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Tuesday, March 22, 2005

The Motley Fool: Cheating the Market

The Motley Fool is always fun to read - particularly for novices to finance. A good deal of their advice s soundly based in finance research. In this article, they give some good investment advice that's based on well cited academic research. The thrust of their article is that investors may have biases that hurt them. First, they mention the tendency of investors to sell winners too soon and hold losers to long:

In The Courage of Misguided Convictions: The Trading Behavior of Individual Investors, Barber and Odean find that we are 50% more likely to sell a winner than a loser. Our tendency to avoid pain -- in this case, refusing to take a loss that already exists -- is just one psychological weakness that leads us to poor investing decisions.
Next, they discuss how the investors' preference for high-flying "glamour" stocks may result in lower returns (an anomaly examined by Fama and French and later by Lakonishok, Shleifer, and Vishny (LSV for short)). LSV found that high earning-price stock s outperformed "glamour" stocks (low E-P stocks) by about 4% per year. In addition, they also found that firms with low historical sales growth those with high historical sales growth by over 7% per year. When the combined the two strategies (stocks with both high E-P AND low sales growth vs those with both low E-P and high sales growth), the value portfolio (high E-P/low sales growth) outperformed the glamour portfolio by 11% per year on average.

Click here for the whole article.

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