Reverse Your Emotions. React Intelligently to the Market. It freaks out from time to time.

Benjamin Graham:  "Nobody ever knows what the market will do, but we can react intelligently to what it does do."

If the price is rising and everything you liked about the company still persists, such as strong earnings, high margins, low debt, and steady cash flow, then you might decide to invest more.  The market is finally recognizing what a great company you're invested in and people are beginning to buy.  As William O'Neil recommends, you should move more money into that winner.  Business owners buy more of what's working.

If the price is falling and everything you liked about the company still persists, you just stumbled onto a great company at a bargain price.  It's incidental that you happen to already own shares purchased at a higher price, you still have the chance to buy a great company on sale.

Think of owning property.  Say you bought a 10-acre parcel at $5,000 an acre because of its beautiful meadows and stream.  You build your dream home there.  Two years later, another 10-acre parcel adjacent to yours goes on sale for only $2,000 an acre.  It contains different parts of the same beautiful meadows and a different section of the same stream.  Would you react by selling the land and home you already own?  Of course not!  It's still beautiful.  Instead, you'd snap up the adjacent lot because of its identical beauty and the fact that it's selling at 60 percent less than what you paid for the first parcel.  That, in a sense, is exactly how you should react when a perfectly solid company drops in price without any fundamental reason for doing so.

React intelligently to the market.  It freaks out from time to time, but you don't need to.

• If the market goes haywire and drops the price of your company for no reason, smile coolly and buy more shares.  
• If the market goes haywire and drives the price of your stock through the clouds, buy more on the way up. (However, don't buy and consider selling bubbly priced stock).

Master investors say to buy more of what's working and to take advantage of price dips.  That seems to mean that no matter what's happening, you should buy more.  That's only true regarding price.  Price is not really the most important thing.  It seems to be and it's eventually the bottom line, but in the course of stock ownership there are a lot of things more important.  For instance, Warren Buffett keeps an eye on profit margins and return on equity.  If the company remains strong and keep doing everything right, the market will eventually catch on and the price will rise.

If you bought quality companies after conducting thorough research, you have little to fear in the markets.  You will prosper over time.  The market will rise and fall, gurus will claim to know where it's going and when, you will hold winners and losers, and by reacting intelligently to all this cacophony your profits will mount.

Market Behaviour: Pendulum Swings (Volatility)

Your work isn't finished once you own a stock.  You must be psychologically ready to deal with the pendulum swings (volatility) of the market.  Any stock you buy will go up and will go down.  The trick is to not get caught up in these ups and downs, but to stick to the plan you had for the stock when you picked it.

Don't watch CNBC and the other news shows that follow the market as though it's a sports game.  that will just make it harder for you to stick to your plan.  You don't have to know exactly what the price of your stock is each day.  Watching your stocks that closely will just make you nervous and most likely lead you to make the wrong choices.

Your best bet is to not watch the financial news on TV.  Read the respected financial press, such as The Wall Street Journal and the Financial Times, to stay up on the critical news about the companies you follow and get ideas for new possible investments.

You'll find much more serious, in-depth stories in the financial press.  These stories will help you make the best choices in building your portfolio.

Related topics:

Market Behaviour: The Least You Need to Know
Market Behaviour: Crowd Impacts on Stock Prices

Market Behaviour: Can You Beat the Market?
Market Behaviour: Bull Runs
Market Behaviour: Bear Stalls
Market Behaviour: Pendulum Swings (Volatility)
Market Behaviour: Irrational Exuberance
Market Behaviour: Unjustifiable Pessimism
Market Behaviour: Control Yourself (Patience)

Marc Faber: "If you cannot swallow a 30% correction in whatever you buy, then don't even get up in the morning from your bed."

A 30% correction in emerging markets?

More money than you can imagine. Billions and trillions of currency notes. The Fed's quantitative easing program sent a lot of cheap money floating around the world. This money directly found its way to emerging markets. With high interest rates, and strong economic recoveries, the flow of money in this direction was but obvious.

For a while, increased cash makes everyone feel happy. FIIs pumped in a total of US$ 29.3 bn in India so far in 2010. This sent stock prices soaring. The very same stocks which were selling at their lows a year back, reached their lifetime highs. Stock markets climbed quickly to their previous peaks.

