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)

PE Ratio and Future Stock Returns

PE Ratio and Future Stock Returns

Although the PE ratio can be a very misleading indicator of future stock returns in the SHORT RUN, in the LONG RUN, the PE ratio is a very useful predictor. The reasons may be understood by analysing how stock and bond returns are calculated.

Current yield of a bond
= interest received / the price paid

This is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.

Earnings yield of a stock
= EPS / Price
= 1 / (PE)


Bonds vs Stocks

Stocks

• Since the underlying assets of a firm or stock are real, the earnings yield is a REAL, or inflation-adjusted, return.
• Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.

Bonds

• In contrast, the NOMINAL return earned from fixed-income assets, where all the coupons and the final payment are fixed in money terms and do not rise with inflation.

The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns.

• The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%.
• This earnings yield exactly matches the 6.8% real return on equities from 1871.

Predicting Future Short-term Stock Returns using PE ratio

There are limitations to using the PE ratio to predict future short-term stock returns.

For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.

And in the short run, there are many other sources of market movement, such as:

• changes in interest rates or
• the risk premium demanded by stockholders.

Valuing the Market - Market PE Ratio

Valuing the Market - Market PE Ratio

The Price-to-Earnings Ratio

The most basic and fundamental yardstick for valuing stocks is the PE ratio. It is simply the ratio of the price of a share of stock to the annual EPS and measures how much an investor is willing to pay for a dollar's worth of current earnings.

The single most important variable determining the PE ratio of an individual stock is the expectation of future earnings growth.

If investors believe that earnings growth is going to accelerate, they will pay a higher price relative to current earnings than if they expect earnings to stagnate or decline.

However, earnings growth is not the only variable influencing the PE ratio. PE ratio are also influenced by other factors such as:

• interest rates,
• risk attitudes of investors,
• taxes, and
• liquidity among others.

Market PE Ratio

The PE of the entire Market =
Total market value of all stocks / aggregate earnings of all stocks

The historical average value of Market PE since 1870 is 14.5.


High Market PE due to drop in Earnings

Peaks in the Market PE ratio are not always bad omens for investors.

If a sharp drop in earnings cause the PE ratio to spike upward, such as occurred in the 1894, 1921, 1938, and 1990 - 1991 recessions, real returns following these spikes have averaged a robust 9.7% annually over the subsequent 5 years.

These returns are high because sharp declines in earnings always have been temporary, caused by recession or other special circumstances, and earnings as well as stock prices have rebounded subsequently.

Nevertheless, the PE ratio associated with the 2000-2001 recession is so high that investors should not expect above average returns to prevail.

High Market PE due to High Stock Prices

When surges in stock prices cause Market PE ratios to rise, as occurred in September 1929, July 1933, June 1946, November 1961, and August 1987, 5-year future real returns have averaged only 1.1%.

Surging stock prices often reflect undue optimism about future earnings growth. When faster earnings growth is not realized, stock prices fall, and returns suffer.

Certainly the Market PE spike that occurred in late 1999 and early 2000 accurately foretold poor future returns.

Long-Term Earnings Growth and Economic Growth (2)

Long-Term Earnings Growth and Economic Growth (2)


Long-Term Growth of GDP, Earnings and Dividends, 1871 -2001
Real GDP Growth 3.91%
Real Per-Share Earnings Growth 1.25%
Real Per-Share Dividend Growth 1.09%
Dividend Yield (median) 4.54%
Payout Ratio (median) 58.75%

The above shows the summary statistics for dividends per share, earnings per share (EPS), and stock returns from 1871 through September 2001. The data show that real per-share earnings growth over the entire 130 years has been a paltry 1.25%, considerably below the nearly 4% growth rate of real GDP. Because of the funding requirement, EPS growth does not match aggregate economic growth over the long run.


Long-Term Growth of GDP, Earnings and Dividends, 1871-1945
Real GDP Growth 4.51%
Real Per-Share Earnings Growth 0.66%
Real Per-Share Dividend Growth 0.74%
Dividend Yield (median) 5.07%
Payout Ratio (median) 66.76%

Long-Term Growth of GDP, Earnings and Dividends, 1946-2001
Real GDP Growth 3.11%
Real Per-Share Earnings Growth 2.05%
Real Per-Share Dividend Growth 1.56%
Dividend Yield (median) 3.53%
Payout Ratio (median) 51.91%


The data before and after World War II also show that the acceleration of earnings growth since World War II is associated with the drop in the dividend yield. Greater retained earnings allow firms to buy back shares and reinvest for growth. John Williams' contention that dividends withheld today spur earnings growth in the future is strongly supported by the data.


Also read:
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (2)

Long-Term Earnings Growth and Economic Growth (1)

Long-Term Earnings Growth and Economic Growth (1)

How do you value stock?

Stock prices are the present value of future dividends.

What are the determinants of stock prices?

These are earnings and dividends on a PER-SHARE basis.

Is economic growth an important factor influencing future dividends and hence stock prices?

Not necessarily. Although economic growth may influence AGGREGATE earnings and dividends favourably, economic growth does not necessarily increase the growth of per-share earnings or dividends. It is earnings per share (EPS) that is important to Wall Street because per-share data, not aggregate earnings or dividends, are the basis of investor returns.

