Bad Advice

Madder Money

Me vs. Jim Cramer, Round 2.

Browse the entire Bad Advice series here.

My article about Jim Cramer two weeks ago generated a lot of feedback. For starters, I underestimated how many people take Mad Money seriously. Here are some of the arguments his fans made to me. My responses follow.

1. “Jim Cramer does not think you should speculate with your retirement savings—just your ‘mad money.’ “If this is true, phew. (I say “if” because I didn’t see this caveat in the Mad Money show description or in the introduction to Cramer’s new book, Mad Money: Watch TV, Get Rich.) Assuming you define “mad money” as “the amount you would be willing to blow on a weekend in Vegas,” you’ll be OK. The odds of winning the speculation game—e.g., doing better than a low-cost index fund—are low, but as long as you understand this, there’s nothing inherently wrong with speculating. Speculating is fascinating, entertaining, and fun. Unless you have a major talent or information edge, however, it’s also a bad investment strategy.

If you’re looking for speculation advice, then Cramer’s is probably as good as any pundit’s (or would be, if it weren’t broadcast on national TV). Before you rush to the gaming tables, however, just remember that every dollar won by one speculator has to be lost by another, and your competition is a lot tougher than you might think. When you speculate, you are competing against thousands upon thousands of full-time professionals who have information and resources that you can only dream of (and who also watch Mad Money). After accounting for costs and risks, your odds of out-trading such professionals consistently are very low, even if you have above-average skill.

(For a detailed explanation of why most speculators lose, please see Chapter 6 of The Wall Street Self-Defense Manual, available as a free excerpt here. For more information on your competition, read Chapter 7: “Meet Your Competition.”)

2. “Jim Cramer is right a lot.” No argument here. Cramer’s a smart guy and an experienced trader, so of course he’s right a lot. He predicted Google would go to $500, for example, when most Wall Street analysts were suggesting it might peak at $200. I am not arguing that Cramer is usually wrong. I am arguing that his overall investment advice—try to out-trade the pros—is lousy. A far more intelligent strategy, one that will beat most pros, is to buy and hold a diversified portfolio of low-cost index funds. In the vast majority of cases, this will yield higher returns with less risk, time, effort, and stress than short-term speculation. The good news is, even if you pursue the smarter strategy, you can still watch Cramer’s show. Just don’t fool yourself into thinking that it will give you a good chance of winning the speculation game.

3. “If you had followed Jim Cramer’s Mad Money recommendations, you would have beaten the market.”  I have seen no studies that conclude that Cramer’s recommendations have beaten the market even before costs (and I have seen a couple that have concluded the opposite).  In the real world, of course, you can’t ignore costs, and costs usually bring even talented speculators to their knees. If you want to convince me that you would have beaten the market by following Cramer’s recommendations, please:

a) Explain how, exactly, you are defining a “recommendation.” Which of the dozens of opinions, recommendations, and/or remarks Cramer makes on a given day are you acting on? Are you weighting all the recommendations equally, or giving greater weight to some? Are you doing this ahead of time, or after the fact?b) Deduct all transaction, research, opportunity, and tax costs. This is critical. In any given period, about half of speculators will beat the market before costs. After costs, however, most will lag it. When adding up your costs, please be sure to include the time you spend watching the show, doing research, and monitoring your portfolio (“research costs”); your annual tax bill (“tax costs”); what you would have earned had you just invested the money in a low-cost index fund ("opportunity costs”); and, of course, your brokerage commissions.c) Calculate the risk of the portfolio relative to that of the market. Riskier portfolios are more volatile. This often produces higher returns but only by exposing you to more risk. A simple analogy is roulette: Gamblers lucky enough to hit a single number in roulette make a far better return than those who just bet on red or black. This doesn’t make them better investors.

If, after doing this, you still believe that Cramer’s recommendations have beaten the market in the past, ask yourself why you should reasonably expect them to continue to do so in the future. Past performance is generally not a good predictor of future results.

4. “Jim doesn’t say you should just blindly do what he says. He recommends that do your own research—and he tells you how to do it.” At first blush, this sounds responsible and persuasive (and it’s certainly more responsible than “watch TV, get rich.”) The trouble is that it encourages amateur investors to believe that, if only they watch the show and do a bit of research, they can win the speculation game. The reality is that your odds of winning are low even if you have above-average skill and even if you do nothing but research.

Remember, your competition—all other traders—are primarily full-time professionals who do nothing but research and trade all day long. Unless you have a multimillion-dollar research budget, a platoon of brilliant analysts, relationships with salespeople at all major brokerage firms, relationships with senior managers at every company, a Rolodex full of industry contacts, and a decade or two of trading experience, you will be at a serious disadvantage no matter how much research you do. Remember, too, that the vast majority of professionals, even those who possess all of the above advantages, lose the speculation game (because it is really hard to win). Then ask yourself again why, by watching a TV show and doing some part-time research, you should reasonably expect to win.

(By the way, how do you think the managers of 15,000 U.S. hedge funds and mutual funds feel about competing against millions of part-time amateurs who think that watching Mad Money gives them an edge? Answer? Stoked. Finally, some easy money.)

5. “Jim Cramer is smart and talented.” Again, no argument here. I have great respect for Cramer’s brains, talents, and work ethic. Given how much he could actually help average investors, I’d like to see him use those talents to promote intelligent investing instead of speculation. Perhaps, someday, he will.