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Beware Investing Gimmicks

I was reading USA Today a couple weeks ago when I saw John Waggoner’s [3] column about the Dogs of the Dow investing strategy [4]. It’s a pretty easy strategy and one that I find really appealing. All you do is buy equal amounts of the ten highest dividend yielding components of the Dow each year and swap them out each year.

The strategy relies on the idea that each of the thirty components of the Dow is a stable company that will be here for decades to come. The ones with the highest yields are simply the companies that have had their share price beaten down by Mr. Market. By buying into the companies with the highest yields, you’re assuming you’re buying good companies at a discount and that they will eventually revert to the mean.

One problem… and Waggoner, to his credit, states it right off the bat, there are problems with “formulaic investing,” or what I consider gimmicky investing, and the fact that the Dogs of the Dow have performed terribly until this year is an example of that. (I don’t like the term formulaic because isn’t all analysis in some way formulaic?)
There are a lot of little gimmicks like Dogs of the Dow and many of them are popular to talk about when they work and popular to ignore when they don’t. “Sell in May And Go Away” is another popular one of these investing gimmicks that says you should sell all of your stocks in May, buy bonds, then shift back into stocks in November. While you may scoff at the idea, since 1950 the Dow, on average, has gained 7.4% from November through April while only 0.4% from May through October (Huffington Post [5]).

Another popular one is the January Effect [6], first observed by Donald Keim at the University of CHicago. It says that stocks tend to increase in the month of January because investors have been selling stocks into the end of the year for tax purposes, so you should buy them in January as investors re-enter positions after the 30 day wash rule period [7].

In the end, there is no “get rich quick” system for the stock market for the individual investor. It’s a random walk [8] and you can only “win” by buying for the long term and waiting.

As an aside, let’s say one of these gimmicky investing schemes does actually work. Eventually, and usually very quickly, it’ll fail under its own popularity. If some strategy were to work, everyone would pile into it and the strategy wouldn’t work anymore. Dogs of the Dow looks great on paper: buy stable blue chip companies when they’re down and out, recycle each year, book the profits. The problem with that strategy is that blue chip companies can go kaput just as easily as “unstable” startups. When that happens, this strategy takes a huge hit as 10% of it goes to zero.

In the end, there’s no shortcut to investing in the stock. You have to do your homework, diversify, and reduce your costs… which is why index funds are so appealing (but also so boring).