What is the reason economic growth does not necessarily increases EPS?

Economic growth requires increased capital expenditures and this capital does not come freely. Implementing and upgrading technology requires substantial firm investment. These expenditures mus tbe funded either by borrowing in the debt market (through banks or trade credit or by selling bonds) or by floating new shares. The added interest costs and the dilution of profits that this funding involves place a burden on the firm's bottom line.

Can earnings increase without increasing capital expenditures?

Yes, in the short run, this may occur, but the long-run historical evidence suggests that it will not. One of the signal characteristics of long-term historical data is that the level of the capital stock - the total value of all physical capital such as factories and equipment, as well as intellectual capital, that has accumulated over time - has grown in proportion to the level of aggregate output. In other words, a 10% increase in output requires a 10% increase in the capital stock.

Will investment in productivity-enhancing technology spur earnings growth to permanently higher levels?

"Cost-saving investments" frequently touted as a source of increasing profit margins, only temporarily affect bottom-line earnings. As long as these investments are available to other firms, competition will force management to reduce product prices by the amount of the cost savings, and extra profits will quickly be competed away. In fact, capital expenditures often are undertaken not necessarily to ENHANCE profits but rather to PRESERVE profits when other firms have adopted competitive cost-saving measures.


Also read:
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (2)

Valuation of Cash Flows from Stocks

Valuation of Cash Flows from Stocks

Stocks have value only because of the potential cash flows that investors receive. These cash flows can come from any distribution (such as dividends or capital gains realized on sale) that stockholders expect to receive from their share of ownership of the firm, and it is by forecasting and valuing these expected future cash flows that one can judge the investment value of shares.

The value of any asset is determined by the discounted value of all expected future cash flows.

Future cash flows from assets are DISCOUNTED because cash received in the future is not worth as much as cash received in the present. The reasons for discounting are:

1. the innate TIME PREFERENCES of most individuals to enjoy their consumption today rather than wait for tomorrow,

2. PRODUCTIVITY, which allows funds invested today to yield a higher return tomorrow, and

3. INFLATION, which reduces the future purchasing power of cash received in the future.

4. UNCERTAINTY associated with the magnitude of future cash flows.

These factors 1, 2, and 3 also apply to both stocks and bonds and are the foundation of the theory of interest rates. Factor 4 applies primarily to the cash flows from equities.

The fundamental sources of stock valuation are the dividends and earnings of firms.

Fed Model of Stock Market Valuation

Fed Model of Stock Market Valuation

Greenspan's testimony in his semiannual address to Congress in 1997 suggested that the central bank regarded the stock market as overvalued whenever this earnings yield fell below the bond rate and undervalued whenever the reverse occurred.

The basic idea behind this Fed model is that bonds are the chief alternative for stocks in investors' portfolio.

• The return on a bond can be termed the interest yield.
• The return on stocks is termed the earnings yield.
• When the interest yield rises above the earnings yield, stock prices fall because investors shift their portfolio from stocks to bonds.
• On the other hand, when the interest yield falls below the stock yield, investors move into stocks, boosting their price.

Institutions have been using the relation between interest yields and stock yields to determine their asset allocations for many years.

What is unique about the Fed model is that it directly compares these two yields rather than just noting a correlation between them.

The Fed model appears to have worked fairly well since 1970. When interest rates fell, stocks rallied to bring the earnings yield down, and the opposite occurred when interest rates rose.

What is surprising is that this relation holds despite the fact that stocks and bonds are very different assets. The reason why the Fed model works is that the market rates these two advantages as approximately of equal value when inflation is an important factor.

There is no question that both bonds and stocks do badly when inflation increases.

• Bond prices fell in the late 1960s and 1970s because rising inflation forced interst rates up to offset the depreciating value of money.
• Inflation was accompanied by an increase in energy costs, poor productivity growth and poor monetary policy. Therefore, inflation depresses corporate profits and real stock returns.
• Finally, inflation increases uncertainty and raises the threat of central bank tightening of money policy to halt rising consumer prices. This is also negative for stocks.

Falling interest rates boosted both stock and bond prices as economic growth increased. The 1980s amd 1990s were good decades for both stocks and bonds as inflation declined from its record high levels.

However, both history and theory suggest that the Fed model breaks down when inflation is very low or when consumer prices are stagnant and deflation threatens. In such circumstances, bonds (especially risk-free government bonds) will do very well, but stocks returns will be ambiguous.

Given that interest rates and inflation have now shrunk to their lowest level in four decades, stock investors should be wary of using the Fed model.

• Stocks still will welcome any Fed reduction in interest rates, but declines in long-term government bond rates often signal strong deflationary or recessionary forces. It will be harder under these circumstances for firms to raise their output prices to cover costs. Deflation undermines firms' pricing power, and this cuts into profit margins.
• Moreover, because it is extremely difficult for firms to negotiate nominal wage cuts, deflation increases real wage costs and reduces profits. Thus nominal assets such as bonds will shine under deflation, whereas real assets often suffer.

Unless inflation heads upward again, it is unlikely that the tight correlation experienced over the past two decades between these two yields will continue.

