Markets: News  

Mark Hulbert

Don't get mad, get even!

8/3/12 12:01 AM ET (MarketWatch)

CHAPEL HILL, N.C. (MarketWatch) -- Don't get mad, get even!

I say this because everyone's up in arms in anger over the lunacy that became even more evident this week in how Wall Street operates: Knight Capital, a firm that engages in high-frequency trading, experienced a software glitch that led to millions of shares being traded in a number of stocks in just a few minutes. (Read full story.)

But why get mad when we can make money from the market's madness?

Take the increased volatility to which high-frequency trading and other Wall Street developments sometimes lead. I would have thought that investors would, at a minimum, see a silver lining in it -- since it makes it easier to buy good-quality stocks at bargain-basement prices, and to sell stocks they already own at rich valuations.

To be sure, very short-term traders -- those whose average holding period is measured in hours, minutes, or even seconds -- will rightly be alarmed by the lack of orderly markets, whether they be caused by a rogue high-frequency-trading program or by something else entirely that Wall Street is thinking up. But I would argue that 99.9% of the people reading this column shouldn't even be trying to play that game.

That's because there's no way that we as individuals stand any chance of competing against large firms like Knight Capital that have powerful computers, sophisticated trading programs, and superfast connections to the stock exchanges that enable millions of trades to take place in a second.

After all, what are the odds we can get a trade executed at a better price than those firms? By the time we even have the information on our screens that they are reacting to, they've bought and sold millions of shares.

An analogy helps illustrate how silly I think most individual investors are who try to compete against the Wall Street firms: Imagine being able to choose two different playing fields -- one containing only players who are more or less our size and ability, with the other filled with athletes who qualified for the Olympic games.

Which playing field would you rather play on?

I would have thought the rational answer is utterly obvious, and yet -- over and over again, at least in the investment arena -- individuals are drawn to compete with the Olympians, against whom they are virtually guaranteed to lose. My wife, a clinical psychologist, refers to it as a death wish.

Consider a study I recently conducted of the 200 investment advisors monitored by the Hulbert Financial Digest, in which I investigated the relationship between their performance and the frequency of their trading. I found a statistically very significant inverse correlation between the two -- which means that the advisers who traded the least often had much better long-term performance, on average, than those who traded the most often.

How often do the top long-term performers trade? Take a look at the accompanying table, which lists the three advisers among those monitored by the Hulbert Financial Digest with the best performance over the last 25 years.

Their holding periods are about as far away from high-frequency trading as you can imagine.

Interestingly, there are four stocks that each of these three advisory services currently holds in their portfolios. You could have some fun with these stocks by placing buy orders for them well below their current prices and, if and when they are filled, sell orders well above.

At a minimum, you may find yourself purchasing at bargain-basement prices one or more of these stocks that the top performers already own. And, if the market's lunacy gets really out of hand, you will be able to turn a relatively quick and sizeable profit.

The four stocks that each of these three top services is currently holding in its portfolio are:

3M Co. (MMM)

IBM (IBM)

PepsiCo(PEP)

Walt Disney (DIS)