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Play Averages to Succeed at Investing? Deal!

So what does this have to do with investing?
Quite often we see the same sort of behavior in the stock market: always trying to do better than the average, folks will use all kinds of methods (including paying extra to get the top dog stock picker's advice) because they're sure they can beat the market. If a chosen stock shoots up in value the investor hangs on, "knowing" that if it went up 10% it is bound to go up another 10%. And what happens when the stock goes on up to 20%? Yep, they hang in there again.

Then suddenly the stock pulls back, and now is down 5% from the original investment -- what happens now? This is just like when the banker on the show reduces his offer: Investors feel like they've lost something already in hand, so they begin to take more risks, perhaps buying more of the stock -- again, "knowing" they'll "make it up." But it rarely works out.

The problem is that the investor didn't go into the investment with a plan -- and the same would hold true for a contestant on the game show. If you decided you were shooting for a 10% return from this particular stock, you'd have sold out at that level and could have gone looking for the next great option. Without a plan, you never know when to get out of the position.

A plan!
If contestants were to go into the show with a plan to do better than average: The first time the banker offered more than $131,477.50 (the average of all the amounts in suitcases), they would take it. It's an excellent strategy, especially when you consider that 20 of the 26 cases have less than the average amount inside.

As an investor, the odds are much better for you using history as a guide. The investor could choose to take a shortcut and get a return that is the average of the stock market. Since in the past four or five decades the stock market has returned a negative roughly 20% of the time, using the average would assure you of a positive return 80% of the time. That's much better than the results of the average Joe or Jane who plays the active stock-picking game.

To get the average of the overall marketplace, the investor can choose to invest in broadly diversified indexes. This is very cost-effective -- and you don't have to worry about when to get in or get out, or even shout "no deal." Go for it. And if you want a Deal or No Deal-style fist-bump, fine, come by my office. But I won't be afraid to actually shake your hand.


This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.
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