• In a low-inflation world, pricing power and earnings potential will dominate stock valuations, whereas bonds will be valued for their ability to hedge deflationary risk.
• Rising and falling interest rates still will be very important determinants of stock prices in the very short run but long-run patterns are apt to diverge as investors recognize the fundamental differences in the assets.

Additional notes:
Present market PE of KLSE is around 15, giving an earnings yield of 6.7%.
The interest rate is about 3%.

Does the value of stocks depend on dividends or earnings?

Does the value of stocks depend on dividends or earnings?

Management determines its dividend policy by evaluating many factors, including:

• the tax differences between dividend income and capital gains,
• the need to generate internal funds to retire debt or invest, and,
• the desire to keep dividends relatively constant in the face of fluctuating earnings.

Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.

However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.

Dividend Payout Ratio

Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments.

The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.

Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.

How to value Stocks?

Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings.

Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)

John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote:

"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."


Ref: Stock for the Long Run, by Jeremy Siegel

Sources of Shareholder Value

Sources of Shareholder Value

For the equity holder, the source of future cash flows is the earnings of firms.

Earnings create value for shareholders by the :

• Payment of cash dividends
• Repurchase of shares
• Retirement of debt
• Investment in securities, capital projects, or other firms.

If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.

If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.

Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.

Which creates more value?

Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.

Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.

Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.

Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.

-----

Fear of misusing retained earnings

If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.

Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.

Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.

In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.

Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.

Ref: Stocks for the Long Run, Jeremy Siegel

Nature of Growth and Value Stocks

Nature of Growth and Value Stocks

These designations are not inherent in the products the firms make or the industries they are in. The terms depend solely on the market value of the firm relative to some fundamental variable, such as earnings, book value, etc.

The stock of a producer of technology equipment, which is considered to be an industry with high growth prospects, actually could be classified as a value stock if it is out of favor with the market and sells for a low market-to-book ratio.

Alternatively, the stock of an automobile manufacturer, which is a relatively mature indsutry with limited growth potential, could be classified a growth stock if its stock is in favor.

In fact, over time, many stocks go through value and growth designations as their market price fluctuates.

The literature often showed value stocks beating growth stocks. What does this mean?

As many stocks go through value and growth designations as their market price fluctuates, this implies that stocks become priced too high or low because of unfounded optimism or pessimism and eventually will return to true economic value. It definitely does not mean that industries normally designated as growth industries will underperform those designated as value industries.

There is no question that investors always should be concerned with valuation, no matter which stocks they buy.

Stocks and the Business Cycle

Stocks and the Business Cycle

The stock market has been surging to new highs almost daily, driving down dividend yields and price-earnings ratios skyward. Is this bullishness justified? The careful investors want to know if the economy is really going to do well enough to support these high stock prices.

What do the economists forecast?

• Will the real GDP increase over the next four quarters?
• Will the growth be at a healthy rate?
• Will there be a recession in the next year or few years?
• Even if a recession occurs, will it be brief or prolong?
• What will corporate profits (one of the major factors driving stock prices) be in the next year or 3 years?

The lesson is that the markets and the economy are often out of sync. It is not surprising that many investors dismiss economic forecasts when planning their market strategy.

Quote: 'The stock market has predicted nine out of the last five recessions!' (Paul Samuelson)

Quote: 'I'd love to be able to predict markets and anticipate recessions, but since that's impossible, I'm as satisfied to search out profitable companies as Buffett is.' (Peter Lynch)

However, do not dismiss the business cycle too quickly when examining your portfolio. The stock market still responds quite powerfully to changes in economic activity. Although there are many 'false alarms' like 1987 when the market collapse was not followed by a recession, stocks almost always fall prior to a recession and rally rigorously at signs of an impending recovery. If you can predict the business cycle, you can beat the buy-and-hold strategy.

This is no easy task, however. To make money by predicting the business cycle, one must be able to identify peaks and troughts of economic activity BEFORE they actually occur, a skill very few, if any, economists possess. Yet business cycle forecasting is a popular stock market endeavour not because it is successful - most of the time it is not - but because the potential gains are so large.

Risks and Investors' Holding Period

Risks and Investors' Holding Period

Total Real Returns

The focus of every long-term investor should be the growth of purchasing power - monetary wealth adjusted for the effect of inflation.

The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social, and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0% per year after inflation in all major subperiods.

The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to investors when they occur, are insignificant when compared with the upward movement of equity values over time.

Risk and Holding Period

For many investors, the most meaningful way to describe risk is by portraying a worst-case scenario.

Stocks unquestionably are riskier than bonds or bills in the short run.

• In every 5-year period since 1802, the worst performance in stocks, at -11% per year, has been only slightly worse than the worst performance in bonds or bills.
• For 10-year holding periods, the worst stock performance actually has been BETTER than that for bonds or bills.
• For 20-year holding periods, stocks have never fallen behind inflation, whereas bonds and bills once fell as much as 3% per year behind the rate of inflation.
• For 30-year periods, the worst annual stock performance remained comfortably ahead of inflation by 2.6% per year, which is just below the average 30-year return on fixed-income assets.

