Drawing on his vast experience to create a set of behavioural indicators, Nick Dewhirst provides an insight into who is most likely to beat the market and how an investor can join this elite minority
If the vast majority of private and professional investors underperform, who actually beats the market? And how can one join this elite minority?
Using more than three decades of experience, I have created a set of behavioural indicators to predict future market direction. These analyse investment decisions by different types of investors using official market statistics and investor surveys.
The indicators compare those decisions with subsequent market performance to identify who is more often right or wrong. And I have now built up a library of 500 effective indicators covering the bond, forex and stock markets in 50 countries and regions.Here are my conclusions:
The most successful US investors I ever knew owned seats on the New York Stock Exchange (NYSE). Their roles as specialists obliged each of them to make a market in a small number of individual stocks. In exchange for ensuring all buyers and sellers were matched up, they were awarded the monopoly of trading in those stocks.
Their dealing books show how many shares are bid and offered at different limits, so they can see whether demand or supply dominates at any point in time. They can also get to recognise winners and losers so can lean whichever way they want, going long or short.
It is their job to co-operate with brokers who are running a tap - a large line of stock bought or sold over days or weeks discretely without alerting the market.
The Securities Exchange Commission requires that the overall activity of specialists be published by the NYSE and their statistics can be used to confirm it. The ratio of public/specialist short sales is one of the longest-established behavioural indicators in the world, with a track record going back to the 1930s.
To join the elite by that route is very expensive and by invitation only. However smaller investors can profit by buying shares in those stock exchanges that have demutualised and become listed public companies.
Despite legal restrictions on insider dealing, there are still important areas where knowledge of their own company or its marketplace may give investors an entirely legal advantage.
Not only may they be substantial investors through founders' shares, but also via accumulating stock options as part of executive compensation packages.
Of somewhat more dubious legality is the practice of backdating that has recently come to light. This involves retrospectively selecting the date for issuing options to coincide with short-term setbacks to the share price.
While it is not possible to join that privileged group, it is possible to benefit by studying directors' dealings, which companies are obliged by law to reveal on both sides of the Atlantic.
However, insiders are not always right and it is important to remember they are experts only on their company, not on the stock market as a whole. Thus, their individual dealings are a better indication of relative than absolute performance.
Both subjective experience and objective statistical analysis show that those who pay for their shares in full outperform those who take on leverage.
Objectively it shows up in trading statistics of the world's two largest stock markets, as New York and Tokyo publish data about the aggregate purchases and sales of individual investors in cash and margin accounts.
Even though my experience of individual investors on Wall Street suggested those dealing on margin were much better informed than those dealing in cash accounts, the margin investors fared worse. In my opinion there are two factors behind this.
Firstly, margin investors have often decided to make investing a hobby, whereas for others investing is a marginal activity. Thus, it is easy for the former to confuse high performance with high activity, especially when brokers are paid by commission to encourage it.
Apart from the steady drain of dealing costs, this fosters a short-term mentality, where investors believe they are early enough to profit from projecting whatever trend is current. They may be right for days or weeks and occasionally months, but if they are betting against the long-term flow of funds, they will eventually lose out and their losses can quickly become bigger than their gains. On the other hand, I found it easier to persuade less active cash investors to focus on these longer-term trends.
Secondly, there is the problem of market setbacks. For the cash investor these are uncomfortable but far from disastrous. Many a time I found myself writing handholding letters after a market crash. While very few acted upon my recommendation to take advantage of an unexpected second bite at the cherry, at least they did not sell and sat out the setback to profit fully from the next bull market.
Conversely, margin buyers do not have the luxury of time. They must keep the margin of equity to assets above the minimum required by the law or their bankers. If they cannot provide additional funds to restore the required equity, they must sell down their portfolio, or the brokerage house will do it for them.This is as true of institutional as of individual investors.
Entering the winner's enclosure this way is easy. It is merely necessary to pay fully for shares in limited companies. The glory of this legal entity is that investors have unlimited upside potential but downside risk limited to their initial investment - that is if they pay for them in full. Thus, it is better to buy risky smaller companies fully paid, than blue-chip shares on credit.
Generally, it seems large investors beat small ones. That shows up in Odd Lot statistics produced by the NYSE for US shares. In the futures markets there are various indicators, which allow me to calculate that large speculators investors beat small ones in most commodities. While the average professionally managed fund may underperform the London stock market, this is decidedly better than many private investors, whose portfolios are frequently decimated.
If a large number of institutional investors underperform modestly and individual investors underperform less modestly, it follows that a small number of investors must outperform by large margins.
A large part of the explanation lies in the joys of compound growth. In addition, success attracts funds as assets are reallocated to the investment game at which best results are being achieved and to the players achieving those results.
Therefore, a small investor who is successful ceases to be a small investor. To join the winners via this route requires hard work, courage and persistence. Nevertheless, it is possible. Next month I shall look into this approach in depth.
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