But, was the excess money even needed in the first place? Increased inflows of money have led to inflationary pressure, currency appreciation and asset bubbles forming in these countries. According to Nobel Prize-winning economist Joseph Stiglitz, these are "considerable risks". So, how do the emerging markets react? Well, economies from San Paulo to New Delhi have been trying hard to control these volatile capital inflows. Brazil raised its taxes on foreign bond purchases by almost three times. India tried to raise interest rates to stem rampant inflation.

But now, India has inadvertently done something to further reduce FII inflows. The recent bribery scams, stock price riggings and political uncertainty led to FIIs dropping Indian stocks like hot potatoes. The pace of FII inflows has slowed down considerably over the past three months. Marc Faber believes that emerging markets could easily see a 20-30% correction. Tightening monetary conditions, high crude prices and food supply concerns are all adding to the mess.

But, if you bought the right stocks at the right valuations and with the right management, you may still be safe. We believe that Faber has it right by saying that if you cannot swallow a 30% correction in whatever you buy, then don't even get up in the morning from your bed.

Equimaster

Volatility Play Investing

Volatility Play Investing

A method of trading stocks that myself and my team have developed. It involves buying and selling the same stocks, again and again, as they undergo repetitive fluctuation in price. 

http://www.pennystocks.org/glossary-of-terms-used.php

Finding Opportunities Amidst Volatile Markets

Finding Opportunities Amidst Volatile Markets by
Wong Sui Jau, General Manager
Fundsupermart

View Video with Slides

This talk was delivered on 18th October 2008
Below are the 'printed' notes of the slides.


Markets Year to Date
Market ... Indices ... YTD as at 10th Oct 2008
China ... HSMCI Index ... -54.10%
Emerging Markets ... MXEF ...-52.5%
Asia ex-Japan ... MXASJ Index ... -51.80%
India ...SENSEX Index ... -48.60%
Hong Kong ... HSI Index ... -46.80%
Nikkei 225 ... NKY Index ... -45.90%
Singapore ... STI Index ... -43.80%
Europe ...SX5P Index ... -43.70%
Taiwan ... TWSE Index ... -39.70%
US ... SPX Index ... -38.80%
Malaysia ... KLCI Index ... -35.40%
Korea ... KOSPI Index ... -34.60%

Source:  Bloomberg



Bad News Abound

• More losses expected from the ongoing US financial crisis there.
• US likely to fall into recession.
• Europe and Japan economies now also facing a slump.
• Asia will be affected as well.

How to handle all the Turbulence?

• With the large movements in markets so far this year, many investors may be considering going all cash.
• Is cash the best alternative for investors?
• Inflation levels in Malaysia is high, likely to be at least above 6% in 2008 with food prices going up.
• Negative real short term interest rates very possible this 2008
• Trying to time the market too closely and selling out when faced with a flood of bad news and sentiment is often not the best move.
• Why?

Some of the worst bears and best bulls
HK
Market Crashes:  Sept 87 to Nov 87 -45.8%
Market Recoveries:  Nov 87 to Dec 93 +281.5%

HK 

Market Crashes:  Jul 81 to Nov 82 -59.1%

Market Recoveries:  Nov 82 to Dec 86 +264.8%

Korea

Market Crashes:  Apr 96 to Jun 98  -69.6%

Market Recoveries:  Jun 98 to Dec 99  +245.1%

Singapore 

Market Crashes:  Feb 97 to Aug 98  -58.4%

Market Recoveries:  Aug 98 to Dec 99  +189.5%

HK 

Market Crashes:  Feb 73 to Dec 74  -89.5%

Market Recoveries:  Dec 74 to Mar 76  +166.4%

US 

Market Crashes:  Mar 37 to Apr 42  -57.3%

Market Recoveries:  Apr 42 to May 46  +150.4%

US 

Market Crashes:  Aug 29 to Jun 32  -86.0%

Market Recoveries:  Jun 32 to Jun 33  +146.3%

Singapore 

Market Crashes:  Jul 90 to Sep 90   -33.2%

Market Recoveries:  Sep 90 to Dec 93  +141.6%

Some observations

• Bear markets do not last forever.  Market crashes have ranged anywhere from a few months to a few years in length.  (Most tend to last just a few months to one year though).
• The best rebounds happen after the market crashes (can be as much as 100% or more).
• Missing out on these rebounds can affect one's overall return significantly.

