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Book Review: The Big Secret for the Small Investor

April 15, 2011 | About:
Geoff Gannon

Geoff Gannon

414 followers
Joel Greenblatt is out with a new book: "The Big Secret for the Small Investor."

I downloaded it onto my Kindle the second it became available – because Joel Greenblatt is our modern day Ben Graham.

You Can Be a Stock Market Genius

Joel Greenblatt wrote the best investment book ever. It’s called “You Can Be a Stock Market Genius.” If anything, the title underpromises. Reading the book will, in fact, make you a stock market genius.

But that’s not why "You Can Be a Stock Market Genius" is the best investment book ever written. It’s the best investment book ever written…

“…Because Joel Greenblatt doesn’t talk personal finance. He doesn’t talk bonds. He doesn’t talk portfolios. He just says diversification is overrated and starts picking stocks. The next 250 pages are case studies. Greenblatt tells you how he found a stock, the situation it was in, why he bought it, and how much money he made. Benjamin Graham is value investing’s Old Testament. Warren Buffett is its New Testament. And You Can Be a Stock Market Genius is our Gospel of Mark. It doesn’t repeat saying or rehash dogma. It just tells stories. The case studies read like the present tense. You feel like you and Greenblatt are analyzing the stocks together.”

(Gannon On Investing)

Greenblatt’s new book is nothing like that.

Spoiler: The Big Secret

Joel Greenblatt’s big secret is value-weighted indexing. Value-weighted indexing means buying an index of stocks where the cheapest stocks make up the largest part of the index and the most expensive stocks make up the smallest part of the index.

The S&P 500 is a market cap weighted indexed. The biggest stock in the S&P 500 – Exxon Mobil (XOM) makes up 3.45% of the index. The smallest stock in the S&P 500 makes up just 0.01% of the index.

Using Greenblatt’s method the biggest part of the index wouldn’t be one of the biggest stocks – like Exxon Mobil – it would instead be one of the cheapest stocks.

So, for example – even though Apple (AAPL) is now a bigger part of the S&P 500 than Microsoft (MSFT), using Greenblatt’s approach would mean putting more money into Microsoft than Apple, because Microsoft is currently cheaper than Apple. It’s not their relative size that matters. It’s their relative cheapness.

Should You Buy the Book?

So should you buy Joel Greenblatt’s “The Big Secret For the Small Investor?”

That depends.

Have you read “You Can Be a Stock Market Genius?”

If not, go out and buy that book now. It’s better. In fact, Greenblatt’s second book – “The Little Book That Beats the Market” – is also better than “The Big Secret for the Small Investor.”

Greenblatt’s books from best to worst are:

1. You Can Be a Stock Market Genius

2. The Little Book That Beats the Market

3. The Big Secret for the Little Investor

Yes. That means Greenblatt is getting worse with each book.

The Big Problem with the Big Secret

There’s a reason for that:

“…this is my third investing book. The first one, “You Can Be a Stock Market Genius,” (yes, I know, I know) was meant to help the individual investor, too. It didn’t. It assumed investors had a lot of specialized investment knowledge and a lot of free time. (Actually, it did end up helping a few dozen hedge fund managers, but…) My second book, “The Little Book That Beats the Market,” gave a step-by-step method for the individual investor to just 'do it yourself.' I still believe strongly in this method and I still love that book. But here, too, I missed the boat. As it turns out, most people don’t want to do it themselves. Yes, they want to understand it. But they still want someone else to do it for them. So maybe the third time really is the charm.”

And that’s the problem with Greenblatt’s third book. It isn’t a dumbed down version of his earlier two books. Dumbing something down isn’t bad. Stripping the jargon out of a technical work and making it easy for the uninitiated to understand – that’s a useful service. But Greenblatt’s first two books didn’t have any jargon in them. They weren’t hard to understand. They weren’t technical. They just expected something from their reader.

Greenblatt’s first two books were written for what Ben Graham called “enterprising investors.” Graham didn’t separate investors based on education, or I.Q., or occupation. Nor did he separate investors based on risk tolerance. Those things matter. But only a little bit. Only a very little bit when compared to the key variable in every competition – drive.

How bad do you want it?

And how hard are you willing to work?

Warren Buffett had his road to Damascus moment when he was 18. Until Buffett read Ben Graham’s “The Intelligent Investor” he didn’t have a framework for picking stocks. He didn’t have any principles. He was adrift.

But Warren Buffett was driven.

Ever since he was a little kid, Buffett thought about stocks. He’d been trying and trying to learn. Buffett was – even before he was out of high school – already an enterprising investor by Ben Graham’s definition.

The truth is high school Warren Buffett had more business investing in stocks than mid-life anybody else. Not because he was brilliant. Not because he had the right principles or the right knowledge or the right anything – because at that point he didn’t. All he had was drive. All he had was a willingness to work.

And that’s the first thing every investor needs. If you aren’t driven – if you aren’t willing to work – you shouldn’t invest in stocks.

Greenblatt’s third book is written for investors who aren’t driven, who aren’t willing to work, and who – frankly – shouldn’t be investing in stocks.

Don’t get me wrong. Greenblatt has written a good book. But – because of its intended audience – it’s a useless book at best. And a dangerous book at worst.

Greenblatt has written the investing equivalent of "Appendectomies for Dummies."

He’s trying to teach value investing to a bunch of students with their fingers in their ears. Even if Greenblatt’s first book wasn’t suitable for some individual investors because they didn’t have the time to read SEC filings, his second book – “The Little Book That Beats the Market” – was appropriate for all individual investors who were willing to pick stocks themselves.

Greenblatt’s third book is only intended for investors who lack the will to pick stocks for themselves.

People like that exist.

Shouldn’t someone write a book for them?

No.

I’ve met these folks, I know these folks, and their problem isn’t that they don’t have the right plan. Their problem is that they don’t have the emotional equipment needed to carry out any plan.

Passive investors are misdiagnosed. These aren’t folks who are saying I’m interested in running a marathon but I just don’t know where to start. Show me. These are folks who are saying, "I’m interested in running a marathon but I’m not interested in training."

The best advice Ben Graham ever gave is that investing is most intelligent when it is most businesslike.

Investing isn’t a hobby. If you treat investing like a hobby, it’ll pay off like a hobby. Like betting horse races. Like going to casinos.

Systematic Human Error

“An investment strategy where 100 percent of your assets are invested in the stock market can result in a drop of 30%, 40%, or even more in your net worth in any given year … since most of us are only human, we can’t take a drop of this size without opting for survival. That means either panicking out or being forced to sell at just the wrong time.”

Greenblatt’s answer?

If a 100% allocation to stocks will cause an occasional 40% drop in your net worth – and you can’t handle that – you should change the allocation.

And that’s what most experts say. It’s the accepted wisdom.

It’s also wrong.

The evidence is obvious. The problem isn’t the plan. It’s the person executing the plan.

If you can’t stomach a drop of 40%, you can’t invest in stocks.

The problem is you.

Not your portfolio.

You.

No one wants to say that. No one wants to say that Wall Street is an investment Eden where stocks compound wealth in ways no other asset ever will. But the gates of this paradise are closed to most mortals simply because they’re too human.

But that’s the truth. That’s what all the research – even the research Greenblatt cites – actually tells us. To succeed in picking stock or mutual funds or asset classes – or heck even just holding on to them when everyone is selling – you need to behave inhumanly.

If there’s one thing behavioral finance has taught us it’s that when it comes to investing our human instincts are wrong, wrong, wrong.

We can either train ourselves to be inhuman or we can fail.

There isn’t a third option. Unless you actually have investors sign away authority over their own accounts – stop them from pulling money out of stocks when there’s blood in the streets – individual investors will always commit systematic human error.

No matter how well you engineer the plane, you won’t be safe with an untrained pilot at the controls. Eliminating other forms of failure isn’t enough. You have to either eliminate the human or train the human to eliminate the errors inherent in their own humanity.

Ben Graham had the right answer.

The investing world is divided into enterprising investors and defensive investors. Enterprising investors aren’t enterprising because they are willing to take more risk. They’re enterprising because they are willing to be trained.

Greenblatt has written a wonderful book. And he’s written it really, really well. It’s a terrific read. Breezy. Honest. Full of investment gems.

So why aren’t I quoting those gems?

Because those gems aren’t what the book is about. Greenblatt’s book is about doing something you can’t do.

It’s like handing a new recruit “Principles of Warfare for the Untrained Soldier.” It doesn’t matter how good that book is – it won’t remove the danger you’ve created by dropping someone who is emotionally unequipped into a situation we know humans can’t handle without conditioning.

Investors need practice. They need training.

Training starts with the willingness to be trained.

This book was written for those readers who refused to train themselves in the methods Greenblatt laid out in his first two books.

Putting a book in their hands is asking for trouble.

I know. That’s heartless.

Doesn’t everyone deserve a chance to earn good long-term investment returns?

Sure.

And anyone who is willing to be trained – by reading “You Can Be a Stock Market Genius,” by reading “The Little Book that Beats the Market.” by reading “The Intelligent Investor.” by reading “Common Stocks and Uncommon Profits.” by reading “One Up on Wall Street,” by reading Buffett’s letters – can earn good long-term returns in stocks.

You don’t need a certain income level or a certain I.Q. or a certain degree to invest in stocks. You can get the necessary training for free. You can buy the best books for less than $100.

But you can’t invest without working at it.

Which is really what "The Big Secret for the Small Investor" is all about. It’s about telling people who shouldn’t invest in stocks that they can invest in stocks if they just stick to a plan.

Which is true. But untrained investors won’t stick to a plan. They won't keep their heads when everyone else is losing theirs.

Without training, humans are too human to invest in stocks.

Training isn’t about technical knowledge. It’s about modifying behavior. It’s about teaching humans who naturally zig to instead zag.

This book isn’t going to train anyone. It’s just going to send people out there to invest in value weighted indexes and pull their money at the wrong time.

It’s just going to be another perfectly engineered plane with an imperfect pilot at the controls. And it’s going to lead to as many disasters as every other index fund.

"The Big Secret for the Small Investor" is a brilliant plan that won’t be carried out.