It is very significant that stocks, in contrast to bonds or bills, have never offered investors a negative real holding period return yield over periods of 17 years or more. Although it might appear to be riskier to accumulate wealth in stocks rather than in bonds over long periods of time, precisely the opposite is true. The safest long-term investment for the preservation of purchasing power clearly has been a diversified portfolio of equities.

As the holding period increases, the probability that stocks will outperform fixed-income assets increases dramatically.

• For 10-year horizons, stocks bea bonds and bills about 80% of the time.
• For 20-year horizons, it is over 90% of the time, and
• For 30-year horizons, it is virtually 100% of the time.

Although the dominance of stocks over bonds is really apparent in the long run, it is more important to note that over 1- and even 2-year periods, stocks outperform bonds or bills only about 3 out of 5 years. This means that in nearly 2 out of every 5 years a stockholder will fall behind the return on Treasury bills or bank certificates. The high probability in the short run of underperforming bonds and bank accounts is the primary reason why it is so hard for many investors to stay in stocks.

Investor Holding Periods

Some investors question whether holding periods of 10 or 20 or more years are relevant to their planning horizon. Yet these long horizons are far more relevant than most investors recognize. One of the greatest mistakes that investors make is to underestimate their holding period. This is so because many investors think about the holding periods of A PARTICULAR stock, bond, or mutual fund. But the holding period that is relevant for portfolio allocation is the length of time the investors hold ANY stocks or bonds, no matter how many changes are made among the individual issues in their portfolio.

Average Investor Holding Period

Let us study the average length of time that investors hold financial assets based on gender and the age at which they BEGIN purchasing such assets. It is assumed:

• That individuals accumulate savings during their working years in order to build sufficient assets to fund their retirement, which normally occurs at age 65.
• After age 65, retirees live off the funds derived from both the returns and sale of their assets. It is also assumed that investors either plan to exhaust all their assets by the end of their expected life span or plan to retain one-half of their retirement assets at the end of their expected life span as a safety margin or for bequests.

Under either assumption:

• Individuals who begin accumulating assets in their 30s will hold financial assets for 40 years and more.
• Even investors who begin accumulating assets near retirement will have a holding period of up to 20 years or more. It should be noted that the life expectancy for males is now about 82 years; for females, more than 86 years; and for either spouse, about 90 years.
• Many retirees will be holding assets for 20 years or longer. In addition, if the investor works beyond age 65 , which is increasingly common, or plans to leave a large percentage of assets as a bequest, the average holding period is even longer than those indicated.

Conclusion

No one denies that in the short run stocks are riskier than fixed-income assets. In the long run, however, history has shown that this is not the case.

There is still much uncertainty about what a dollar will be worth two or three decades from now.

Historical evidence indicates that we can be more certain of the purchasing poer of a diversified portfolio of common stocks 30 years hence than we can of the final payment on a 30-year U.S. government bond.

Reap the benefits of market volatility

Reap the benefits of market volatility

When stocks are collapsing, worst-case scenarios loom large in investors' minds. On May 6, 1932, after stocks had plummeted 85% from their 1929 high, Dean Witter issued the following memo to its clients:

"There are only two premises which are tenable as to the future. Either we are going to have chaos or else recovery. The former theory is foolish. If chaos ensues, nothing will maintain value; neither bonds nor stocks nor bank deposits nor gold will remain valuable. Real estate will be a worthless asset because titles will be insecure. No policy can be based upon this impossible contingency. Policy must therfore be predicated upon the theory of recovery. The present is not the first depression; it may be the worst, but just as surely as conditions have righted themselves in the past and have gradually readjusted to normal, so this will again occur. The only uncertainty is WHEN it will occur.... I wish to say emphatically that in a few years present prices will appear as ridiculously low as 1929 values appear fantastically high."

Two months later the stock market hit its all time low and rallied strongly. In retrospect, these words reflected great wisdom and sound judgment about the temporary dislocations of stock prices. Yet, at the time they were uttered, investors were so disenchanted with stocks and so filled with doom and gloom that the message fell on deaf ears. Investors often overreact to short-term events and fail to take the long view of the market.

1987 Crash v.s. 1929 Crash

Despite the drama of the October 1987 market collapse, which often has been compared with 1929, there was amazingly little lasting effect on the world economy or even the financial markets. Because this stock market crash did not augur either a further collapse in stock prices or a decline in economic activity, it probably will never attain the notoriety of the crash of 1929. Yet its lesson is perhaps more important: Economic safeguards, such as prompt Federal Reserve action to provide liquidity to the economy and ensure the financial markets, can prevent an economic debacle of the kind that beset our economy during the Great Depression.

This does not mean that the markets are exempt from violent fluctuations. Since the future will always be uncertain, psychology and sentiment often dominate economic fundamentals. As Keynes perceptively stated 60 years ago in The General Theory, "The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." Precarious estimates are subject to sudden change, and prices in free markets will always be volatile. But history has show that investors who are willing to step into the market when others are panicking to leave reap the benefits of market volatility.

Behavioural Traps (3)

Rules to Avoid Behavioural Traps

(Continuing the investing story of Dave and his Investment Counselor)

Dave: I don't feel secure enough to trade again soon. I just want to master investing. How can one get over these behavioural traps and be a successful long-term investor?

