Strategies For The Stock Market

You might ask whether it is worth your time to do hardheaded analysis of business or whether you would be better off letting other people do the work and then free riding on their effort. Economists illustrate this free rider strategy by positing a country that taxes its citizens in order to build a good military. Everyone agrees that this is desirable to defend against foreign enemies. A tax dodger free rides on the public good of a strong military while not contributing to it.

Is it possible for an investor to let others do the investment research (pay the taxes) yet participate as a free rider in the market anyway? Not quite.

First, in the classic free rider example, there are two classes of people: those who pay their taxes and those who free ride.

In stock investing , there are three: those who do their homework, those who speculate, and those who free ride. The addition of the speculators makes it possible for those who would otherwise be content with a free ride to exploit the folly of the speculators by doing their homework.

You might ask, If those doing the homework can gain so much from the speculators, why doesn’t everyone shift from speculating to homework? Good question. People should. But they don’t. Ben Graham and Warren Buffett the consummate home work devotees repeatedly marvel at the inertia of speculators and can only wonder why so many people choose lemming-like laziness over active analysis.

Yet the speculator is here to stay, as the trends identified earlier suggest. Even the strategies that come closest to resembling the free rider gambit require some work. The most common version of a free rider strategy, which may be best for many people, is long-term investment in an index fund. An index fund is a mutual fund that buys the same securities that are in a given index, such as the S&P 500. They have grown to gigantic proportions of total invested capital.

People are attracted to such funds for lots of reasons. For one thing, the S&P 500 and similar indexes consistently outperform the managers of active portfolio funds. Indexes also change relatively little, and so index funds have low stockturnover and therefore lower costs and better management of taxable gains. The chief potential downside of indexing is that it pays no attention to fundamentals, emphasizing past returns rather than evaluating future prospects.

The trade-off hinges on an investor’s ability and inclination to conduct business analysis. While using an index fund gives a reasonable assurance of obtaining the average market return with very little effort, the investor should still have some reasonable basis for believing that the basket of stocks that constitutes the index whether the S&P 500 or something else is cheap relative to the value it contains.

Monitoring of fundamentals is plain common sense. Buyers of a market index need to know what value they are getting, just as buyers of shares do. Both can fluctuate on the upside and the downside. There is no assurance that the overall stock market will go up any more than there is any assurance that attendance at major leaguebaseball games will go up. Both can and do go down.