Dealing with our emotions

• The main culprit that affects our returns from volatility is that our emotions often cause us to buy high and sell low.
• Right now, with many Asian markets had already slumped 40% to over 50% from their peak, some markets are priced very attractively - is this the right time to lose your confidence?
• Choosing to sell out of markets now only make it that much harder emotionally to re-enter markets again even when they have truly bottomed out.

Bad news is not always bad

• Interestingly, a time when bad news abound is not necessarily bad.
• Historically, it is when everything looks rosy, when there is no black cloud at all, when markets are expensive.
• Historically, it is when everything looks bleak, with little to be positive about when markets are cheap.

Don't wait for bad news to end

• Markets are forward looking.  When they are see some signs of improvement, they will rebound.
• By the time the recovery actually takes place, they would be up already.
• At near to market bottoms, everything looks bad.
• When did the US market bottom during the period of the second world war?  (It started in 1939 and ended in 1945).

Past bottoms

• The bottom of the US market during the second world war was in April 1942.  (The war ended in 1945)
• The bottom of the US market, during the saving and loans crisis was in Sep 1990.  (Banks were still going bankrupt all the way up till 1993).

Now is a good time for making money

• Money is made by buying low and selling high.
• Good news abound during times of market highs, and bad news abound during times of market lows.
• So, the prevalent bad news all around now, is a signal that markets are low.
• Another signal is low valuations of markets in general.

Our views on various issues

• US in a recession and the ongoing US financial Crisis.
• Where we find bargains and value at this point in time.

US is likely already in Recession

• US property market slump continues.
• Financial sector in turmoil due to subprime woes, further losses expected.
• Consumer sentiment is going to be hit and large portion of these consumers are spending on credit and paying mortgages at the same time.
• Federal Reserves efforts won't prevent this.
• US is already in a recession.

Where we see bargains

Asian Equities

• Asian markets are oversold.
• Asian valuations are currently at very attractive levels.
• Asian remains a high growth region.
• Asian financials have very little exposure to the toxic sub prime related mortgages.

Valuations have come down.

MSCI Asia Excluding Japan and Estimated PE

In Jun 1997:  

Index level was 400

Estimated P/E was 20

In May 2000

Index level was 300+

Estimated P/E was 37

In Dec 2001  

Index level was 160

Estimated P/E was 12

In Nov 2007:  

Index level was 700

Estimated P/E was 20

(see graph)

Source: Bloomberg

Some tips on handling volatility

• Try not to focus so much on the bad news.  Markets cannot drop 5 to 10% every day.
• Have faith that markets and economies are self correcting, they won't go down forever.
• Is the correction really all negative?  Falling markets can prevent buying opportunities.
• Long term investing is less stressful and has a higher probability of making gains.
• Diversify, diversity, diversify!

Yearly Return of MSCI World

1970 to 2007

(graph)

Source:  MSCI Bloomberg

Of these 38 years, the yearly returns of MSCI World were 

• negative for 11 years, and
• positive for 27 years.

Years with Negative Return:

1970

1973

1974

1977

1981

1989

1992

1994

2000

2001

2002

Cumulative 10 years are usuallly Positive

10 year Cumulative Returns of MSCI World Index

(graph)

Source:  MSCI Bloomberg

Diversify!

• Diversification also forms a key part of lowering ones risk and easing the burden our emotions place on us during turbulent times.
• Diversification prevents us from putting everything into just one market or asset and is a key part in how we form our portfolios.

Conclusion

• Bad news abound, but that is not necessarily a bad thing.  It is a signal that markets are low.
• We like - Asia ex Japan equities.
• Stay invested, have a diversified portfolio and most importantly, keep calm!

http://www.investorexpo.com.my/webcast/webcast_flash_fundsupermart_20081018/

Seven Strategies For Investing During Volatile Markets

July 17, 2010   

Written by admin, in Investment & Trading

The markets don’t always behave the way we’d like them to: Geopolitical turmoil, natural disasters, interest rates and world events can have a profound effect on market movements. If recent market volatility has you concerned about the economy, you are not alone; this is a confusing time for many investors. Some have decided to stay the course, while others are sitting on the sidelines waiting for the market to rebound. However, since no one can predict how the markets will perform, it’s important to develop an investment strategy that can help you stay on the right track to meeting your long-term financial goals. Here are some strategies that you can implement today, that may help to manage risk during these uncertain times.

