Sunday, 5 February 2012

Market Timing - If you absolutely must play the horses

Though Benjamin Graham in no way recommend trying it, he did say that there is a way to combine market timing and value investing principles.

However, Graham noted, the method makes heavy demands on human fortitude, and it can keep an investor out of long stretches of a booming market*.  It sounds simple.  Yet for those who realize how difficult it is to follow, this strategy can diminish the risk of trading on market movements.

Here is the way it works:

1.  Select a diversified list of common stocks (for example, buying undervalued stocks).
2.  Determine a normal value for each stock (choose the PE ratio that seems appropriate).
3.  Buy the stocks when shares can be bought at a substantial discount - say, two-thirds of what the investor has established as normal value.  As an alternative to buying at one target price, the investor can start buying as the stock declines, beginning at 80 percent of normal value.
4.  *Sell the stocks when the price has risen substantially above normal value - say 20 percent to 50 percent higher.

The investor thus would buy in a market decline and sell in a rising market.

*When you buy wonderful companies at fair prices, you often do not need to sell.  You may consider selling some or all when the stock prices are obviously very overvalued.  In these situations, the upside gains are limited and the downside losses are high.  These will impair the total returns of your portfolio.  However, even in such overvalued situations, you should only consider selling when the prices have risen very substantially above their normal values, for example, >> 50% over their normal values.  Also, remember to reinvest the money back into other wonderful companies at fair prices that offer a higher reward/risk ratio and that promise returns commensurate with your investment objective.

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