IC: Dave, I'm glad you are not trading, since trading is right for only a very small fraction of my clients.
Researchers have found that you must set up rules and incentives to keep your investments on track - this is called PRECOMMITMENT. Set an ASSET ALLOCATION RULE and then stick to it. If you have enough knowledge, you can do this alone or else with an investment advisor. Do not try to second guess your rule. Remeber that the basic factors generating returns change from less than we think as we watch the day-to-day ups and downs of the market. A disciplined investment strategy is almost always a winning strategy. Furthermore, you need to get rid of the temptation to trade stocks. One way to do this is by closing all your trading and online accounts. If you have to pay higher commissions, you are less likely to trade more frequently.
If you do buy stocks for a short-term trade, set a stop-loss order to minimize your losses. You do not want to let your losses mount, rationalizing that the stock will eventually come back. If you are tempted to sell a stock that has a gain, think of the taxes you will have to pay, and if you are reluctant to sell a stock that has a loss, think of the tax savings you will realize. Finally, do not tell your friends about your trades. Living up to their expectations will make you even more reluctant to take a loss and admit that you were wrong.

Dave: I'll have to admit that I sometimes enjoyed trading.

IC: If you really enjoy trading, establish a rule that every year you are going to establish a small trading account that is completely separate from the rest of your portfolio. All brokerage costs and all taxes must be paid from this account. Consider the money you put into the account lost, because most likely it will wither to nothing, being consumed by transaction costs and trading losses. And you should never consider exceeding the rigid limit you place on how much money you put into that account.
If that does not work, or if you feel nervous about the market and have a compulsion to trade, seek help. There are some reformed traders establishing Traders' Anonymous (TA) programs designed to help people who cannot resist the temptations of trading too frequently.

Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)

Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327

Behavioural Traps (2)

Behavioural Traps (2)

(The investing story of Dave, Jennifer and the investment counselor)

Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.

The Technology Boom, 1999 -2001

TIME: October 1999

Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.

Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?

Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.


Fads, Social Dynamics, and Stock Bubbles
[IC: When everyone is excited about the market, you should be extremely cautious. Stock prices are based not just on economic values but also on psychological factors that influence the mood of the market. Fad and social dynamics play a large role in the determination of asset prices. Stock prices have been far too volatile to be explained by fluctuations in economic factors such as dividends or earnings. Much of the extra volatility can be explained by fads and fashions that have a great impact on investor decisions.]

[IC: Note how others influenced your decision, against your better judgment. Psychologist have long know how hard it is to remain separate from a crowd. It was not social pressure that led the subjects to act against their own best judgment but rather their disbelief that a large group of people could be wrong.]

[IC: The Internet and technology bubble is a perfect example of social pressures influencing stock prices. The conversations around the office, the newspaper headlines, the analysts' predictions - they all fed the craze to invest in these stock. Psychologists call this penchant to follow the crowd the HERDING INSTINCT, the tendency of individuals to adapt their thinking to the prevailing opinion.]

[IC: "We find that whole communities suddenly fix their minds upon one subject, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion and run after it... Sober nations have all at once become desperte gamblers, and risked most their existence upon the turn of a piece of paper... Men, it has been well said, think in herds... they go mad in herds, while they only recover their senses slowly and one by one." This happens again and again through history. Dave was convinced that "this time is different." The propensity of investors to follow the crowd is a permanent fixture of financial history. And following the crowd is not always irrational, although it may lead to some very bad results. Individuals have a feeling that "someone knows something" and that they shouldn't miss out. Sometimes that's right, but very often that is wrong. Economists call this decision-making process an INFORMATION CASCADE.]

TIME: March 2000

Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.

Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!

Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.

TIME: July 2000

Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?

Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.

I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.

Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.

Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.

Excessive Trading, Overconfidence and the Representative Bias
[IC: From examining your trading records, I see that you were an extremely active trader. Let me tell you something. Trading does nothing for you but cause extra anxiety and losses. A couple of economists examined the records of tens of thousands of traders, and they showed that the returns of the heaviest traders were 7.1% below those who traded infrequently.]

[IC: It is extraordinarily difficult to be a successful trader. Even bright people who devote their entire energies to trading stocks rarely make superior returns. The problem is that most people are simply OVERCONFIDENT in their own abilities. To put it another way, research has confirmed that the averge individual - be he or she a student, a trader, a driver, or whatever - believes that he or she is better than average, which of course is statistically impossible.}

[IC: What causes this overconfidence? Overconfidence comes from several sources.
First, there is what we call a SELF-ATTRIBUTION BIAS that causes one to take credit for a favourable turn of events when credit is not due. Remember in March 2000 bragging to your wife about how smart you were to have bought those Internet stocks? Your early success fed your overconfidence. You and your friends attributed your stock gains to skillful investing, even though those outcomes were frequently the result of chance.
Another source of overconfidence comes from the tendency to see too many parallels between events that seem the same but are remarkably different. This is called the REPRESENTATIVE BIAS. This bias actually arises because of the human learning process. When we see something that looks familiar, we form a representative heuristic to help us learn. However, the parallels we see are often not valid, and our conclusions are misguided.

