Beating the stock market seems like easy work. Any public library has a shelf of books on the topic and many of these books rest on a solid foundation of academic research. Finance professors have identified literally scores of market inefficiencies that appear to generate big profits—at least on paper.
So why do most mutual funds and most individual investors still lag behind the market? Aswath Damodoran, a professor of finance at the Stern School of Business at New York University, says the problem is transaction costs.
Your costs include trading fees and brokerage expenses. In addition, you may find that the stock price on paper is actually a “bid” price that is far below the “ask” price that current owners are demanding. There’s also the matter of liquidity: if a stock doesn’t trade much, your attempt to buy it may nudge the price upward. All of these factors can turn a strategy that works on paper into a money loser in reality.
Damodoran cites the case of the “loser stock” strategy. Academics noticed in the mid-1980s that stocks that have lost the most in any year seem to generate much better returns over the next five years than stocks that have done the best. This finding suggested that contrarian investing could produce big profits.
But there’s a hitch. It turns out that almost all the profits from this strategy come from buying stocks that have dropped below a dollar. The bid-ask spread on these penny stocks is enormous—20% to 25% of the stock price is typical. To make matters worse, these stocks are not very liquid. The moment you try to buy one of them, the price floats up. As Damodaran concludes: “Talking about money is easy…actually making money is far more difficult.”
Freelance business journalist Ian McGugan blogs for the Financial Post