CMU: Why popular investing strategies don’t work

By Jani Ziedins | Free CMU

Sep 27

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday.

Why popular investing strategies don’t work

The library, bookstore, and late night TV are filled with “surefire” investing strategies that will allow you to quit your job and live a life of leisure. At least that is what the flashy dust jacket or energetic pitchman promises us. Follow their extra special fundamental screen, chart pattern, or buy a piece of software and you are well on your way to printing money. Sounds great, doesn’t it? If only it was that easy.

The first thing to realize is the stock market is largely a zero-sum game. That means under most circumstances, one trader’s profits come directly out of another trader’s pocket. This isn’t always a bad thing and both of sides can earn handsome profits in a rising market. But like every pyramid scheme, the last person loses out.

Profit opportunities arise in the stock market when prices are not where they are supposed to be. This is commonly referred to as an inefficiency. For one reason or another a stock’s price is out of alignment. Maybe sentiment is overly bullish or bearish. Maybe the public doesn’t know the company’s sales are about to miss expectations by a wide margin. Or maybe a secret product is about to be announced. Whatever the reason, the stock is about to experience a large move and owners are rewarded for being in the right place at the right time.

One of the most important things to realize about these profit opportunities is they are limited in potential. Not everyone can profit from the same opportunity. If too many people buy a discounted stock, their buying increases the stock price until the discount disappears.

Think of these profit opportunities like a $100 bill lying on the street. If I find it by myself, I keep all $100. If a good friend and I see it at the same time, we split it and both of us are $50 richer. If five friends come across the $100, each person benefits by $20. If 1,000 people find the $100, each person gets ten cents and at that point it is hardly worth the effort.

This same phenomena occurs with popular investment strategies. Let’s say a hypothetical formula identifies stocks that are undervalued by 20%. If we keep this strategy to ourselves, we make a lot of money. But if we publish a book with our strategy, a lot of people are going to start chasing the same 20% discounts. The more people looking for them, the harder it will be to get there first.

After missing out a few too many times, some investors decide they are perfectly happy with a 19% profit. Rather than wait for the stock to fall 20%, they jump in early so they don’t get left out again. Soon a lot of other people start doing the same thing and because of all the early buying, the stock never falls to a 20% discount.

Then some people decide 18% is good enough and they start buying even earlier. This process repeats over and over again until the discount shrinks from 20% to 10% to 5% and even 1%. The process of beating each other with the same investing strategy only stops once the profit opportunity is so small it isn’t worth the effort.

The above describes value investing, but the same process occurs in momentum stocks too. Let’s say there is a great stock screen that identifies companies with the largest profit growth. The strategy tells us to buy these momentum stocks when they breakout from a consolidation because that is when they have the most explosive upside. But soon everyone is chasing the same growth stocks at the same time and the breakout moves so fast few people can buy it before the stock is too far extended to buy safely.

Frustrated investors who get left behind a few too many times commit to buying the stock a little before it breaks out so they don’t get left behind again. It doesn’t take long before more and more investors are buying the stock before it breakouts and soon the buy early crowd is causing a breakout before the stock is ready. Without a sufficient consolidation, the breakout fizzles and tumbles back into the consolidation, triggering everyone’s stop-loss. Rather than make money using this surefire investing idea, all the followers are sitting on losses.

Every popular investing strategy stops working once too many people start using it because the crowd quickly distorts the price-action that made it work in the first place. They sucks up all the profit potential and it is hardly worth the effort. Or the crowd triggers fake breakouts that suck everyone in and then spit them out with less money than they started with.

Dogs of the Dow, value investing, momentum investing, technical analysis, candlesticks, cup-with-handle, etc, etc. When any strategy gets too popular, it stops working. The very act of people following a strategy changes it and that is enough to destroy the profit potential.

But don’t despair, there are a million different way to profit from the stock market. The key is to find a strategy that fits the way you look at the market and then add your special sauce. There is nothing wrong with starting with an existing strategy, but you must bring something extra to the process to make it profitable. Maybe you are a technophile and have a knack for knowing which products will be a hit before Wall Street figures it out. Or maybe you know which laggards are about to turn things around. Something, anything, but you absolutely must have that special sauce otherwise you are just one of clones fighting over the same $100.

In future Cracked.Market University pieces I will help you find unique ways to look at the market that will help you find your special sauce. Be sure to come back for more free CMU posts.

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About the Author

Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.

[…] Why popular investing strategies don’t work […]

Sean O'Shaughnessey September 30, 2017

I completely disagree with your premise. The market is just too big and diverse to think that you can use it up unless you are a major hedge fund or major investment fund. If you are an individual investor then you cannot affect the market and therefore a thousand of you cannot affect the market (unless you specifically coordinate your trading).

Since I published my book The Confident Investor my personal portfolio (which follows the advice of the book) has continued to produce 25-35% YoY returns and significantly beat the market. It doesn’t matter how many people that buy the book. Now maybe they aren’t following my advice and that is the reason but telling everyone your strategy of investing doesn’t seem to affect the success of the system.

More smart investors should publish their systems to the market. I am not advocating they all publish their trade analysis in advance of a trade but publishing the algorithm would simply allow others to understand it and possibly improve it. Don’t hold back, everyone needs to learn from each other. Don’t go to your grave with a great idea hidden in your brain.

    Jani Ziedins September 30, 2017

    The Dow 30 has some of the biggest companies in the world and the “Dogs of the Dow” investing strategy did well for a period of years. But then it got too popular and it hasn’t worked since.

    Buffet’s amazing success popularized value investing and encouraged an entire generation of copycats. It is no surprise Buffet’s results in the second half of his career are no match for what he was able to accomplish before value investing became so popular.

    There are only so many dollars to go around and the more popular something is, the fewer dollars there are for each investor. I’m not familiar with your strategy, but I suspect it is nowhere near as popular as value investing of the Dogs of the Dow. Being under the radar is the only reason it still works. It wouldn’t surprise me if Jim Cramer started promoting your strategy to his legion of millions, that the masses would distort the price-action that makes your strategy work and it would stop being so profitable. That largely happened to Bill O’Neil’s very solid and sensible CAN SLIM strategy. Now that it is so popular, there are far more failed cup with handle breakouts than legitimate signals.

    If a trader wants to be successful, he has to find his own thing. It sounds like that is exactly what you did and in my opinion, that is the only reason you have been successful.

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