A reader contacted me with an interesting question. He owns a stock that is subject to a takeover bid. The bid has caused a spike in the price. He wants to know if he should sell now or wait until after the takeover is complete.
I checked for news stories. There is no shortage of analysts who have an opinion. Their advice is based on an assessment of the likelihood of success of the hostile takeover bid.
Here was my advice. Post a piece of paper on a wall. In vertical order, write “buy”, “sell”, and “hold” on the paper. Move back 20 feet. Throw a dart. Take whatever action is closest to where the dart lands. In my opinion, this strategy is as likely to produce a favorable outcome as relying on investment professionals. This is true because many of these professionals make a living confusing luck with skill.
You would think mutual fund managers are investment experts. They are paid handsomely to beat their designated benchmarks, yet most of them fail to do so in any given year or over longer time periods. Those that do are quickly anointed as investment gurus by the financial media. The reality is the positive returns of most of the winning fund managers can be explained by luck. One study of the performance of 3,156 mutual funds found fewer funds with statistically significant outperformance than you would expect by chance.
There’s another fundamental problem with relying on the opinion of experts. All information about public companies, including the company subject to the takeover bid, is in the public domain. Millions of traders, including professional arbitrageurs, are no doubt running complex “what if” scenarios into their mega computers. The current price of the stock reflects the collective judgment of these traders. Is it likely they are wrong?
When you are confronted with a decision to buy or sell, you are assuming the stock is mispriced. However, consider this fact: If you decide to sell, who will be buying? Someone who has decided, based on the same information you have, that the stock is a good buy. One of you will be correct. Why would you assume your information and analysis is better than theirs?
There is no shortage of people willing to make predictions. Many of them would give my reader an answer he would find more satisfactory than mine. A website tracks the predictions of self-appointed investment gurus, like Jim Cramer and Abby Joseph Cohen. Most of those tracked did worse than if they had just made random choices.
One study found that, in bad economic times, forecaster errors were four times greater than when the country is not in a recession. The ramifications of this study are troubling: When investors really need the assistance of experts, the accuracy of their predictions is worse.
You need to be aware of this data if you are relying on the guidance of investment experts. Your decisions based on chance are likely to be as reliable as theirs. If you want to get really lucky, recognize the difficulty in demonstrating the investment skill of any fund manager. Focus on your asset allocation and invest in a globally diversified portfolio of low management fee index funds.
Dan Solin is the author of the New York Times best sellers, The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.