Image credit: “The Blue Boat (Ship of Fools),” Pieter van der Heyden, believed to be after Hieronymus Bosch, engraving, 1559, Rijksmuseum
By Jason Zweig | July 2, 2015 9:14 p.m. ET
This debate, relating to a column on performance hype that I wrote back in the Paleolithic Era of 1999, still might be worth reading, because it sheds light on how investors should evaluate ideas and techniques. I present it here without further comment, but I welcome your feedback.
Fools and Their Money
In her response to my [recent] column, Ann Coleman of the Motley Fool wrote, “It’s easy to criticize something you don’t understand and haven’t closely examined.”
Well, the better you understand the Foolish Four’s portfolios and the more closely you examine them, the less sense they make. While a basic Dow Dividend strategy of buying high-yielding blue-chip stocks makes perfect sense (as I took pains to point out in my column), the byzantine contortions of the Foolish Four portfolios do not.
It’s remarkable that when a Fool asks, “why do you think the price of a stock has anything to do with its performance?” Ms. Coleman has no answer. Stop and think about this for a moment: How can you possibly advocate an investing technique based largely on low price if you don’t know why–or even whether–low price affects performance? Considering that the intellectual validity of the Foolish Four “strategy” depends on the answer to this question, it’s stunning that Ms. Coleman admits she simply doesn’t know.
This is precisely the point I was making in my column: There is no reason why the current price of a Dow stock should have anything to do with its future performance. The Fools’ own explanations claim repeatedly that beta and stock price are correlated. There is indeed academic evidence that small-cap stocks have higher betas; and historically, small-cap stocks have had lower share prices than large-cap stocks. But this relationship can’t apply to the Dow; it’s not a small-cap index.
Nevertheless, the Fools plunge ahead and act as if this relationship between beta and stock price holds for the Dow too. But as Abraham Lincoln liked to say, it’s a poor thinker who claims there’s no difference between a horse chestnut and a chestnut horse. There is no logical reason why Dow stocks with lower share prices should be more volatile than Dow stocks with higher share prices.
In fact, there is massive evidence that no such relationship exists. Ask yourself this: If lower share prices of blue-chip stocks really are correlated to higher returns and higher volatility, then why don’t all the Dow companies split their stock constantly? Just think what it would do for the value of the managers’ stock options! [The Black-Scholes options theorem, used to price most executive stock options, holds that increased volatility increases the value of an option. So, if lower share prices really raised volatility, corporate executives could enrich themselves–risk-free!–simply by splitting their stock like mad.]
In short, without an explanation of why share price should affect the return of Dow stocks, and without any evidence for it either, there is no rational basis to the “evolved” versions of the Dow Dividend strategy.
But, as one Fool wrote, “It works, you idiot.” If you think that’s reason enough to justify investing in the Foolish Four, why does it not also justify investing in my Very Stupid and Extra Dumb portfolios? They, too, beat the market over a 20-year period. In fact, over the same time, stocks headquartered in South Dakota also pummeled the S&P 500. Should you buy a portfolio of stocks that are based in the Coyote State just because they’ve beaten the market? Of course not. The test of a valid investment strategy cannot be merely that “it works.” There has to be a simple, sensible explanation of why it works, or else we can’t tell whether it’s sheer dumb luck or whether there’s any reason to assume it will work in the future.
Finally, I’d like to respond to some other points raised by the Fools.
I do not write, and never have written, an investing newsletter. The Fools who believe this have apparently confused me with Martin Zweig (no relation).
Referring to the concluding section of my column, Ms. Coleman wrote : “To me the most revealing paragraph in the whole article is this: ‘When 90% of professional investors with their MBAs and powerful computers and multimillion-dollar research budgets can’t beat the market, why should you believe anyone who says you can do it…’ ”
To me that’s the most revealing paragraph in Ms. Coleman’s response, too. What were the words she chose to omit with that “…” at the end of the sentence? Here they are: “by day trading.” Did Ms. Coleman disagree with the sentence as I actually wrote it? I doubt she did. So she simply concocted a new sentence she *could* disagree with, one that directly contradicts my own beliefs. The sentence “reveals” what Ms. Coleman claims it does only after she deliberately hides the most important part of what I said. By omitting those three crucial words–and by presenting her doctored sentence as if it were my own original–the only thing Ms. Coleman has revealed is her own inability to stick to fair facts.
While I find this a little touching, if not sad, I can’t say it surprises me. The Fools seem to have a terribly hard time confronting honest criticism.
Source: Mutual Fund Mailbag, CNN.com, July 21, 1999: http://money.cnn.com/1999/07/21/mailbag/mailbag/index.htm