Saturday 25 October 2008

Market Fluctuations of the Investor's Portfolio

Every investor who owns common stocks must expect to see them fluctuate in value over the years.

The behaviour of the DJIA probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, prominent, and conservatively financed companies.

Since the individual stocks set their high and low marks at different times, the fluctuations in the Dow Jones group as a whole are less severe than those in the separate components.

The price fluctuations of other types of diversified and conservative common-stock portfolios are not likely to be markedly different from the above.

In general, the shares of second-line companies* fluctuate more widely than the major# ones, but this does not necessarily mean that a group of well established but small companies will make a poorer showing over a fairly long period.

( *non index linked stocks, #index linked stocks)

In any case, the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent 1/3 (one-third) or more from their high point at various periods in the next 5 years.

A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer.

But what about the longer term and wider changes?

Here practical questions present themselves, and the psychological problems are likely to grow complicated.

A substantial rise in the market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action.

Your shares have advanced, good! You are richer than you were, good!

  • But has the price risen too high, and should you think of selling?
  • Or should you kick yourself for not having bought more shares when the level was lower?
  • Or - worst thought of all - should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments?

Presented thus in print, the answer to the last question is a self-evident NO, but even the intelligent investor is likely to need considerable will power to keep from following the crowd.

It is for these reasons of human nature, even more than by calculation of financial gain or loss, that we favour some kind of mechanical method for varying the proportion of bonds to stocks in the investor's portfolio. The chief advantage, perhaps, is that such a formula will give him something to do.

As the market advances, he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure.

(For today's investor, the ideal strategy for pursuing this formula is rebalancing)

These activities will provide some outlet for his otherwise too-pent-up energies. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.

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Note carefuly what Graham is saying here.

It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price - regardless of which stocks you own or whether the market as a whole goes up or down.

If you can't live with that - or you think your portfolio is somehow magically exempt from it - then you are not yet entitled to call yourself an investor.

(Graham refers to a 33% decline as the "equivalent one-third" because a 50% gain takes a $10 stock to $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.)


Ref: The Intelligent Investor by Benjamin Graham

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