The Little Book that Beats the Market has quickly become one of my favorite investing books. Below you’ll find my written book review for this classic. If you prefer to consume this book review in an audio format, I have also recorded it in podcast form. I actually read the second version of this book, which is called The Little Book that Still Beats the Market. Basically, the contents of the book are identical. However, the newer version has a changed introduction and afterword which takes into account the Financial Crisis of 2009.
Synopsis of The Little Book that Beats the Market
The Little Book that Beats the Market is written by Joel Greenblatt to explain the concepts of value investing to his children. The investing concepts are explained at a sixth-grade reading level. Thus, concepts are kept simple and the use of examples and allegory is extensive.
This is one of the best aspects of the book. Joel Greenblatt is a great teacher because his explanations are simple. In addition, his examples are easy to understand and are well explained. Therefore, I would recommend this book to readers of all ages interested in investing.
The basic concept of the book is that it’s quite simple to beat the market. So simple in fact, that a specific magic formula can be spelled out. As long as you follow the magic formula, you’ll be able to beat the market over the long-term.
If that sounds too good to be true, that’s understandable.
Author’s goals for The Little Book that Beats the Market
The author Joel Greenblatt understands your skepticism. His goal is twofold:
- Share his magic formula with you
- Explain the concepts that make the magic formula work.
The second part, teaching the concepts is much more important than the magic formula itself.
As Joel Greenblatt says on page 6 of The Little Book that Beats the Market: “If you don’t believe the magic formula will make you rich, it won’t.”
The reason is quite simple. Only someone who understands that the “magic” in the magic formula isn’t really magic at all, will be able to use the magic formula to beat the market.
For those that read the full review, I’ve included a special bonus near the end. I have built a better way for you to invest using the magic formula. The best part is you don’t have to pay any ongoing fees to implement the strategy. Thus, it’s even cheaper than an index fund.
Rating of The Little Book that Beats the Market by Joel Greenblatt
I give the book five stars.
For those who don’t know my rating system, it’s somewhat unique. I developed my rating system in-house. My rating system is specifically tailored to those interested in investing and personal finance. A 5-star rating means the book is a “Must Buy Book for anyone interested in the broad subject.” In this case, the broad subject is investing.
I believe The Little Book that Beats the Market by Joel Greenblatt is a must buy for those interested in investing. I would recommend this book to anyone and everyone interested in investing. Joel Greenblatt succinctly teaches the major concepts of value investing. In addition, he provides an easy to understand investing strategy that anyone can use to beat the market.
Those are exactly the qualities that you want in an investing book. No more, no less.
The Little Book that Beats the Market Book Review
My book review of The Little Book that Beats the Market by Joel Greenblatt will mirror the structure of the book itself. Joel Greenblatt divides the book into three sections.
- First, I will explain the core concepts that drive above-average investing performance.
- Second, I will explain how the Magic Formula works to capture these core concepts into a single formula.
- Third, I will explain how you can implement the Magic Formula as an investment strategy.
Now, I want to walk you through the core investing concepts that are foundational to the “magic” in the magic formula. My hope is that you’ll learn enough from this review to understand that the magic formula isn’t a hoax, a scam, or too good to be true. Joel Greenblatt provides key insights which all investors can learn from.
Core Concepts of Value Investing covered in The Little Book that Beats the Market
- Every share of stock is a “share” of ownership in a business
- Stocks are shares of a business. When you buy stock in a company, you are buying a proportional ownership interest in the company. This means that you are entitled to a “share” of all future earnings and dividends that the company produces.
- Discounting of Future Cash Flows
- Cash today is worth more than cash tomorrow. If you had to choose between receiving $100 today or $100 in five years, which would you choose? Obviously, you would choose the $100 today.
- Opportunity Cost
- What rate of return should you demand before investing your money? This is typically based off of your next best available alternative.
- Mr. Market
- Price changes in the stock market don’t always reflect changes in the underlying business.
- Margin of Safety
- Your Margin of Safety is the difference between the price you pay for a stock and the value you have determined the stock is worth. The larger the difference between these two values the better. Benjamin Graham recommended that you pay no more than 2/3rds the value which you determined a stock to be worth.