[IC: You mentioned your investment newsletters say that every time that such and such an event occurred in the past, the market has moved in a certain direction, implying that it is bound to do so again, but when you try to use that advice, it never works. This is finding patterns in the data when in fact there are none. Searching past data for patterns is called DATA MINING, and it is easier than ever to do with inexpensive computer programs. Throw in a load of variables to explain stock price movements, and you are sure to find some spectacular fits.
Psychologically, human beings are not designed to accept all the randomness that is out there. It is very discomforting for many to learn that most movements in the market are random and do not have any identifiable cause or reason. Individuals possess this deep psychological need to know WHY something happens. This is where the reporters and so-called experts come in. They are more than happy to fill the holes in our knowledge with explanations that are wrong more often than not.]

[IC: Before you bought the technology stocks in July of 2000, your broker compared these companies to the suppliers providing the gear for the gold rushers of the 1850s. It seemed like an insightful comparison at the time, but in fact the situations were very different. This is an obvious representative bias. It is interesting that you mentioned your broker, who is supposed to be the expert, is subject to the same overconfidence that you are. There is actually evidence that experts are even more subject to overconfidence than the layperson. These so called experts have been trained to analyze the world in a particular way, and selling their advice depends on finding supporting, not contradictory evidence.
Recall the failure of the analysts to change their earnings forecasts of the technology sector despite being bombarded with bad news that suggested that something was seriously wrong with their view of the whole industry. After being fed great news by the corporations for years, supported by 20 to 30 % earnings growth rates, they had no idea how to handle downbeat news, so most just ignored it.
The propensity to shut out bad news was even more pronounced among analysts in the Internet sector. Many were so convinced that these stocks were the wave of the future that despite the flood of ghastly news, many only downgraded these stocks AFTER they had fallen 80 or 90%!
The predisposition to disregard news that does not correspond to your worldview arises from what psychologists called COGNITIVE DISSONANCE. Cognitive dissonance is the discomfort we encounter when we confront evidence that conflicts with our view or suggests that our abilities or actions are not as good as we thought. We all display a natural tendency to minimise this discomfort, which makes it difficult for us to recognize our overconfidence.]

TIME: November 2000

Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.


Prospect Theory, Loss Aversion, and Holding onto Losing Trades
[IC: Let me explain why you end up holding so many losers in your portfolio? A key finding of Kahneman and Tversky Prospect Theory was that individuals form a REFERENC POINT from which they judge their performance. They found that from that reference point individuals are much more upset about losing a given amount of money than they are from gaining the same amount. They called this behaviour LOSS AVERSION and suggested that the decision to hold or sell an investment will be dramatically influenced by whether your stock has gone up or down, in other words, whether you have a gain or a loss.]

[IC: When you buy a stock, how do you track its performance? Exactly, you calculate how much the stock has gone up or down since you bought it. Often the reference point is the purchase price that investors pay for the stock. Investors become fixated on this reference point to the exclusion of any other information. This investor behaviour is referred to as MENTAL ACCOUNTING.
When you buy a stock, you open a mental account with the purchase price as the reference point. Similarly, when you buy a group of stocks together, you will either think of the stocks individually or you may aggregate the accounts together. Whether your stocks are showing a gain or a loss will influence your decision to hold or sell the stock. Moreover, in accounts with multiple losses, you are likely to aggregae individual losses together because thinking about one big loss is an easier pill for you to swalllow than thinking of many smaller losses. Avoiding the realisation of losses becomes the primary goal of many investors.]

[IC: Dave, you mentioned that the thought of realizing the losses on your technology stocks petrified you. That is a completely natural reaction. Your pride is one of the main reasons why you avoided selling at a loss. Every investment involves an emotional as well as a financial commitment that makes it hard to evaluate objectively. You felt good that you sold out of your Internet stocks with a small gain, but the networking stocks you subsequently bought never showed a gain. Even as prospects dimmed, not only did you hang onto those stocks, but you also bought more, hoping against hope that they would recover.
Prospect theory predicts that many investors will do as you did - increase your position, and consequently your risk, in an attempt to get even. ]

[IC: You thought that buying more stock would increase your chances of recouping your losses. Millions of other investors think likewise. In 1982, Leroy Gross wrote a manual for stockbrokers and called this phenomenon the "GET-EVEN-ITIS" disease. He claimed "get-even-itis" probably has caused more destruction to portfolios than any other mistake.
It is hard for us to admit that we have made a bad investment and it is even harder for us to admit that mistake to others. To be a successful investor, however, you have no choice but to do so. Decisions on your portfolio must be made on a FORWARD-LOOKING basis. What has happened in the past cannot be changed. It is a "SUNK COST," as economist say. When prospects do not look good, sell the stock whether or not you have a loss. ]

[IC: You bought more shares because you thought the stocks were cheap, as many were down 50 % or more from their highs. Cheap relative to what? Cheap relative to their past price or their future prospects? You thought that a price of 40 for a stock that had been 80 made the stock cheap, yet you never considered the fact that maybe 40 was still too high. This demonstrates another one of Kahneman and Tvrsky's behavioural findings: ANCHORING, or the tendency of people facing complex decisions to use an anchor, or a suggested number, to form their judgement. Figuring out the correct stock price is such a complex task that it is natural to use the recently remembered stock price as an anchor and then judge the current price a bargain. ]

