The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [21]
What caused the January jolt? First of all, many investors sell their crummiest stocks late in the year to lock in losses that can cut their tax bills. Second, professional money managers grow more cautious as the year draws to a close, seeking to preserve their outperformance (or minimize their underperformance). That makes them reluctant to buy (or even hang on to) a falling stock. And if an underperforming stock is also small and obscure, a money manager will be even less eager to show it in his year-end list of holdings. All these factors turn small stocks into momentary bargains; when the tax-driven selling ceases in January, they typically bounce back, producing a robust and rapid gain.
The January effect has not withered away, but it has weakened. According to finance professor William Schwert of the University of Rochester, if you had bought small stocks in late December and sold them in early January, you would have beaten the market by 8.5 percentage points from 1962 through 1979, by 4.4 points from 1980 through 1989, and by 5.8 points from 1990 through 2001.10
As more people learned about the January effect, more traders bought small stocks in December, making them less of a bargain and thus reducing their returns. Also, the January effect is biggest among the smallest stocks—but according to Plexus Group, the leading authority on brokerage expenses, the total cost of buying and selling such tiny stocks can run up to 8% of your investment.11 Sadly, by the time you’re done paying your broker, all your gains on the January effect will melt away.
Just do “what works.” In 1996, an obscure money manager named James O’Shaughnessy published a book called What Works on Wall Street. In it, he argued that “investors can do much better than the market.” O’Shaughnessy made a stunning claim: From 1954 through 1994, you could have turned $10,000 into $8,074,504, beating the market by more than 10-fold—a towering 18.2% average annual return. How? By buying a basket of 50 stocks with the highest one-year returns, five straight years of rising earnings, and share prices less than 1.5 times their corporate revenues.12 As if he were the Edison of Wall Street, O’Shaughnessy obtained U.S. Patent No. 5,978,778 for his “automated strategies” and launched a group of four mutual funds based on his findings. By late 1999 the funds had sucked in more than $175 million from the public—and, in his annual letter to shareholders, O’Shaughnessy stated grandly: “As always, I hope that together, we can reach our long-term goals by staying the course and sticking with our time-tested investment strategies.”
But “what works on Wall Street” stopped working right after O’Shaughnessy publicized it. As Figure 1-2 shows, two of his funds stank so badly that they shut down in early 2000, and the overall stock market (as measured by the S & P 500 index) walloped every O’Shaughnessy fund almost nonstop for nearly four years running.
FIGURE 1-2
What Used to Work on Wall Street…
In June 2000, O’Shaughnessy moved closer to his own “long-term goals” by turning the funds over to a new manager, leaving his customers to fend for themselves with those “time-tested investment strategies.”13 O’Shaughnessy’s shareholders might have been less upset if he had given his book a more precise title—for instance, What Used to Work on Wall Street…Until I Wrote This Book.
Follow “The Foolish Four.” In the mid-1990s, the Motley Fool website (and several books) hyped the daylights out of a technique called “The Foolish Four.” According to the Motley Fool, you would have “trashed the market averages over the last 25 years” and could “crush your mutual funds” by spending “only 15 minutes a year” on planning your investments. Best of all, this technique had “minimal risk.” All you needed to do was this: