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Investing Lessons from Martha Stewart

By Christopher Farrell Has a stranger ever regaled you at a cocktail party with tales of his stock-picking prowess? Has a relative bragged at a barbecue about the killing she's making in the market? Did you beat yourself up for missing at $10 a share and not being able to sell it at $100? Are you chagrined about the stocks you did take a flyer on -- and lost money on?

Well, don't feel bad. Most people love to talk about their winners while ignoring the losers. It's tough to consistently rake in the cash trading individuals stocks, even for exceptionally smart professionals and savvy entrepreneurs. Just ask Martha Stewart.

Despite her recent legal troubles, no one doubts that Stewart is an incredibly successful entrepreneur. The former hard-charging stockbroker turned the art of homemaking into a multimillion-dollar media conglomerate. Still, a fascinating analysis of her stock portfolio by Meir Statman, a finance professor at Santa Clara University, shows just how ordinary an investor Stewart was. "The portfolio that Martha Stewart revealed to prosecutors and the jury at her trial is a portfolio of normal investors, containing both winners and losers, and the investment behavior she revealed is normal behavior, affected by cognitive biases and emotions," says Statman.

"LOATH TO SELL." Here are some of the pertinent, publicly available details: In her personal account with Merrill Lynch (MER), Stewart had a portfolio consisting of 35 stocks valued at more than $2.3 million as of Dec. 20, 2001. She also had a money-market account with Merrill of some $125,000. A wealthy, valued client, Stewart received highly desirable allotments in hot initial public offerings, such as those of Charter Communications (CHTR) and the original Palm.

Yet Martha didn't do so well on her investments. Her portfolio lost 47.35% of its value from June 30, 2000, when it was worth $4.5 million, to Dec. 20, 2001, vs. a decline of 21.26% for the Standard & Poor's 500-stock index, according to Statman's calculations. Problem is, she liked high-tech stocks like Amazon (AMZN), Doubleclick (DLCK), and Lucent (LU), among others, and she was reluctant to shed her losing investments. She seemed equally unwilling to cash in short-terms gains. She also held on to shares she had bought of various IPOs, watching her instant paper gains eventually turn into losses.

Here's what Peter Bacanovic, her former broker, said in his testimony last winter about Martha's trading strategy: "I have often recommended that she sell stocks at high prices to lock in gains. And she's very loath to sell stock, ever, and has often watched good gains evaporate."

HIGH PRICE. She did manage to pull the trigger, however. She sold 20 stocks on Dec. 21, 2001, two stocks on Dec. 24, and ImClone (IMCL) on Dec. 27. The 22 stocks were sold for a loss of more than $1 million, and ImClone for a gain of more than $166,000. Says Statman: "Normal investors are reluctant to realize losses and suffer the pain of regret when they do." By the way, the ImClone shares she sold for less than $60 in December that attracted the attention of prosecutors? They're now selling around $66 a share (see BW Online, 7/23/04, "A Beat-Up ImClone Looks Good").

But my point here isn't to beat up on Martha Stewart. Enough of that is already going on. I think some valuable lessons can be drawn from examining her investing style. Her portfolio emphasizes just how hard it is for even smart people or wealthy investors to consistently beat the market.

Why is it so tough? For starters, stock-picking is a sideline activity for most of us. We spend hours on our job, and then struggle to find time for family, friends, and hobbies, and maybe we're able to scrounge a few hours for some volunteer activity. There's little time or inclination to tear apart balance sheets, learn the dynamics of an industry, and gain insight into management.

BREAKING RULES. So, the answer must be to hire a professional to oversee your money, right? But no, Martha didn't pay much attention to her broker, which raises an obvious question: Why pay a steep price for advice that's ignored? Well, maybe the answer isn't using a pro after all. An investor who blindly takes a broker's recommendations isn't acting so smart, either.

For most long-term savers the better path, per Wall Street wizard Warren Buffett, is equity index funds. If that's how you invest, history suggests that you'll outperform 80% or so of professional money managers on a yearly basis and, most important, avoid a lot of common investing mistakes -- including the honest kind Stewart made. And fees are razor thin with index funds.

Stewart also violated the cardinal rule of investing: diversify, diversify, diversify. On the one hand, her stock portfolio was heavily weighted toward high-tech companies like Apple (AAPL), Nokia (NOK), JDS Uniphase (JDSU) and Sycamore Networks (SCMR). And on the other hand, most of her wealth was tied to the fortunes of her company, Martha Stewart Omnimedia (MSO), whose stock took a nosedive, especially since she became ensnared with the law.

CHUMP CHANGE. The lesson: Even driven entrepreneurs proud of their creation need to diversify their investment wealth. As the great financial adviser Don Quixote de la Mancha once said: "It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket."

On a more positive note, Stewart was smart with her portfolio in this sense: She didn't risk her wealth to her own stock-picking abilities or her brokers' acumen. A portfolio of $4.5 million is the equivalent of entertainment money for someone whose 60% stake in MSO was worth some $500 million before her legal troubles started. (It had been considerably higher in the wake of post-IPO euphoria.) It's a bad idea to put your standard of living or retirement at risk to stock-picking prowess. Too much trading is hazardous to wealth. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

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