In the late nineteenth century, Charles Dow, a journalist with a high school education, conceived an index to act as a barometer of everyday stock prices. His thirty-company index, known as the Dow Jones Industrial Average, has stood the test of time and is the metric by which even today the performance of the stock market is judged. In the ensuing hundred-plus years after the index was established, a cottage industry has come into existence with strategies for beating the Dow. The developers of these strategies, some dubious, but a number of them that are linked firmly to financial theory, seek to identify ways by which the investor can outperform the market.
Charles Carlson for long has espoused the cause of the average investor through his books on fiscally prudent investing. As a money manager and the editor of an investment newsletter, Carlson’s daily work life is entwined with the Dow Jones Industrial Average. Intrigued by the possibilities offered by the index, Carlson systematically analyzed the historical performance of this thirty-stock basket. He presents his findings in the form of an investment strategy in the current book.
In any given year, some of the Dow stocks perform poorly in relation to the others. These are the “dogs” of the Dow, but Carlson thinks of them more as “underdogs,” because in his study he found evidence to believe that the underdogs of one year outperform the index in the following year. In other words, his investment strategy calls for buying the underdogs of one year (he suggests various strategies of buying either one, two, or several of these underdog stocks depending on the investor’s risk propensity and available funds) and selling them exactly one year later when these erstwhile underdogs have shown a significant increase in price. The financial underpinning of this strategy is the tendency of large company stocks to revert to the mean. Using the analogy of a stretched rubber band that eventually comes back to its original position, Carlson argues that large company stocks ultimately come back to the equilibrium point, or their normal state. To support his treatise, Carlson uses stock data going back to 1930 to prove the point that there is money to be made in underdog stocks.
The stock market is filled with investors, money managers, and myriad ideas for making money. It is often difficult to separate the wheat from the chaff, from the charlatans to the prudent. Carlson’s compelling study allows normal investors to look for value in the stock market and using limited resources benefit from market swings in prices. Carlson is careful in pointing out, at several points in the book, that the strategy he suggests should be part of an investor’s diversified investment program and not a stand-alone strategy. Written in a friendly, self-deprecating style, the book is an easy read and more importantly, actionable. It should be a part of every investor’s library.