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Betting Against the House

It's New Year's Day 2012. In addition to overdosing on televised college football, you're spending part of the holiday working on the family finances. Armed with a laptop and various online financial tools, you're on the hunt for appealing stock market opportunities. To prune the list of candidates to a manageable size, you decide to focus on firms that are leaders in their respective industries and exhibit above-average scores on various measures of financial strength. As you work your way through the alphabet, you come to the "P" stocks, and another candidate appears. It's a prominent player in a major industry (good), but operates in a notoriously cyclical industry (not so good), pays no dividend, and has a junk-bond credit rating of BB-minus. Next! You push the "delete" key and move on. Congratulations. You just passed up the best-performing stock in the entire S&P 500 Index for 2012.

Stock Prices Are Forward-Looking

Shares of Pulte Group, a Michigan-based homebuilder with a 60-year history, jumped 187.8% last year amid strong performance for the entire industry. For the year ending December 31, 2012, all 13 homebuilding firms listed on the New York Stock Exchange outperformed the S&P 500 Index by a wide margin, with total returns ranging from 34.1% for NVR to 382.8% for Hovnanian Enterprises. The Standard & Poor's Super Composite Homebuilding Sub-Index rose 84.1% in 2012 compared to 13.4% for the S&P 500 Index.

The point? For those seeking to outperform the market through stock selection, underweighting the market's biggest winners can be just as painful as overweighting the biggest losers. Investors are often caught flat-footed by stocks that do much better or much worse than the broad market, and the problem is not limited to individuals. Not one of the 10 seasoned professionals participating in Barron's annual Roundtable stock-picking panel in early January 2012 mentioned homebuilding stocks or any housing-related firms.

The recent surge in housing shares also serves as a reminder that stock prices are forward-looking and tend to rise or fall well in advance of clear changes in company fundamentals.

"There is an easy way to own the best performing stocks in the S&P 500. Own all of them!"
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Waiting for Evidence of Healthy Profits Can Lead to Frustration

Investors who insist on waiting for evidence of healthy profits before investing are often frustrated to find that a firm's stock price has appreciated dramatically by the time the firm begins to report cherry financial results. Shares of Hovnanian Enterprises, for example, rose 580% between October 7, 2011, and December 31, 2012, even though the firm continued to report losses. Similarly, it is not unusual for a firm's stock price to decline long before signs of trouble become obvious.

Many observers in recent years predicated that a recovery in the housing industry would be agonizingly slow, and they were right. Many investors in recent years have avoided housing stocks as a consequence, and they've been wrong: Housing stocks have outperformed the broad U.S. stock market by a healthy margin from the market low in March 2009 to the present day.

BOTTOM LINE: Markets have 101 ways to remind us of Nobel laureate Merton Miller's observation—diversification is the investor's best friend.

Source: DFA Fund Advisors

About Bruce J. Berno, CFP® Bruce J. Berno, CFP® is the founder of Berno Financial Management, Inc. a fee-only comprehensive personal financial planning and investment advisory firm headquartered in Cincinnati, Ohio. Since 1993, Berno Financial Management has been helping individuals and families achieve financial peace of mind. For more information about Berno Financial Management, visit http://www.bernofinmgt.com.