Five Ways To Beat The Market

By Wayne Middlesteadt

Since the turn of the century, gyrations in the financial markets have brought to light the risk that one is burdened with when investing in stocks. After hitting an all-time high in early 2000, the S&P 500 lost over a third of its value in two years. It recovered the loss only to fall again in 2008, but this time the crash was even worse. In just seventeen months the S&P 500 plummeted 57%! An investment made in 2000 was only worth half its original value nine years later. One is left wondering, "is there a way to invest in stocks that will allow me to make money without keeping me awake at night?" The good news is there is not only one way but five. Drawing on analysis of fifty years worth of data, "Five Ways to Beat the Market" presents five methods that will allow you to make money more quickly than the stock market itself will grow. These methods have the added bonus of getting you out of stocks when the market sours, thereby reducing your risk. Each method is presented with performance data from 1960 through 2009 detailing how much money an investment would have made and how likely a loss would have been. Step by step instructions are included, outlining exactly what you need to do to employ these methods successfully. Ways to boost your performance are also suggested, once the basic methods are covered. Over the fifty year test period, average compounded returns of 12% - 13% per year were recorded while avoiding the huge stock market crashes that have occurred. The "experts" will tell you that the only way to safely invest is to buy stock and hold on to them indefinitely. What they don't tell you is that you'll also need to cross your fingers and pray nothing bad will happen. Once you've mastered the simple methods in this book, you'll no longer need to worry. You will know when to get into the market and when to get out. Not only will you sleep better at night, but you'll enrich yourself in the process.

• Language: English
• Publisher: Wayne Middlesteadt
• Release date: Jan 30, 2013
• ISBN: 9781301871476

Book preview

Five Ways to Beat the Market

Simple Methods That Yield High Returns

Wayne Middlesteadt

Smashwords Edition

Copyright 2012 Wayne Middlesteadt

This book is available in print at most online retailers.

Smashwords Edition, License Note

This ebook is licensed for your personal enjoyment only. This ebook may not be re-soldor given away to other people. If you would like to share this book with another person,please purchase an additional copy for each recipient. If you’re reading this book and didnot purchase it, or it was not purchased for your use only, then please return toSmashwords.com and purchase your own copy. Thank you for respecting the hard workof this author.

Table of Contents

Introduction

1. Is It Possible to Beat the Market?

2. Investing In Efficient Markets

3. Is There a Safer Way to Invest?

4. Is the Stock Market Really Efficient?

5. Taking Advantage of Inefficient Markets

6. Using the Calendar to Make Money

7. Technical Analysis

8. The Simplest Technical Analysis Method

9. Another Simple Technical Method

10. Waltzing to Riches

11. What Method Makes the Most Money?

12. A Better Exit

13. Choosing a Method

14. Turbo-charging the Systems

15. To Roth or Not to Roth?

Afterword

Appendix 1: Formulas

Appendix 2: Simulation Assumptions

Appendix 3: System Statistics

Acknowledgment

Introduction

I was first introduced to the Efficient Market Theory, the theory that the current price of a stock is determined by all existing information about that stock, when I was working on my MBA. Immediately some of the assumptions used in formulating the theory struck me as odd. Most glaring was the assumption that all investors will make rational decisions. Really?

I’ve known a lot of people in my life, but I’ve never met anyone I thought made rational decisions 100% of the time. In fact a few seem to muddle through life despite the inanity of their thought processes. I can understand why the formulators of the Efficient Market Theory would assume rational market participants, it makes constructing the theory and using it as a tool less difficult. But personal experience has shown me that the assumption is inaccurate, possibly invalidating the whole theory.

One of the primary conclusions of the theory is that you can’t beat the market in the long run, therefore you should stay invested in it indefinitely, through good times and bad. But if the validity of the theory is questionable, couldn’t this conclusion be incorrect? I became determined to find out.

I started reading books by or about some of the legendary investors such as Warren Buffet and Peter Lynch. The methods they use fit within the framework of conventional academic financial theory. They spend thousands of hours pouring over corporate financial records, analyzing economic indicators, visiting companies, and gauging consumer trends, to determine if a company’s stock is over or under valued. If they decide it is under valued, they buy, but if it’s over valued, they sell. This is the basic model taught in universities throughout the world for the last fifty years.

On the surface, the security analysis they perform sounds like the most logical way to approach investment decisions. But is it practical for the average investor? Most of us don’t have the time or resources available to pursue such exhaustive research. Therefore we end up acting on incomplete information, chasing the latest trendy stock, and trading on tips. The alternative is to hand over your money to a mutual fund or financial manager and hope he knows what he’s doing. The statistics would indicate he probably doesn’t. In any given year the stock market average, represented by the S&P 500 index, beats 85% of all mutual funds.

Want more evidence that handing your cash over to a professional might not be the best plan? In 1988 the Wall Street Journal began running a stock picking contest. They had a panel of securities analysts pick a portfolio of stocks and measured how it performed over a period of one to six months. At the same time the Journal’s staff taped the stock page from their paper to the wall and threw darts at it. Using this method the staff created a competing portfolio of stocks. The dartboard contest was repeated over 100 times until 2002. The pros beat the darts 61% of the time. Sounds good right? But wait, that means you would have performed better than a highly paid analyst 39% of the time just by picking stocks randomly! When measured against the Dow Jones Industrial Average the pros only won 51% of the time. In other words, you can save a lot of money in management fees by putting your cash into a mutual fund designed to mimic the stock market and do just as well as the pros!

