Investing 101

How to Become a Profitable Stock Market Investor

On October 19, 1987 (“Black Monday”), the Dow Jones Industrial Average dropped 22.6% in a single day.

To put that number in perspective, that’s about twice as much as the S&P 500 has fallen in all of 2022 (so far).

Back then, my mother was still new to the stock market.

But she always had solid contrarian instincts – combined with a deeply ingrained reluctance to pay retail price for anything.

She told me that she spent the day after the October crash on the phone with Merrill Lynch, buying blue chip stocks hand over fist.

Was my mother a passionate investor?

Did my mother spend hours a day poring over stock reports?

Was her strategy to bet big on the stock market part of a well-thought-out investment strategy?

The answer to each question is an emphatic “no.”

In fact, my mother didn’t care much about investing at all.

She had no formal investment education. She could not read a company’s financial statement. She didn’t follow the ebb and flow of the stock market on TV. (CNBC didn’t hit the airwaves until 1989.)

After all, my mother was an English professor.

She made a single big decision the day after the crash of 1987.

And that was to buy stocks “on sale.”

She did this believing that stocks would eventually rebound like they always had.

And that single decision in 1987 made a bigger difference to our family’s finances than any other decision she made over the next decade.

The Meaning of Mean Reversion

Unknowingly, my mother was applying a principle she could not even name.

Statisticians call it “mean reversion.”

[First Look: Used on board SpaceX Dragon, one device could change medicine forever…]

It is the tendency, after extreme changes, for things to revert to their long-term averages.

The short-term, day-to-day movements of the stock market are chaotic and unpredictable. (Academics call this a “random walk.”)

At the same time, markets often oscillate between extremes within a long-term trend.

You’ll recognize mean reversion even as a casual market observer.

Periods of pessimism are followed by periods of euphoria.

Sharp market rebounds are followed by equally sharp sell-offs.

High-volatility periods are typically followed by low-volatility periods.

You see mean reversion in many investment strategies. Much of technical analysis is based on mean reversion.

You’ll often hear experts opining on “overbought” or “oversold” market conditions.

Well, that’s all about mean reversion.

Mean Reversion Works… Until It Doesn’t

If mean reversion is such a no-brainer, why doesn’t everyone do it?

Why didn’t more people pile into the market as my mother did in October 1987?

I see two major reasons.

First, when you bet on mean reversion, you are betting against the crowd.

And that is easier said than done.

In many ways, my mother’s indifference to investing allowed her to bet big on a market rebound.

She just saw a big sale in stocks. So she decided to buy a lot of them.

No modern portfolio theory is required.

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Second, mean reversion sometimes fails.

A drop in a company’s stock price could mean that it no longer has the same promise it once did.

This is especially the case for growth stocks, which are priced on promises of glorious futures.

That’s why disruptive technology stocks and other high-risk assets tend to get hit hardest during a sell-off.

Still, it’s hard to tell the difference between a simple short-term sell-off and one that signals a lasting shift in a company’s prospects.

The good news is that what applies to individual stocks does not necessarily apply to the market as a whole.

The Paradox of Mean Reversion

This leads me to a subtle but important point about mean reversion.

Over the long term, the U.S. stock market trades predictably upward.

That was precisely what my mother was betting on.

At the same time, many companies in the stock market do fail or drop out of the S&P 500.

In 1969, 166 of the companies in the S&P 500 Index – a full 33% – were industrial stocks.

By 2019, that number had dropped to 70.

Meanwhile, the number of S&P 500 companies from the technology sector grew from just 16 to 68.

Betting on the wrong industrial – or the right tech – company would have either made or lost you a fortune.

But you’d never be able to predict the outcome in advance.

Contrast that with the fate of the overall market.

Despite all the changes throughout the last 50-plus years, the S&P 500 has closed the year with a gain 42 out of 52 times since 1970.

That’s a win rate of close to 81%.

On balance, mean reversion often fails at a company level.

But it holds up remarkably well for the stock market as a whole.

Lessons From My Mother’s Investment Success

My mother’s financial advisor once told me that her portfolio is the best-performing one among all his clients.

He described her strategy this way…

She always swings for the fences – but does so with blue chip stocks.

Today, a whopping 45% or so of her portfolio consists of Apple stock.

As it happens, Apple accounts for just about the same percentage of Warren Buffett’s firm Berkshire Hathaway’s publicly traded portfolio.

The bottom line?

You don’t need to become a trained financial expert to become a profitable stock market investor.

Just take advantage of a handful of opportunities that come your way, as my mother did.

And you, too, can put Wall Street professionals to shame.

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Read more from Nicholas Vardy at LibertyThroughWealth.com

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