The Little Book That Still Beats the Market Chapter 4: Why It Works

"If the magic formula worked all the time, everyone would use it. If everyone used it, it would stop working. Therefore, the fact that it doesn't work all the time is the exact reason why it continues to work over the long term." — Joel Greenblatt

The Investment Context

If the Magic Formula is so simple and so lucrative, the obvious question is: why isn't everyone a billionaire? Greenblatt answers this in the most important section of the book.

The Magic Formula works over a 10-year period, but it frequently underperforms the market over a 1-year, 2-year, or even 3-year period. Human beings—and particularly professional fund managers—do not have the psychological endurance to stick with a strategy that loses to the market for three consecutive years.

The Wall Street Translation

Wall Street operates on a quarterly timeline. If a mutual fund manager uses the Magic Formula and it underperforms the S&P 500 for two years, clients will withdraw their money and the manager will be fired. Because professionals cannot use the formula, the opportunity is left wide open for retail investors.

1. The Pain of Underperformance: When you buy Magic Formula stocks, you are buying companies that the market currently hates. In the short term, the market might continue to hate them, and their prices might go down further. This is psychologically agonizing.
2. The Discipline to Hold: The formula only works if you commit to it entirely. Greenblatt recommends holding the basket of stocks for exactly one year (to optimize for taxes), selling them, and immediately replacing them with the new top-ranked stocks on the list.
3. The Ultimate Arbitrage: Value investing is the arbitrage of human impatience. Because most investors demand immediate gratification, they sell good companies at absurdly cheap prices during temporary downturns. The Magic Formula systematically scoops up these bargains.

Actionable Trading Rules

1. The Three-Year Commitment: Never start using the Magic Formula (or any value investing strategy) unless you are mentally and financially prepared to strictly follow it for a minimum of 3 to 5 years. If you evaluate its success after 6 months, you will fail.
2. Rebalance Mechanically: Once a year, without emotion, sell the stocks in your Magic Formula basket. Calculate your taxes. Then, log back into the screener and buy the new top 20 or 30 stocks. Do not let your opinion of the companies interfere with the mechanical rebalancing.
3. Embrace the Difficult Years: When the formula underperforms the broader market for a year or two, remind yourself that this underperformance is the "fee" you pay to achieve market-beating returns over the long haul. The difficulty is the moat that protects the strategy.