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Speculating Is a Dumb Way to Invest

There's a big difference between investing and speculating. "Investing" is for the long term. It should be based on sound, peer-reviewed evidence. "Speculating" is for the short term. It involves buying and selling stocks based on many factors, such as technical analysis and intuition -- none of which are supported by credible data.

I write articles for investors, not speculators. However, it's worth noting this observation by the French mathematician, Louis Bachelier, in his paper "The Theory of Speculation." He concluded that the expected return of speculation is zero before costs. After costs, speculating can be expected to yield a negative return.

Poor performance. It's understandable that most investors do not achieve market returns which are theirs for the taking. Much of the financial media and most brokers widely disseminate the notion that investing is extremely complicated. When confronted with something complex, it's a normal human tendency to look for "experts" who can make sense of it. This is particularly true with investing. The market seems so random and chaotic. Surely there are "gurus" out there who can bring order from this chaos and tell the rest of us what we should do to maximize our return.

Recent index-based returns. A cautionary note: Although I am going to use the returns of the Standard & Poor's 500 index in the examples that follow, that index is not a proxy for the U.S. stock market. A more complete proxy would be the Wilshire 5000 Total Market index. In addition, few advisors would recommend investing 100 percent of your stock portfolio in either the S&P 500 index or the Wilshire 5000 index. A properly diversified portfolio includes domestic and international stocks. It also includes all major asset classes.

The S&P 500 index returned 11.74 percent in 2014. However, if you reinvested dividends (as most investors do) your return would have increased to 14.04 percent, according to Seeking Alpha. The return in 2013 was even better. It was 32.39 percent, with dividends reinvested. In 2012, the return with dividends reinvested was 16 percent.

Think about that. If you bought an S&P 500 index fund (as part of your allocation to stocks) on Jan. 1, 2012, and sold it on Dec. 31, 2014, you had a return of 74.60 percent, which assumes dividends were reinvested. Raise your hand if your returns remotely approached the aggregate return during this period, even if you held a simple, low-cost S&P 500 index fund.

Relying on predictions of "experts." It's easy to understand why you underperformed this index, probably significantly, during this time (and likely other periods as well). You made a perfectly logical, but fatally flawed, assumption: You relied on the predictive powers of "experts."

Mark Hulbert certainly qualifies as an expert. He is a senior columnist at MarketWatch and the editor of the Hulbert Financial Digest. He has been a columnist for The Wall Street Journal, The New York Times and Forbes. These are impressive credentials. I can understand why advisors believe Hulbert has a special insight into the future direction of the market.

But some of his past predictions don't inspire confidence.

In December 2012, he spoke of an "unmistakably bearish" stock-market indicator. His observation was based on the fact that insiders had been selling stock "recently." He compared the "sell-to-buy ratio" for shares listed on the New York Stock Exchange for the prior week with the ratio for a month prior. Based on the increase in this ratio, he detected this "bearish" indicator.

In January 2014, he warned: "The U.S. stock market is more overvalued than it was at the majority of the past century's peaks, according to six well-known valuation ratios."

And then in August 2014, he noted three market warning signs he believed predicted a 20 percent "stock tumble." He relied on research from Hayes Martin, president of Market Extremes, an investment consulting firm in New York, whose "research focus is major market turning points." Martin identified these three market-warning signs and, according to Hulbert, "in late July, he advised clients to sell stocks and hold cash."

Hulbert (who I am sure has made many accurate predictions) was not alone in failing to discern the strength of the current bull market. In a September 2011 article in The New York Times, "If It Looks Like a Bear, and Moves Like a Bear..." respected financial journalist Paul Lim raised the possibility of a coming bear market. He noted four of the 10 sectors that make up the S&P 500 index had slipped into bear-market territory. There were also steep declines in small-company stocks, foreign stocks and emerging market stocks.

He observed: "If this slide stops short of the 20 percent mark, it will have been the most severe correction for the S&P 500 in recent memory that didn't morph into an official bear market."

It was little comfort to investors who acted on Lim's concerns, or those of other experts, that the bear market never arrived.

The takeaway for investors. There are no experts who can peer into crystal balls and predict the direction of the market. Sometimes they get it right but, when they do, you can attribute it to luck and not skill.

Relying on them is a dumb way to invest. There's no gentle way to say it.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."



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