[IC: You are concern that following my advice and selling your losers whenever prospects are dim will register a lot more losses on your trades. Good! Most investors do exactly the opposite and realize poor returns. Research has shown that investors sell stocks for a gain 50% more frequently than they sell stocks for a loss. This means that stocks that are above their purchase price are 50% more likely to be sold than stocks that are in the red. Traders do this even though it is a horrible strategy from the point of view of paying taxes.
Let me tell you of one short-term trader I successfully counseled. He showed me that 80 percent of his trades made money, but he was down overall because he lost so much money on his losing trades that they drowned out his winners.
After I counseled him, he became a successful trader. Now he says that only one-third of his trades make money but that overall he is way ahead. When things do not work out as he planned, he gets rid of losing trades quickly while holding onto his winners. There is an old adage on Wall Street that sums up successful trading: "Cut your losers short, and let yours winner ride." ]


TIME: August 2001

Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.

Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.

Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...

Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.

Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.

Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)


Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327

Behavioural Traps (1)

Behavioural Traps (1)

(The investing story of Dave and Jennifer)

Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.

The Technology Boom, 1999 -2001

TIME: October 1999

Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.

Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?

Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.


TIME: March 2000

Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.

Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!

Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.

TIME: July 2000

Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?

Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.

I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.

Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.

Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.


TIME: November 2000

Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.


TIME: August 2001

Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.

Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.

Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...

Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.

Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.


Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)

Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327

The lure of short-term gains

The lure of short-term gains

There are many strategies employed in the market. During a given period, any strategy may give a negative return, despite having delivered good positive returns in the past or over the long term. The investor maybe tempted to change a proven strategy.

An investor changed from fundamental investing, to technical investing, to warrants investing, to options investing and to investing in U.S. equities. These techniques spoke loudly the resourcefulness of the investor, but the success must await an honest revelation of the total returns. This was certainly bewildering to those who are less savy. Yet, it was both interesting and intriguing to follow the investing adventure of this investor.

Sometimes, the lure of short-run gains, the attraction of a new paradigm, and the relentless pressure to keep pace with hot sectors and hot stocks caused some/many investors to abandon their long-term principles. The long-term moderate rate of return is too slow for many who tasted the spectacular gains made in the bull market.

However, by accepting a modest return of 7 or 8% per year (doubling wealth every 10 years), there are many stocks giving such a return with low or no risk. Patience must be exercised by long-term investors. Stocks remain the best investment for all those seeking steady, long-term gains.

Are CDs Good Protection For The Bear Market?

Are CDs Good Protection For The Bear Market?
by Ana Gonzalez Ribeiro (Contact Author Biography)


A bear market is usually an indication of a sluggish economy and a decrease in the value of overall securities. During this time, consumers tend to be pessimistic in their outlook about financial assets and on the economy as a whole. In a bear market, investors always tend to look into where their investments can be better protected, or which investment vehicles to add to their portfolios to help lessen the blow to their stocks and equity investments. Products investors commonly look into during these difficult times are more stable, income-producing debt instruments such as certificates of deposit (CD). But are CDs actually good protection for a bear market? Read on to find out. (For basic background on CDs, read Are certificates of deposit a kind of bond?)


What Is a CD?

A certificate of deposit is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. You are guaranteed the principal plus a fixed amount of interest at maturity, which is the end of the term. The period of the term varies, but generally you can purchase three-month, six-month, nine-month, or one- to five-year CDs. Some banks have even longer-term CDs. (Learn about investing over the short or long term in Five Things To Know About Asset Allocation.)

CDs are considered time deposits because the purchaser agrees at the time of purchase to leave his or her deposit in the bank for the specific period of time. Make sure you can afford to let go of some of your money for a certain period of time before committing to a CD, because if the purchaser decides to take back the deposit before maturity, he or she will be liable for a penalty, which varies from as little as a week's worth of interest to a month or six months' interest. Any fees or penalty amounts are required to be disclosed upon opening the CD account. (Build Yourself An Emergency Fund can help you ensure you won't have to liquidate your CD in a pinch.)

One major drawback to withdrawing before the term is due is that the penalty imposed could decrease not only the interest, but also the principal amount. This can happen if you purchase a 13-month CD and decide to cash it at three months. The penalty on this CD would be to pay off six months' worth of interest. Unfortunately, your CD has not even earned that amount of interest yet – and so the penalty digs into your principal amount.

Although CDs are considered low-return investments, the return is guaranteed at the specific interest rate even if market rates go lower. Typical CDs are not protected against inflation, so when shopping for a CD, try to buy one higher than the inflation rate so that you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be. Although rates on CDs are not the highest in the debt instrument market, CDs earn more in interest than most money market accounts and savings accounts. (Learn more about these two deposit options in Money Market Vs. Savings Accounts.)