The intended audience shouldn’t read it.

The unintended audience – the enterprising investors reading this review – should.

The book sells for $11 at Amazon. It’s worth it.

I loved this book. Even when I knew the message it was preaching will do more harm than good. I still loved this book.

Buy it.

Enjoy it.

But please don’t give it to anyone who can’t stomach a 40% drop in their portfolio.

They don’t belong in stocks.

And they don’t belong in value-weighted indexes.

Follow Geoff at Gannon On Investing

About the author:

Geoff Gannon
Geoff Gannon


Rating: 3.5/5 (35 votes)

Comments

superguru
Superguru - 3 years ago
I thought Joe Greenblatt had launched some value weighted index fund sometime back. And their fees was quite high for an index fund.
Trustamind
Trustamind - 3 years ago
I thought Joe Greenblatt had launched some value weighted index fund sometime back. And their fees was quite high for an index fund.

sounds like he's doing marketing for his index fund
the Spark
The Spark - 3 years ago


I read the book and thought it could be summarized in about 3 pages. Not worth reading if you have read a summary of it.
EthanI
EthanI - 3 years ago
Some of us are anxious investors. With this slumping economy, uncertainty is normal when it comes to investment matter. Though, one of probably the most basic ways to grow wealth is through investment. Day trading may have that rush of excitement, however basic, sound investing has more to do with a comfortable retirement. To be able to invest effectively, however, it pays to know some fundamentals. Among the things you need to know is how not to invest.
kapil007
Kapil007 - 3 years ago
don't buy it if you are in investing for long time and understands the advantage of ETF's/indexes vs stocks.
Hester1
Hester1 - 3 years ago


I haven't read the new book, read Greenblatt's other two, so take this for what it's worth... But I think Gannon is spot on here, people who can't take the emotional aspect of investing shouldn't be!
Paleface
Paleface premium member - 3 years ago
I enjoyed your heartfelt summary that offers a clear and practical view of the three books by Greenblatt. I also share your enthusiasm for the fact that Greenblatt may have enabled everyone to be his own investment guru. Instead of Old Testament vs. New Testament, perhaps a better analogy would be the Reformation affirming the right of common people to pray without a priest. However perhaps it is best to avoid religion and politics.

Also I think we need to be clear about the performance numbers. Several Guru Focus articles seem to imply an average of 30% or 40% annually for Greenblatt or the Magic Formula. However according to Greenblatt's website FormulaInvesting.com, the Magic Formula backtesting results, plus the live results beginning in late 2009, show for 2001-2010 a 5-year average of about 11% and a 10-year average of about 17% annually. This makes Greenblatt one of my best sources, but there are at least 9 others about equally good.

Also, David Hackensack has written an amusing Guru Focus article, "Plan Not to Panic," in which he alleges... (a) While telling his followers to remain calm under losses of -40%, Greenblatt himself actually threatened to sue an associate for insisting on "not" bailing out at a loss of only -18%. (b) In addition, allegedly Greenblatt does extensive insurance-type hedging which minimizes his own losses. (Not to mention his being a billionaire.)

Also, you seem to imply that maximum leverage is obtained by remaining 100% invested, which I do not believe to be correct, for several reasons.

1. The investor certainly will do better with 10% to 20% of portfolio in cash, rebalanced continually, thus increasing leverage by buying cheap whenever the market drops. According to a Forbes article, Rothschild considered his cash reserves to be his best weapon for wiping out competitors. If you want to play hardball, then for the stock portion, just only raise the resulting dollar allocation and never lower it. So therefore the entire cash portion systematically becomes invested during downturns.

2. Or instead of cash, why not a low-deviation mostly-bond mutual fund. Several have a 10-20 year history of averaging 10-12% annually, while only losing -8% during calendar year 2008. With options like this available, the risk-benefit does not justify holding more than 66% in the Magic Formula earning 15% while tolerating losses of -40%. Once again if you wish, as the market drops, you can systematically reduce the bond fund's proportion, becoming fully invested for the rebound. (You'll potentially make more but I don't recommend it. You'll make plenty just by keeping the 2/3 ratio.)

3. Furthermore, what if next time the rebound does not happen? One glance at a DJIA chart from 1940 to the present suggests that we likely have been living in one big bubble since 1984.

5. Finally, there are other gurus and systems with a track record of at least 15% annually and which did not lose -36% in calendar 2008 but only 10-20%. Warren Buffett for one.

I believe that large portfolios should keep only about 1/3 of portfolio in general stocks, 1/3 in essential commodities such as gold and black gold (meaning oil), and 1/3 in a mixture of cash and low-deviation mutual funds. This reduces maximum overall total portfolio expectation from 16% down to 12% annually but greatly increases security.

For small portfolios, I tend to agree there is not much point in playing safe. When your life savings is not yet enough to save your life, or when your "cash reserve" can not by any stretch amount to more than your monthly paycheck, might as well go with no. 2 above. But if so, I would follow Buffett or someone else with lower deviation, not Greenblatt. Or if you prefer put 1/3 of portfolio in Buffett and 1/3 in Greenblatt, then can't hardly go wrong.

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