Work with a Financial Advisor. There are a lot of do-it-yourself investment resources available to investors today. However, none of those resources can replace the experienced, personal service a Financial Advisor provides. A Financial Advisor can offer an understanding of your complete financial picture, not just your investments. Additionally, in periods of market volatility when you need the most support, a Financial Advisor can provide:

• Access to important decision-making research and information;

• Ongoing monitoring of your investment portfolio, while anticipating your changing needs; and

• A comprehensive market-volatility plan.

Have a plan. Developing a financial plan is one of the best ways to meet your long-term goals. Your plan should also include an action plan to address market volatility, which should be developed well in advance of a turbulent market. Having a market-volatility plan will help you to set realistic goals and appropriately manage your return expectations.

Invest regularly. It may not seem intuitive, but investing regularly—even during market downturns—can help to reduce your overall costs. Dollar cost averaging is one of the best ways to invest regularly, since you’re investing a fixed amount on a fixed schedule, regardless of how the markets perform. Investing regularly can also have intrinsic benefits: It encourages discipline and may also ease the anxiety of daily market fluctuations.

Diversify. If you’ve ever heard the saying, “Don’t put all your eggs in one basket,” then you already have a basic understanding of diversification. Diversifying your portfolio can reduce risk and volatility if the assets have little or no correlation to each other.

Investing in mutual funds is one way to achieve portfolio diversification, since mutual funds are typically a diversified investment. There are also several other ways to diversify and potentially reduce portfolio volatility:

• Within an asset category, such as purchasing different types of mutual funds;

• Among asset categories, such as purchasing stocks and bonds; and

• Outside of the United States, since some markets move opposite to the US stock market.

Put volatility to work for you. Do you think of the glass as half empty or half full? Your perspective can affect the investment decisions you make during market downturns. Investors who view market volatility negatively can make irrational decisions. A down market can be an opportunity for you to build your portfolio and take advantage of lower unit costs.

Stay invested. You are probably anxious during times when the value of your investments has decreased. As a result, you may be tempted to move out of the market, sit on the sidelines and wait for the market to rebound. However, since no one knows how the markets will move, how do you know you’re leaving at the right time? Also, how will you know when it is the right time to get off the sidelines and start investing again?

If you have worked with a Financial Advisor, your investment strategy was developed to help you meet your long-term goals. Timing the market could potentially jeopardize your financial plan—and your future goals.

Be patient. There will always be uncertainty in the markets; market volatility is a natural part of the investment cycle. Although it may take some time, markets do rebound.

In the meantime, call your Financial Advisor to help you develop an action plan for market volatility and continue to focus on your long-term investment goals rather than short-term market moves.

http://www.wallstreetstocks.net/seven-strategies-for-investing-during-volatile-markets

Stockmarket: what should investors do now?

Stockmarket: what should investors do now?
The FTSE100 dropped below the 5,000 barrier in the aftermath of the naked short-selling ban in Germany and the ongoing euro crisis.

By Paul Farrow
Published: 3:07PM BST 21 May 2010

Investors had been enjoying a market revival since shares hit their March 2009 lows. Markets had become more volatile in recent weeks but many fund managers had ruled out any possibility of a full-blown stock market crash.

However, the eurozone crisis is worsening and many analysts are predicting a double-dip recession and further market falls.

Paul Niven, head of asset Allocation at F&C, said: "Equity markets have entered into a technical correction, with major indices, such as the US S&P 500 falling more than 10pc from recent peaks. The VIX index of 'fear and greed' (which measures the volatility of the S&P500) has hit 13-month highs and is back trading at levels only seen during the 2008 meltdown.

"The way that markets are now behaving is suggestive of a move to pricing in renewed and significant economic weakness and the danger for investors is that market action will begin to negatively permeate economic fundamentals. It may be that capitulation is required in the near term to mark a short term trough in risk assets."

Financial advisers admit that no one can predict what will happen and suggest the best way to avoid boom-and-bust cycles is to make objective investment decisions that ignore fashions. What's more there will be some fund managers who argue that the volatility will trigger buying opportunities, although it is understandable that caution is the operative word for many investors at this juncture.

The advice from the great and the good, more often than not, is not to panic. There is the well-trodden argument from Fidelity that "it's about the time in the market, not out of it that counts''. But that can seem flippant when it comes to the prospect of losing your hard-earned cash.