Many people have concluded that evidence such as the dartboard contest proves the Efficient Market Theory is valid, but is that the correct conclusion to draw? The poor performance of the analysts relative to the market average and random chance doesn’t imply that it’s impossible to beat the market. It just means you’ll have a hard time doing it using security analysis. So I continued searching for another way.

One day I ran across an article in my newspaper about Stan Weinstein. A local high school class had been paper investing in the stock market using techniques Weinstein described in his book Secrets to Profiting in Bull and Bear Markets. Some of the students had run up very large gains, as high as 100%, in just a few months. But they weren’t doing it by combing through corporate statements. They were doing it by looking at charts of stock prices and using the tools of technical analysis. Intrigued I bought a copy of Weinstein’s book, soon followed by many other books on the subject.

I realized I was moving in the right direction. I had found a method that didn’t rely on people to make logical decisions. Technical analysis gave me tools that would tell me what people were actually doing in the market, instead of what they should do if they behave rationally. However, there were so many tools I was overwhelmed. None of the books I read had step-by-step instructions telling you how to proceed. I knew I was on the right track but still didn’t really know what to do.

So I threw my self into designing technical systems and back testing them against past stock market data. My goal was to end up with a system that was simple to use, protected me against losses, and beat the market in the long run. After several years of crunching numbers I’ve developed not just one but several systems that meet these goals.

Once I had my systems I thought it would be a good idea to share them with my friends and family. I began writing up the rules and over time it evolved into this book.

About the book - you can read the whole book to achieve a better understanding of how the market works and what you need to do to profit from it. Or, you can skip ahead to chapter 6 and read the step-by-step instructions explaining how to go about implementing the various investing methods yourself.

The first two chapters cover the development of the Efficient Market Theory and the conclusions that are drawn from it. The third chapter discusses alternatives to investing in the stock market. The fourth and fifth chapters cover criticisms of the Efficient Market Theory. Chapters six through fourteen cover the various methods, how to use them, and ways to improve on them. The final chapter is a discussion of the Roth IRA versus the Traditional IRA, another area where financial consultants can lead you astray.

Overall, the book describes conservative methods of investing. It is not a get rich quick guide. The intent is to show you how to make money in the stock market while shielding you from some of the market’s risk. The methods described can be used with individual stocks, however my goal is to teach simple and safe investment strategies, therefore trading individual stocks will not be considered in this book (perhaps a future book). Instead we will limit ourselves to using mutual funds or ETFs that mimic the S&P 500, since this index provides a good proxy for the U.S. stock market. Hopefully the ideas and systems presented will give you the blueprint you need to successfully invest in the market and provide a profitable future for yourself.

1

Is It Possible to Beat the Market?

The Stock Market As A Game Of Chance

In 1900, an undistinguished French mathematics student named Louis Bachelier submitted his PhD thesis entitled The Theory of Speculation. Because the paper's arguments were not deemed rigorous enough, his work only received the designation of Honorable, less than the top designation of Trés Honorable. Despite this less than stellar review, his paper, which dealt with randomness in financial markets, was published in a French scientific journal. Bachelier himself went on to have a successful but obscure career as a professor at several French universities. He died in 1946, twenty years before his dissertation would vault him to fame as the father of conventional financial theory.

So what was in his thesis that was to prove so very influential? In the 19th century the stock market’s reputation was marginally better than that of a casino. It was perceived that, as the Mafia controls a casino, corporate insiders manipulate the market. While this was often true, it didn't stop outsiders from participating, and some of the outsiders began making a killing. Popular interest in the markets grew, prompting wider dissemination of accurate information via newspapers such as the Wall Street Journal. As more people played the market and information became easily available, the insiders lost their ability to control trading. By the end of the century, investing in stocks was still considered gambling, but at least now the average investor could participate on a more equal footing.

Coincident with this development was the trend of scientific investigation into the nature of uncertainty. The more scientists learned about the natural world, the more they realized there are many systems that behave in unpredictable ways. To study these systems they needed a tool to enable them to deal with uncertainty. The tool they employed was the Gaussian or Normal Distribution Curve. Borrowed from the mathematical field of statistics, the Normal Distribution Curve, better known as the Bell Curve, allowed them to guess with a known degree of uncertainty what a result would be. By employing this tool, science no longer needed to struggle to perfectly understand every aspect of nature. Instead they could develop general laws that would roughly predict outcomes. For example, doctors can estimate the mortality rate from a new influenza virus without needing to know every detail of the virus's biochemistry or the infected population's health and behavior. The ability to make educated guesses that are good enough greatly aided scientific efforts to understand complex systems.

Like the natural world, price changes in the stock market can be unpredictable, something Bachelier noticed as he searched for a thesis subject. He decided to see if a normal distribution could be used to describe what happens as prices change. To do this he made two assumptions about the market:

1.The stock market is a zero sum game. For everyone who makes money, there is someone else who is losing