- Earnings Yield
- A cheap business is better to buy than an expensive business.
- Return on Capital
- A good business is better than a bad business
Joel Greenblatt’s Magic Formula:
Joel Greenblatt’s Magic formula combines the last two value investing concepts. He attempts to capture the knowledge that a higher earnings yield and a high return on capital are both good indicators of purchase.
The combination of these two factors is the “Magic” of the Magic formula. Both of these factors are easily quantified.
Joel Greenblatt breaks down the methodology of the Magic Formula on pages 56 and 57 of The Little Book that Beats the Market.
The basic break down is that you take a list of every single company within your dataset and rank them from say 1 to 5000 on the two criteria from chapter 5. The company with the highest earnings yield receives ranking 1 and the company with the lowest earnings yield receives ranking 5000. You then repeat the process with return on capital.
Each company then gets points equal to their ranking. The 30 companies with the lowest # of combined points are the “top 30” companies to buy based on the magic formula.
Now, what do you do with those companies:
Basically, you buy and hold them for a year. After a year, you run the formula again and repeat.
The Magic Formula investing strategy has historically beaten the returns of the stock market by a large margin
The book notes, that an investor implementing this strategy for the 17 years from 1988 to 2004 would have earned annual returns of 30.8% while the S&P 500 earned only 12.4%. This is an outperformance of 18% PER YEAR. The outperformance of this magnitude is ridiculous because it would lead to much greater wealth. I encourage you to consider buying the book if you’re interested in how these numbers were calculated. Joel Greenblatt goes into in-depth detail concerning his methodology. I’ll touch on just a few key aspects in the next section.
Why does the Magic Formula work?
Joel Greenblatt takes head-on the question of why the Magic Formula works. Although the underlying basis is strong, he’s now published the formula available for anyone to view. Having done so, the expectation would be that any benefit of the formula would quickly be diminished.
This is a key question. Yet, the answer is pretty simple.
The strategy works because most people won’t be able to actually follow it.
The strategy works well over long time periods. Such as 5 years or more. Especially over 20 year periods, which aligns with most people’s investing careers.
However, most people are impatient and short-sighted when it comes to investing performance. This strategy often does NOT work over short time periods. A short time period would be anywhere from one to three years.
Although it’s quite well suited to outperform over longer periods of time, most people will give up after even one year of underperformance. It’s difficult to watch the market beat you by 10-20%, and yet still trust the magic formula to work.
That’s why the Magic Formula strategy can work even though everyone knows about it.
Are you one of the people able to stick with it for the long-term? In order for the magic formula to work, you have to believe in it and execute the strategy continuously over the long-term.
Should you implement the Magic Formula Investing Strategy?
If you want to invest your money, you basically have four options:
- Hire an Investing Professional to invest for you.
- Invest in an Index Fund.
- Invest the money yourself. (DIY Investing)
- Use the Magic Formula to invest.
1. Investing Professional
Most investing professionals are paid to sell you something instead of making you money. They are typically brokers, not fiduciaries. Thus, you end up paying fees and not necessarily getting the return you want.
That’s partly why my motto on this website is, “Stop paying fees. Start building wealth.”
2. Index Fund
With an index fund, you’ll match the average. But what if you want to beat the average? What if the average is not good enough? For instance, John Bogle, the modern inventor of the index fund believes that average investment returns from index funds will be much lower than the past. He’s estimated only 4% annual returns over the next decade.
Another valuation expert John Hussman estimates negative annual returns over the next decade for the S&P 500.
If neither of those options sounds good to you, you’re left with only two options:
3. Invest the money yourself.
4. Use the Magic Formula.
Investing the money yourself is the goal of my website. I aim to provide you with the knowledge, tools, and resources you need to intelligently invest your own money. I encourage you to check out additional articles on this site or sign up for my email list. With the email list, you’ll be kept up-to-date with all of my future posts and any other valuable tools or resources I have available.
The magic formula is your last option. There are two ways you can invest using the Magic Formula. The standard way, and an alternative way which I’ve developed. My way is built specifically to make it even easier for you.
First, I’ll describe the standard way to use the Magic Formula. The book is the basis for this method.
