How anyone can beat the street (page 1 of 2)

Is it possible, through a combination of skill and intuition, to make stock market investment decisions with any confidence of future success? Or are such profits merely the rewards for lucky gamblers?

Some would suggest the apparent impossibility of achieving respectable profits in the current depressed state of world markets. Nonetheless successful fund managers are still highly prized and well rewarded by the financial institutions, whilst investment gurus have amassed personal fortunes by following apparently successful strategies.

But can these strategies be adopted profitably by other investors? Intuition suggests not. If an individual possessed a guaranteed winning formula, it would be irrational to disclose the formula to other investors, since they would then adopt it themselves, thereby claiming their share of the profits.

So when investing, or gambling at the racecourse, don't follow tipsters. If their information is that good, they'll keep it, and the profit, to themselves. More likely their information is worthless. Even if based on evidently sound principles, just because an investment strategy has worked well in the past, doesn't mean it will work in the future.

But if the accumulated knowledge of the financial investment institutions has no value to today's decision-maker, why do their fund managers and analysts command good salaries and performance bonuses? The answer is not that the best-paid professionals earn consistently high returns on their investments over and above their competitors. They do however, earn genuine returns on their research activities.

For the practical and even amateur investor, this is a more relevant perspective. How much time are you prepared to invest researching the market and the shares of the companies that are traded in it?

The more time you spend the greater the likelihood of you making profits. But you are still at a disadvantage vis a vis the financial institutions. They possess powerful computerised financial databases and they are often first to receive price sensitive news releases for the companies themselves. That's an important source of their competitive advantage, and their wealth.

So should the ordinary investor abandon research and return to throwing darts at the financial pages? Not necessarily. Applying the principle of maximising potential return on research time, there are still strategies that are rational to follow. The first point to note is that the majority of institutions spend most of their time researching the large companies. Their funds track the performance of leading stock market indexes, so they have to know about the main index constituents.

If you want to pursue this kind of investment strategy yourself, pay the fund manager a commission to do it for you. They can buy the index cheaper than the ordinary investor can. That's another way they make money. This leaves large numbers of smaller companies relatively under-researched. It is more likely that events affecting these firms will not be detected or will not be detected as quickly be the market.

Also, because their shares are more thinly traded, their quotation may not reflect their real value. All in all, there is greater likelihood of under-priced stocks in a population of small firms compared to big firms, so the probability of picking a bargain is greater.

A related strategy is to pick 'value' stocks. These are shares that have performed poorly in the previous period and therefore command low price/earnings ratios.