Observant market watchers have seen repeated confirmation of the theory that the mass of the market is usually wrong—not just the amateur investor, but the majority of professionals as well. You may recall that a previously cited 1985 study by Consumer Reports revealed that only 63 of 289 stock mutual funds outperformed the Standard & Poor's (S&P) 500 over a five-year period.* These funds are professionally managed; yet, less than 22 percent did better than the broad-based S&P 500.
Do not fall for the illusion that professionals perform in the market any better than you can. In fact, one of the highly successful market stories is the history of investment clubs, a form of small, informally managed mutual investing. A small group of people, usually under 20, pool their funds and invest together. If these groups follow fundamental principles, history has shown, investment clubs tend to profit significantly better than market averages. This information, compared to the mutual fund study, could indicate that mutual fund managers might tend to be distracted by technical indicators and crowd thinking; and that adherence to formula investing based on fundamental decision making is the right way to go.
KEY POINT Statistics show that you may do better investing without professional help than you will do depending on someone else. Some distance from the daily workings of the market might be a plus.
Consumer Reports, 1985 (A more recent survey by Morningstar, Inc., studied the same question for United States diversified stock funds. Those beating the S&P 500 were down to a dismal 10 percent in 1997—cited in The New York Times, January 11, 1998.)
Investment clubs following the strategic approach recommended by the organization for such clubs, the National Association of Investment Clubs (NAIC), will very likely do well in the market. (For more information, contact the NAIC at 711 West Thirteen Mile Road, Madison Heights, MI 48071; telephone, 810-583-3212; fax, 810-583-4880.) The NAIC suggests four principles: (1) invest regularly, regardless of the market outlook; (2) reinvest all earnings; (3) invest in growth companies; and (4) diversify to reduce risk.* The advantage an investment club has is twofold. First, the organization is small enough so that each member can have direct and significant impact on the investment policies and strategies of the club; and if any members are tempted to stray from the fundamental approach, other members will tend to redirect that member. Second, the organization is small enough to manage effectively and to make decisions in a timely manner—which might not be true for mutual funds, which handle millions of dollars in investment assets.
The investment club approach, like individual methods of fundamental analysis, is largely contrarian because it assumes a long-term point of view and intentionally ignores the momentary news of the market. This is especially true regarding price movement and DJIA levels. One market test used by contrarians is the odd lot theory. This is an approach based on the belief that odd lot traders are usually wrong, and that a significant change in trading patterns should be taken as a reverse signal.
An odd lot is a trade of fewer than 100 shares of stock. In order to minimize trading costs, stock is normally traded in round lots of 100 shares or shares traded in multiples of 100. By trading in round lots, commission costs are standardized. You may trade in odd lots, but you will pay a higher commission for the privilege. As a general rule, odd lot traders are people who do not wish to purchase 100 shares of stock. Generally speaking, such a trader cannot afford to buy a full round lot; thus, the odd lot trader tends to be a novice with limited capital. Followers of this theory believe that when the volume of odd lot trading grows substantially, it serves as a signal to take the opposite action—a purely contrarian approach.
* Thomas O. O'Hara and Kenneth S. Janke, Sr., Starting and Running a Profitable Investment Club, Times Business, 1996, p. 16.
The odd lot theory is called a sentiment indicator because it measures what investors are thinking, rather than some financial or index movement or value. Economists like to measure what consumers think as a means for determining the direction of the economy; likewise, market watchers believe that future market movements can be predicted by measuring what investors think. However, the contrarian does not put faith in the opinions of odd lot traders; rather, they believe that more than any other trader, the odd lot trader is invariably wrong, and the opposite action is indicated. So when buying volume among odd lot traders grows, that should signal selling activity; and when selling among odd lot traders grows, that should signal buying activity.
Like so many nonfundamental theories, the odd lot theory is broadly generalized and even biased. After all, if you assume that odd lot buyers do not make the right decisions, then why should you invest based on indicators they develop? Even though the odd lot theory tells you to do everything in opposite, that does not mean that the odd lot theory should be used dependably and exclusively. As with all forms of market information, the odd lot theory is one among many indicators and should be used along with other information. As a general rule, any indicated change in the market should be confirmed by other tests before you act.
Example: You are considering investing proceeds from the sale of an investment property in common stocks. You have been watching several growth companies lately, and you are looking for key indicators as to whether or not the timing makes sense. The odd lot statistics show a recent large run-up in buy volume. Under the odd lot theory, this should signal that now is not the time to buy. However, you don't want to act on this information alone. You will depend on other indicators, specifically the fundamentals of the specific companies in which you plan to invest, as well as trends in the industries involved. You plan to monitor net margin, sales volume, price-earnings (PE) ratio, earnings per share, dividend yield, and other tests, not just the odd lot information.
In this example, the odd lot activity may be troubling because, if you accept the theory, it could be bad timing to purchase stocks at this moment. This often is as far as investors go—finding a theory that is relatively easy to monitor and then depending on that theory as the sole means for decision making. It makes more sense to use theories like the odd lot theory as a means for performing other tests or exercising greater caution, but ultimately acting based on what the fundamentals reveal.
A single indicator that catches your attention might give you insight to the market, but any single indicator should be confirmed before you act.
In this instance, you might discover that a flattening in sales activity and a rising PE ratio indicate that stocks are overpriced, and that waiting until prices and the trends settle down makes sense. Alternatively, you might conclude that the fundamentals look better than ever and the odd lot indicator is too generalized and doesn't seem to apply. Thus you will not wait, but will act now on the fundamental information you have compiled.
Odd lot information is market-wide for the most part, so watching this statistic might give you only market-wide opinion. This is relatively meaningless when you are thinking of purchasing a specific stock. In many cases, a momentary mood or trend in the market has no effect whatsoever on one stock's value. At any rate, the concern and the deciding factors should be long-term in nature. The odd lot theory is a favorite contrarian indicator, and can help in the timing of purchases and sales; it should not serve as your sole means of analysis.
