Five Investing Tips I Learned at the Track

3. Eliminate the Losers

Picking winners is not an easy task. However, if you can eliminate the losers, then you are left with a pool of more likely winners. It is like taking the SAT or any another multiple-choice exam. First, you have four possible answers. You eliminate two answers that are definitely wrong. Now, you have increased your percentage of success from 25% to 50%. At the race track, the process is the same. I begin to evaluate a race by crossing out those horses with no chance of winning. You can do the same with investing.

Let's say you want to use the S&P 500 as your performance benchmark. Your objective is to outperform that index. You can do this with a "bottom-up" approach, which is to start with a clean slate portfolio and then build a portfolio that you believe will outperform that benchmark. However, another way to achieve this goal is to start with the entire S&P 500 as your portfolio and eliminate those stocks or sectors that would underperform the index. If you eliminate the underperformers, then you will be left with a portfolio that outperforms. For example, had you eliminated autos, retailers and financials from your investment universe and kept all other S&P 500 sectors in your portfolio, you would have had a leg up on outperforming the index.

4. Not All Favorites Are Good Favorites

Each horse is differentiated by an odds system. For example, a 2-to-1 horse is expected to win by more bettors than a 5-to-1 horse. However, bettors are not always correct. Just because a horse has the lowest odds in the race -- making it the favorite "chalk" -- does not mean that it will necessarily win the race. So a great way to win at the track is to eliminate "bad favorites." These are horses that the crowd thinks will win but which your research indicates may not. Thus, you look for better value with a stronger candidate and at a higher price (odds). The same bad favorite concept exists in investing. It's called the "value trap."

Take a stock like Pfizer (PFE Quote), for example. People think that Pfizer is a solid company in a very stable industry (pharmaceuticals). The stock's dividend yield of 6.70% makes it look much more attractive than other companies in more volatile industries, and that don't pay a dividend -- take Research In Motion (RIMM Quote) for example. Pfizer may look like the best bet out there, but the 6.70% dividend is not enough to replace the lost share price value. I would categorize Pfizer as a bad favorite. Still, investors will "play it" anyway. Between Pfizer and Research In Motion, I would put my money on Research In Motion.