Ugh

Posted at 13:35 on Thursday September 29, 2005 | Filed Under Investing

From Russel Roberts, professor of economics at George Mason University (quoted in the WSJ):

Another airplane passenger story. I'm talking to the woman next to me and she asks me what I do. When I tell her I'm an economist, she says, "Too bad my husband isn't with me today, he'd love to talk to you." "Why's that?" I ask. "He's fascinated by the stock market," she replies. I had to tell her that I knew nothing about the stock market other than the virtues of indexed mutual funds. A useful thing to know -- one of the most useful insights of economics into personal finance -- but it would have made for a short conversation with her husband.

Sigh.

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Comments (4)

1.: Rajit:
you said that you know about indexed mutual funds. I was wondering if one of the better ways to build wealth using the stock market would be to consistently invest in industries as a whole that are under-performing with the expectation that at some point that industry will turn around. That way you would minimize the risks associated with purchasing shares in an individual company, but you would also get the advantage of not investing in a traditional mutual fund that attempts to hedge against large shifts in its price by investing in many different industries which can effectively diminish the possibility of a larger return.

Any thoughts?

Posted by Ian at October 2, 2005 11:57 AM

2.: "...with the expectation that at some point that industry will turn around."

I see two big potential problems:
1. Maybe the industry is dying out and won't experience great growth for a long time (if ever). I'm just picking an industry out of the blue, but let's say I wouldn't really want to be investing in the wood industry right now. If this is true, you're basically just trading one risk (investing in a single stock) for another (investing in a potentially dying industry).
2. There may be cyclical reasons for the industry being down, but that doesn't mean that betting on cyclical shifts is the best way to go. In other words, bet on the specific industry, not the process.

I do think that it's an interesting idea. There is some very good data showing that--at least with mutual funds--investing in the hot ones is often the worst thing you can do (it's too late and they'll be going down soon).

But I wouldn't use it as a catch-all approach to investing. And if you're worried about lesser returns because of diversification, you could also assume more risk and diversify less.

What do you think?

Posted by Ramit Sethi at October 3, 2005 11:41 AM

3.: Ramit--
You're right there is the potential that an industry will not return at all. However, I would think that is rare.
Right now the IT consulting industry is down 32.6 percent for the past 12 months, but it is reasonable to believe that the industry will return within the next 10 years at some point. So buying in that industry is a safe bet and it is likely that you will only get a positive return b/c it is performing so poorly at the present time.
The plan would be to only buy in industries while they are down and hold on to them until they are one of the better performing industries at which point you sell, and then buy into another lagging industry. If this was done on a continual basis, over many years it would be difficult to lose b/c there is always some unexpected industry that is doing really well (i.e. the gold mining industry is up 21.3%...what person outside of the industry would have predicted that?).
The only difficulty I would have right now is finding a mutual fund that only invests in specific industries. I have not put this plan to use, but wanted to see what other people thought.
(I apologize for misspelling your name earlier).

Posted by Ian at October 3, 2005 05:46 PM

4.: Isn't this just the same idea of "buy low, sell high?" The problem is still the same: identifying when "low" and "high" is.

There are lots of industry-specific mutual funds (you can search for them on any brokerage site).

I still think your idea is interesting but it's not as simple as it sounds. I vaguely remember that there is a name for this strategy (and some surprising results), but unfortunately I don't remember the name or the results (oops). If you dig it up, will you let me know?

Posted by Ramit Sethi at October 3, 2005 06:14 PM

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