Experts say that if you haven't already, it would be well worth reviewing your holdings to see if you are overexposed to any asset class or classes. Diversification and getting the balance right are vital.

Patrick Connolly at AWD Chase de Vere said that most people don't appreciate the risk they are taking when stock markets are going up. They only realise when markets are going down or are more volatile and then can panic and sell out at entirely the wrong time, he said.

"Too often investors buy at the top of the market when they are feeling bullish and sell out at the bottom when they are feeling negative. They should not allow short-term sentiment to influence their decision," said Connolly.

"The right approach is to hold a level of cash and then a diversified portfolio including shares, fixed interest and commercial property. These different investments need to be held in the right proportion to meet the requirements and risk profile of individual investors."

AWD Chase de Vere suggest that a diversified portfolio could include investment funds such as, PSigma Income, M&G Global Leaders, Cazenove European, Threadneedle American, JPM Emerging Markets, M&G Property Portfolio, Fidelity Moneybuilder Income and Schroder Strategic Bond.

Connolly added: "While panicking and selling is likely to be the wrong approach, for those who are concerned it is sensible to review their existing holdings and ensure they have the right level of diversification in their portfolios."

Adrian Lowcock at Bestinvest said that investors should look to have exposure to other asset classes, such as bonds, commercial property and absolute return funds.

His favoured funds in each of these sectors include Invesco Perpetual Tactical Bond, Henderson UK Property, Standard Life Global Absolute Return Strategies. He added: "The EU/IMF bail-out package will struggle to contain the issue and markets have responded accordingly. Investors should look to diversify their portfolios to reduce volatility but it is likely to be a bumpy ride in the short term."

http://www.telegraph.co.uk/finance/personalfinance/investing/7749761/Stockmarket-what-should-investors-do-now.html

Eliminate or severely limit your investments in companies with large downside risks to avoid huge losses

When you think that there is a large downside risk in investing in a company, you should be especially vigilant even if expected returns are high.

• A highly leveraged balance sheet is one indicator of high downside risk in a company.  

• Even countries that borrow large amounts of money are not safe:   Russia defaulted on its loans in 1998.

Since even a country the size of Russia can get into trouble, clearly you should never think of any country as "too big to fail."

By eliminating or severely limiting your investments in companies with large downside risks, you should be able to avoid the huge losses emanating from market volatility.

On the other hand, market volatility may cause good companies' stock prices to go down in the short run, giving you good buying opportunities.

Growing at 15% a year - what does this entail?

To achieve a 100% gain in your investment over 5 years, the initial capital has to grow at a compound rate of 15% per year. This means that an initial $100 investment will be worth:

$1.15 at end of year 1,
$1.33 at end of year 2,
$1.52 at end of year 3,
$1.75 at end of year 4, and
$2.01 at end of year 5.

Though the fund managers usually benchmark their fund performances to a certain index, most individual investors should look at the absolute return.

The return on your investment is unlikely to rise in a straight-line upwards. Volatility in the return is to be expected. The return spurts over certain times, declines over certain times, and remains unmoved over certain times.  However, the return over a long time is less volatile and generally relates to the earnings of the business of the invested stock.

What does 15% per year looks like in real-time? Excluding the dividend yield from the calculation, it is actually an average of 1.25% per month appreciation in the share price. The 15% may be returned in a consistent manner or there maybe periods of spurts delivering part or all the returns over many short periods. Do not get disheartened if a stock moves only 1% or 2% per month, it is the consistency in its return that adds to a big return. On the other hand, do not be overly excited by the big returns over a short period. For the long-term investors, it is more important that over a long time, the price of the stock reflects the improving earnings fundamentals of your selected stocks.

To double your initial investment in a stock in 5 years means also selecting a stock that will double its earnings in 5 years. For those who are directly in business, to grow a business consistently over many years is indeed very challenging. The matured large companies are less likely to deliver such growths. Therefore, for those investors seeking such growth rates in the earnings of their stocks, they will need to look at mid-cap stocks or smaller companies where growths can be faster in the early stages of their business life.

It is not difficult to make 7 or 8% returns yearly in your investment in stocks.  However, to grow at 15% or more, this can be very challenging indeed, but not impossible even for the non-professional investors.

Tendency towards Volatility - Always Think about the Crowd!

