Are You Trying Too Hard to Beat the Market?

In 1981, in front of a packed lecture hall in Rockford College, Illinois, investment manager Dean Williams presented what turned out to be a prophetic talk.

Unless you've lived under a rock for the past 20 years, you've undoubtedly been exposed to one of the most liberating investment philosophies of the past half-century. Going back at least as far as the Dean of Wall Street himself, Benjamin Graham, investors have been told to dig deeply into a company's financials, its operating history and its record of corporate governance to assess whether its shares would prove to be a good purchase or not.

Investors who came after Graham widened the circle of study to include items such as competitive position, product quality and the dreaded "scuttlebutt," talking to suppliers and employees to get the inside scoop. The work needed to do a "proper" analysis on a company grew remarkably in size while individual investor returns didn't.

A select group of investors have taken a different approach to their investment projects, however. Rather than plunge neck deep into analysis, they prefer to take a drastically simplified view of their investment choices. Rather than thorough qualitative research, they prefer to leverage statistical anomalies based on simple yet highly profitable financial ratios. These investors have come to be known as "quants."

When Williams gave his talk, the legendary investor David Dreman ( Trades , Portfolio ) was still in the infancy of his career. Only a handful of professionals, such as John Templeton, Irving Kahn or Walter Schloss, came close to falling into the quant category and they were far from household names. Only as more investors adopted a quantitative strategy was it clear just how valuable Williams' advice was.

Williams' idea was decisively simple,

The thought that an investor could actually try too hard to beat the market is still viewed skeptically. Beating the market is hard. Every day we face a tsunami of competition from pros and private investors alike trying to beat us out in what is commonly seen as a zero-sum game. But Williams had good reason to take the position he did. It all started with Isaac Newton.

But, as Williams explained, security analysis, like Newtonian physics, proved to be misguided.

When added to Williams' second observation, the combination proves devastating for modern investors.

The idea that more information does not necessarily make for better predictions drives a stake through the heart of most investment analysis. Consider the modern-day Buffetteers who are basing their investment strategies on discounted cash flow valuations or copper traders who use information from a wealth of different sources to form their purchase decisions. More information does not necessarily mean better judgments. But investors shouldn't be so pessimistic about this state of affairs, according to Williams. Instead, investors should see it as liberating.

So how, then, is an investor expected to profit in the stock market? Again, Williams' thoughts are decidedly simple.

But leveraging investment returns still involves an investment strategy, and an investment strategy still requires human interaction and judgment on some level. Humans, when it comes down to it, are the ones that ultimately still decide which stocks to buy and sell. How are we supposed to invest in Williams' world?

This is exactly the approach that I've taken to invest my own savings. Ultimately, selecting high quality net-net stocks is not rocket science. It comes down to selecting stocks that show simple, yet promising, characteristics. Finding these companies does not require hours of time spent talking to suppliers or reading industry profiles. It really comes down to basing your investment decisions off of a few simple balance sheet and income statement calculations.

But while simplicity is a virtue, it's not enough to guarantee great returns. Another key characteristic comes into play when building a great track. Williams continues:

In my experience, nothing destroys an investor's best chance for outstanding returns over the course of his life like the inability to commit. It's the failure to stick to a promising strategy due to the inability to stomach short-term variance or just the tendency to drift between styles that really sabotages an investor. As I've written to those who've requested free high quality net-net stock picks, sticking with a great strategy is far more important than being the most knowledgeable investor.

According to Williams, all of this suggests that investors should be approaching their work from a different orientation.

Talk about liberating! Williams wasn't kidding. In fact, this has been my approach since adopting Graham's famous net-net stocks strategy. Picking high quality international net-nets and leveraging the great statistical returns associated with them has proven to be a much more profitable, and much less strenuous, approach to investing.

But there's another aspect of this type of investing that I didn't grasp at first. The longer I invested in net-nets, however, the more clearly this came into focus. Williams explains:

So, how can we leverage these probabilities to earn good returns? He continues:

Admitting how little we actually know about the future is a fundamental aspect of good investing. Rather than destroying our chances of earning great returns, admitting our own fallibility sets us up for a different sort of investing - buying a diversified list of stocks with the odds of good returns, as a group, in our favor.

Arriving at that group of stocks involves ignoring market, industry or company forecasts and basing our decisions on hard facts. Those hard facts come down to assessing the firm's financial position, its current valuation and the returns on offer from a proven investment strategy. This is essentially the approach I've taken for my own portfolio.

Proper investing involves getting "meta." Why would you be content to drift between styles, at worst embracing a haphazard approach to investing or at best using a strategy that's not optimal for your time, effort and finances? You really have to take a step back from looking at stocks to assess what it is you're actually doing as an investor. For me, that amounted to researching many different investing styles before arriving at Graham's net-nets.

Probabilities are an interesting thing. You can be right on each one of your picks without all of them working out. After all, you're not right in the stock market merely because your stock has gone up and you're not necessarily wrong if it hasn't. Leveraging probabilities means putting together a portfolio of stocks that, as a group, has a better chance than not of working out. It also means recognizing that some of your stocks will disappoint and your portfolio won't work out each and every year.

Williams continues:

And that's really what it comes down to. Unlike those who have fallen into the Warren Buffett trap, spend time finding a proven strategy that's simple to use in practice and then stick to it. Doing so will mean shifting your chance of earning great investment returns over the course of your life so that the odds are in your favor.

So really, are you trying too hard?

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This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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