongly held beliefs are more likely to lead to financial disaster than to investment success.

I deal with these issues in this week's column.

Thanks for your continuing excellent comments and encouragement. I always look forward to your questions.

Question: Can I beat the markets by buying low and selling high?

Answer: It would be great if you could. One study showed that someone with the ability to be in Treasury Bills during bad times in the market and in stocks during good times over a 52-year period would have seen her $1000 investment increase to a whopping $5.36 billion!

Do you know anyone who achieved these returns? Have you even read about any one who did?

Here is the bottom line: There is no evidence that anyone has the ability to predict highs and lows in the market. If they did, there would be a lot of billionaires out there who made their money market timing. They don't exist.

Question: Can technical analysis programs help me time the market?

Answer: While the research is not entirely free from dissent, the overwhelming weight of authority is that these programs enrich those who sell them, at the expense of investors to whom they are sold.

In order for technical analysis to work, you would need to ignore the following:
  • Markets are random and efficient;
  • The pattern detected in the analysis most likely cannot be exploited for profit because it has been disseminated to investors who subscribe to the program; and
  • Transaction costs involved in implementing the recommendations of the program will substantially reduce or eliminate profits.

There is overwhelming academic evidence that each of these statements is true. It is for this reason Burton Malkiel noted, in A Random Walk Down Wall Street, that "technical analysis is anathema to the academic world."

Warren Buffet dismissed technical analysis, stating: "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer."

Nevertheless, the quest for trying to find patterns in an effort to beat the markets still has many adherents. Most of them will lose money.

Ask yourself this question: If you had a program that successfully predicted the price movement of stocks, would you sell it to other investors? Why not keep the proprietary information to yourself, eliminate the possibility that the markets will react to it, and trade with your own funds?

Question: Can I be assured of beating the markets by buying Berkshire Hathaway stock?

Answer: No. For the five year period from October 1, 2002 through September 30, 2007, the total return of Berkshire Hathaway A stock was 59.72%. The total return of the S & P 500 index during that period was 104.07%.

The correct "market" for comparison purposes is the index that has a comparable risk, as measured by standard deviation, for Berkshire Hathaway stock. This would be an emerging markets value index.

For the 20 year period from 1986 through 2006, this index had an annualized standard deviation of 23.20% which is very close to the 24% annualized standard deviation of Berkshire Hathaway stock. The index had an annualized return of 20.03%. Berkshire Hathaway stock had an annualized return of 21%. Investors in both the index and Berkshire Hathaway stock took similar risks and achieved similar returns.

A portfolio consisting solely of Berkshire Hathaway stock would be far too risky for most investors. In addition, the concentration of assets in one stock would expose investors to a high degree of "idiosyncratic risk"-- the risk of loss due to the unique circumstances of a specific stock. This risk can be eliminated by diversifying your portfolio.

Since you can achieve the same expected return by purchasing an index of emerging market value stocks and eliminate idiosyncratic risk, why would you put all of your eggs in the Berkshire Hathaway basket?

Question: Why do you want to beat the markets?

Answer: I can understand the quest for more money, but at what risk?

Capturing market returns, which is easy to do, will give you returns approximately 300% greater than those achieved by the average equity investor. It will also place you in the top 5% of all professionally managed money over the long term.

Is it really worth it to be in the top 4% or 3% of professionally managed money, when you consider the very real possibility that your efforts will most likely cause you to underperform the markets?

The present system is not working for investors. The rules of the game are set up for brokers and advisors who will happily take your money and entice you with the prospect of "market beating" returns.

There will always be plenty of takers. You should not be among them.

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