Both fundamental and technical analysis can be helpful to investors in deciding when it is a good idea to buy or sell. 

Fundamentals generally change fairly slowly - over a period of quarters or years. 

Technical analysis are used by some as guide to profitable action in the nearer term. 

Prices tend to overshoot both too high and then too low in their attempts to reflect proper reality.

This tendency towards volatility, which seems to have increased in the age of trading at the speed of the internet, can either hurt you or help you.

How it affects us is driven by how well or badly we understand and handle price volatility.

This is a simple realization: that crowd behaviour frequently drives unsustainable and extreme price behaviour at tops and bottoms.

It follows from that observation that extra net returns can be earned by those who constantly watch for the crowd and who think of the market not from their own viewpoints alone but rather in terms of what the crowd is thinking.

Crowd size can be readily observed in trading volume and , with some lag, in net money flows to/from equity mutual funds.

Standing back and discerning where the crowd's often collectively muddled head is will always help you make a better decision.

How Value Investors View the Markets and Market Performance

Value investors really don't care. Do value investors have an attitude problem?

The point is that value investors aren't that concerned about markets, trading processes, and trading behaviour.

The market is simply a place to buy a portion of a business - and perhaps not sell it for a long, long time. Value investors care little about whether an order is executed on the bid or ask price, nor do they care what regional market, ECN, or execution system was used.

The transaction is an investment, a long-term investment. The market simply provides a place to acquire the investment.

So, value investors generally don't talk much about markets. And if you're really a value investor (or want to become one), you yourself don't care about markets... except when they undervalue businesses.

Despite the academic rumblings of the "efficient market theory" (which holds that with good information and a sufficient number of players, markets will find the right price for a business), markets are not perfect. They are always bargains.

Stocks may be undervalued because of:

• lack of knowledge or
• lack of visibility, or
• perhaps they're part of a group that's out of favour altogether.

These stocks are selling for less than may be indicated by the value of the business or the potential of the business.

So, in this sense, value investors love the markets. The markets, through their imperfections, provide value investors their opportunity.

As Warren Buffett says, if markets were perfect, he'd be "standing on the corner holding a tin cup."

Volatility: Use the dips to find value

Market volatility seems to be here to stay.

Markets will rise and fall in 5% or 10% increments in a given month - with no real change in business value to support the change.

Investors must, more than ever, be patient and try to separate real business change from market change.

And they will learn to use the dips to find value.

Volatility is the friend of the value investor

Although most investors express a strong distaste for market fluctuations, volatility must be accepted to reap the superior returns offered by stocks. Risk and volatility are the essense of above-average returns: Investors cannot make any more than the risk-free rate of return unless there is some possibility that they can make less.

While the volatility of the stock market deters many investors, it fascinates others. The ability to monitor a position on a minute-by-minute basis fulfills the need of many people to know quickly whether their judgement, which affects not only money but also ego, has been validated. For many people, the stock market is truly the world's greatest gambling casino.

Yet this ability to know exactly how much one is worth at any given moment also can provoke anxiety. Many investors do not like the instantaneous verdict of the financial market. Some retreat into investments such as real estate, for which daily quotations are not available. They believe that not knowing the current price makes an investment somehow less risky.!

As Keynes stated over 50 years ago about the investing attitudes of the endowment committee at Cambridge University:

"Some Bursars will buy without a tremor unquoted and unmarketable investment in real estate which, if they had a selling quotation for immediate cash available at each audit, would turn their hair gray. The fact that you do not know how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one."

Redefining Risk

Traditionally, investors view "risk" as being synonymous with "volatility." They believe that to get higher returns, they must be willing to stomach bigger short-term swings in a stock's price. Volatility is not risk. Avoid investment advice based on volatility.

Redefining Risk

Risk was the chance that you might not meet your long-term investment goals. And the greatest enemy of reaching those goals: inflation. Nothing is safe from inflation. It's major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments.

Investors usually use Treasury bills as their benchmark for risk. These are considered risk-free because their nominal value can't go down. However, T-bills and bonds are in fact highly risky because of their susceptibility to inflation.

For example, if you buy a 10 year-T-bill that pays 3 percent in interest per year, and inflation is creeping up at, say, 2 percent per year, the real value of your investment at maturity will end up being significantly less than 3 percent greater than the price you paid for it. In the case of low-interest-paying T-bills, higher inflation could even mean that your investment loses value, in terms of real purchasing power, over its lifetime.