How to Implement the Magic Formula Investing Strategy:
- Use Joel Greenblatt’s website www.magicformulainvesting.com to screen for stocks to buy. You have to register to use his screening tool. You also have to agree to receive marketing materials from an asset management company that he’s associated with.
- This tool can only be used if you agree to be contacted and provide your email address.
- First, you’d create a list of stocks from his screening tool.
- Second, you would individually buy each of the stocks.
- Third, you hold for a year and then repeat the process. You would sell the old stocks and buy the new ones. Each of these trades will occur large commissions.
This method has pros and cons:
On the positive side, this strategy will allow you to implement the magic formula for yourself. You can tailor the investments to your personal needs. You can adjust the screening tool to the criteria you find best.
However, there is also a negative side to this strategy. The strategy requires time and additional cost. Yet, those interested need a simple and cost-effective solution. They just want something that works and will lead to good returns. Although Joel Greenblatt’s screener does a lot of work for you, it’s not perfect. Investing in an index fund is often much easier still.
Therefore, I have created an alternative method for you to invest using the Magic Formula without the extra effort. My method is just as simple as buying an index fund.
How to implement the Magic Formula Investing Strategy DIYInvesting.org style
If you go to www.diyinvesting.org/magicformula you will be forwarded to a self-created index which I built to track the performance of the magic formula. This index has ZERO ongoing fees. If you compare it to an index fund, the expense ratio for this index is exactly ZERO.
How is this possible?
I used a broker called Motif Investing to create a 30 stock index of companies. These companies meet the criteria used by the magic formula screener. At this broker, they call indexes “Motifs.”
I’ve done all the work for you.
I’ve used his screener to build the list of 30 companies, so you don’t have to. This way you don’t have to receive marketing communications from his asset management company. You also don’t have to buy each individual company. You can buy the entire set of 30 companies with only a single commission of $9.95.
Cost Comparison of the Two Magic Formula Strategies
For comparison, if you were to use Joel Greenblatt’s screener yourself it would cost much more. You would have to buy each individual company and pay a commission each time. Typically a commission for a single stock trade is about $5. Therefore, building a thirty stock portfolio would cost $150. You would also have to pay this commission each time you add new money to the strategy.
Instead, using the index/motif which I built for you, only costs a single commission of $9.95.
I aim to update this index once per year according to the Magic Formula guidelines. This way you won’t need to worry about repeating the process either.
You can simply focus on saving money and regularly contributing it to your investment account.
If you’re interested then head to www.diyinvesting.org/magicformula.
[Disclosure: I believe in being fully upfront and honest about any compensation I receive. If you buy my index of the Magic Formula, then I receive a small commission at NO additional cost to you. The commission is always $9.95 whether you buy my index/motif or build and manage your own. If you buy my index of the Magic Formula then $1 of that $9.95 goes to me. The remaining $8.95 is kept by the broker Motif Investing.]
Again, there are no ongoing expenses for investing in this way. So although you pay a commission of $9.95 to buy the 30 stocks, you will not have to pay any further annual fees. Your investment could grow into hundreds of thousands or millions of dollars and you’d only pay the small upfront commission.
This strategy has much lower expenses than even an index fund over time.
In conclusion, I highly recommend Joel Greenblatt’s book, The Little Book that Beats the Market.
I give the book 5 stars. I would recommend this book to anyone and everyone interested in investing. Joel Greenblatt succinctly teaches the major concepts of value investing. In addition, he provides an easy to understand investing strategy that anyone can use to beat the market.
If you’d like to buy The Little Book that Beats the Market, please use one of my affiliate links. Thank you for your support.
Finally, if you’d like to implement the Magic Formula Investing Strategy. Consider buying the index fund/Motif which I have built. You can do so at www.DIYInvesting.org/magicformula.
Thank you for your support
Disclosure: Some of the links below, on my book review pages, and throughout my website are affiliate links. If you make a purchase through one of these links, I may earn a commission. This commission comes at no additional cost to you. Please understand that I have personally read all books that I review. I recommend them because I believe they are helpful and useful, not because of any small commission I might receive. Please do not spend any money on these books unless you feel you need them or that they will help you achieve your goals.
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