Realistic definition of Risk

A realistic definition of risk recognizes the potential loss of capital through inflation and taxes, and includes:

1. The probability your investment will preserve your capital over your investment time horizon.

2. The probability your investments will outperform alternative investments during the period.


Why Volatility is not Risk?

Traditionally, investors view "risk" as being synonymous with "volatility." They believe that to get higher returns, they must be willing to stomach bigger short-term swings in a stock's price.

There is no correlation between this volatility-related-risk and return.

• Higher volatility does not give better results, nor lower volatility worse.
• Studies have shown that there is not necessarily any stable long-term relationship between volatility-related-risk and return, and often there is no relationship between the return achieved and the volatility-related-risk taken.

Volatility is not risk. Avoid investment advice based on volatility.

So if volatility is not risk, what is?

The major risk is not the short-term stock price volatility that many thousands of academic articles have been written about. Rather it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. To measure monthly or quarterly volatility and call it risk - for investors who have time horizons 5, 10, 15 or even 30 years away - is a completely inappropriate definition. (David Dreman)

In the short-term, stocks fluctuate unpredictably, so if you're saving to buy a house or a car within the next two years or so, bonds and T-bills are a good choice. But over the long term, stocks far more often than not outperform alternative investments like bonds or T-bills.

In fact, Dreman's research shows that inflation-adjusted returns for stocks - which, unlike bonds or T-bills have the ability to produce increasing earnings streams - have consistently outpaced those of bonds and T-bills since the start of the 1800s. The gap has widened since the mid-1920s, when inflation began to have a more significant impact.

What's more, from 1946 to 1996, according to Dreman, compound returns after inflation for stocks were better than those of bonds 84% of the time if your holding period was 5 years.

• Stocks also outperformed T-bills in 82% of those 5-year periods.
• Using 10-year periods, stocks beat bonds 94% of the time and T-bills 86% of the time.
• When you look at 20-year holding periods, stocks beat both bonds and T-bills 100 percent of the time.

Take Home Lesson

Using Dreman's definition of risk, stocks are actually the safest investment out there over the long term.

Investors who put some or most of their money into bonds and other investments on the assumption they are lowering their risk are, in fact, deluding themselves.

"Indeed, it goes against the principle we were taught from childhood - that the safest way to save was putting our money in the bank."

Volatility is the friend of the Value Investor (2)

Volatility is the friend of the Value Investor (2)

September 3, 1929:
DJIA hit a historical high of 381.17
Seven weeks later, stocks crashed. The next 34 months saw the most devastating decline in share values in U.S. history.

July 8, 1932:
The carnage was finally over. DJIA stood at 41.22.
The marke value of the world's greatest corporations had declined an incredible 89%.
Millions of investors' life savings were wiped out.
Thousands of investors who borrowed money to buy stocks were forced into bankruptcy.
America was mired in the deepest economic depression in its history.


LESSONS FOR THE LONG-TERM VALUE INVESTOR

In summer of 1929, a journalist interviewed John J. Raskob, a senior financial executive at General Motors, about how the typical individual can build wealth by investing in stocks. Raskob claimed that America was on the verge of a tremendous industrial expansion. He maintained that by putting $15 a month into good common stocks, investors could expect their wealth to grow steadily to $80,000 over the next 20 years. Such a return - 24% per year - was unprecedented, but the prospect of effortlessly amassing a great fortune seemed plausible in the atmosphere of the 1920s bull market. Stocks excited investors, and millions of people put their savings into the market seeking a quick profit.

On September 3, 1929, a few days after Raskob's ideas appeared, the Dow Jones Industrial Average hit a historic high of 381.17. Seven weeks later, stocks crashed. Raskob's advice was ridiculed and denounced for years to come. It was said to represent the insanity of those who believed that the market could rise forever and the foolishness of those who ignored the tremendous risks inherent in stocks.

Conventional wisdom holds that Raskob's foolhardy advice epitomizes the mania that periodically overruns Wall Street. However, is this verdict fair? The answer is a decidedly no.

If you were to calculate the value of the portfolio of an investor who followed Raskob's advice, patiently putting $15 a month into stocks, you would find that:

• his or her accumulation would exceed that of someone who placed the same money in Treasury bills after less than 4 years!
• after 20 years, his or her stock portfolio would have accumulated to almost $9,000, and
• after 30 years, over $60,000.

Although not as high as Raskob had projected, $60,000 still represents a fantastic 13% return on invested capital, far exceeding the returns earned by conservative investors who switched their money to Treasury bonds or bills at the market peak. Those who never bought stock, citing the great crash as the vindication of their caution, eventually found themselves far behind investors who had patiently accumulated equity.

An important theme in the history of Wall Street is not the prevalence of foolish optimism at market peaks; rather, it is that over the last century, accumulations in stocks have always outperformed other financial assets for the patient investor. Even such calamitous events as the great stock crash of 1929 did not negate the superiority of stocks as long-term investments.

Volatility is the friend of the Value Investor

Volatility is the friend of the Value Investor

May 1994
Dow Jones Industrial Average 3,700
Interest rates rising rapidly. Worst year in the history of the bond market.
Stocks already up 60% from their October 1990 low. Few forecasters predicted further gains for equities.
Just 7 months later, stocks would embark on the greatest bull market run in history.

March 1998
Dow was at 8,800
The world stock market had been rolled the previous October by collapse of the Asian markets.
This precipitated a record 550-point drop in the Dow and closure of the New York Stock Exchange.
Few months later, the markets were shaken by collapse of the huge hedge fund Long-Term Capital Management.
From July to early Septermber 1998, Dow fell 20%.
The trillions of dollars of contracts held by this fund on the verge of bankruptcy threatened the functioning of financial markets, causing an unprecedented intervention by the Federal Reserve to restore liquidity.
Three quick rate cuts by the Fed restored investor confidence.
With the uncertainty surrounding Y2K less than 2 years away, few envisioned that October 1998 would begin one of the most spectacular bull markets in history.

March 2000
The technology-laden Nasdaq more than tripled, crossing 5000.
Prices of the world's largest equities surpassed 100 times earnings for the first time in the history of the markets.
Investors optimism was rife.
The Internet launched a gold rush that made instant millionaires of many workers in start-up companies who were paid with stock options.
John Doerr, a venture capitalist, called the run-up of Internet stocks the largest legal act of wealth creation in world history.
And many who missed the first round were lured into a bull market that appeared to ensure profits to all who participated.
This domestic exuberance was matched by a feeling that liberal democracies built on free markets had triumphed as a model for international development.
The entire world seemed to stand at the threshold of unprecedented economic growth, where U.S. based corporations would lead the way.
The communications revolution confirmed that the world was getting smaller and that national boundaries were shrinking.
Communism had been replaced by democracies in eastern Europe, apartheid was peacefully eliminated in South Africa, and even the Israelis and Palestinians were close to a historic peace accord.

Post March 2000
Then it all came crashing down.
The Nasdaq, which had peaked in March 2000 at over 5,000, fell by more than 70% in the next 18 months.
Internet stocks declined even further, and international terrorists launched a successful full-scale attack on the United States.
From March 2000 - September 2001, stock values, as measured by the broad Wilshire 5000 Index, fell 40% and wiped about $5 trillion from market values.


LESSONS AND CHALLENGES FOR THE LONG-TERM VALUE INVESTOR

• The public, once universally regarded as fickle and quick to abandon stocks in difficult times, stuck with equities.
• There was remarkably little panic selling by investors, and surveys showed that few lost their faith that stocks were still the best long-term investment.
• Long-term real returns on equities have averaged about 7% per year over all long-term periods.
• Even counting the bear market of 2000 - 2001, real returns averaged 11.3% per year in the 8 years since 1994.
• From the beginning of grand bull market in August 1982 through March 2000, real returns averaged 15.6% per year.
• These stock returns were significantly above the long-term average.
• Be cautious of bull market that drove investor expectations too high.
• During the bear market, many investors should not have un-realistic expectations of what the stock market can deliver.
• The lure of short-run gains, the attraction of various paradigm, and the relentless pressure to keep pace with hot sectors and hot stocks caused many investors to abandon their long-term principles.
• Real returns of 7% per year, even though doubling wealth every 10 years, is too slow for many who tasted the spectacular gains made in the bull market.
• Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. (John Maynard Keynes 1937)
• Although future stock returns may be diminished from the past, there is overwhelming reason to believe that stocks will remain the best investment for all those seeking steady, long term gains. (Jeremy J. Siegel, Stocks for the Long Run)