CDs Vs. Stocks

Stocks tend to have a higher rate of return than most securities, but this is because of the higher risk that is involved. If a company goes through rough times, the stockholders will be the first to feel it. If the stock loses value as a result of bad management or a lack of public interest in its products or services, the value of your portfolio may be compromised. However, if the company does really well, the return you can obtain from its stock's value could be significantly higher than you would've obtained through a CD investment. (Learn more in Why Stocks Outperform Bonds.)

For the past several years, the stock market has been through turbulent ups and downs, resulting in great losses (and gains) for some stockholders. CDs are one option that can help protect your investment from these times of turmoil by providing a stable income. Although the returns gained from these investments won't usually be as high as those provided by stocks, they can serve as a "cushion" to balance your portfolio and keep it afloat when the market is down in the dumps. Because CD rates are locked in for a certain period of time, the interest rate agreed upon at the time of purchase is the interest rate that will be gained on the CD despite how poorly the market might be doing. In addition, unlike stocks and various other investment vehicles, CDs are almost always insured. (Learn how to protect your portfolio through diversification in Introduction To Diversification and Diversification: It's All About (Asset) Class.)

Guaranteed Protection

CDs are primarily a safe investment. They are guaranteed by the bank to return the principal and interest earned at maturity. The Federal Deposit Insurance Corporation (FDIC) insures certificates of deposit for up to $100,000 for individual accounts at its insured banks. This means that it will guarantee payment of your CD investment if the bank goes under. The National Credit Union Administration (NCUA) serves the same purpose for its insured credit unions.

If you have a joint account with your spouse, you can be covered for up to $250,000 (which was increased temporarily from $200,000 by the FDIC on October 3, 2008) at each institution, but if you set up your accounts under a different set of provisions (for example, as a trust), you might be covered up to an even higher amount. Check with your bank first. Knowing how much insurance you have against bank failure is essential, especially when the stock market is not faring well. It is during these times that investors tend to look deeper into insured investments. Neither the FDIC nor the NCUA insures stocks, bonds, mutual funds, life insurance, annuities or municipal securities. (For more on making sure your money is safe, read Are Your Bank Deposits Insured? and Bank Failure: Will Your Assets Be Protected?)

When searching for CD products, it is a good idea to look into how well the bank offering the CDs is doing. The FDIC has a watch list where it lists banks that might be in trouble; however, according to the FDIC, they never release ratings on the safety of financial institutions to the public. To get an idea of the how banks are performing, consumers need to visit the listings of several financial institution rating services provided on the FDIC's website. For further info visit FDIC.gov, and review detailed credit union data at NCUA.gov.

In addition to commercial banks, thrifts and credit unions, you can also buy CDs through brokerage firms or online accounts. One drawback to buying through a brokerage account is that the broker is considered a third party to the transaction - it is buying the CD from a bank and selling it to you. If a bank fails, it will take longer to get your money back because the request will have to go through the brokerage rather than directly to the bank. (Read more about the role of a broker in Full-Service Brokerage Or DIY?)

CD Laddering

CD laddering can provide a flexible security blanket if done properly. Laddering helps lower your risk while increasing your return, because it allows you to continue investing in the highest-rated CDs available. The method is to use your funds to buy CDs at different maturities and interest rates.

Here's how it works:

When you start a CD ladder, research the best rates, either locally or in different states. Let's say you have $5,000 in your minimal interest-bearing savings account. Because you want to make the most of your stationary money, you decide that a CD with an interest rate of 3% looks much more appealing. Do not use money you'll need for emergencies. After you decide this is money you can afford to lock up for a period of time, go ahead and start your ladder. You can begin by buying five different CDs at various rates and maturity dates. For example, the ladder could consist of purchasing the following CDs, each at $1,000:

a one-year CD at 3% interest
a two-year CD at 3.5% interest
a three-year CD at 3.7% interest
a four-year CD at 3.9% interest
a five-year CD at 4.1% interest

When the first CD matures, you will have the flexibility of either reinvesting by rolling it into a higher CD rate or cashing it out. In laddering, you will roll it over. When your CD matures, roll it over into a higher-rated five-year CD. When your second-year CD matures, roll it over into another five-year high-rated CD, and continue doing the same until you've rolled over all your initial CDs. Because a CD in your ladder will mature each year, you will always have liquid money available. The advantage of laddering like this is that you will always get the benefit of the highest interest by rolling into the longer-term five-year CD. (For more details, read Step Up Your Income With A CD Ladder.)

Tax Consequences

Interest that you earn on your CD throughout its term is taxable. The tax on it depends on your tax bracket. According to the Internal Revenue Service (IRS), you must report the total interest you earn on the certificate of deposit every year. Even if the interest on the CD was not paid to you directly, you will be taxed on the amount earned in that year. Interest income is considered ordinary income and taxed as such.

Conclusion

CDs are a comparatively safe investment. If they are managed properly, they can provide a stable income regardless of stock-market conditions. When considering the purchase of CDs or starting a CD ladder, always consider the emergency money you might need in the future.

Laddering can help protect your investments by providing you with stable interest income in a bear market (or any market, for that matter), but make sure you can afford to do without that money for the term of the CD, and investigate the institution you decide to buy from.

For more advice for surviving a bear market with your assets intact, read Adapt To A Bear Market and Has Your Fund Manager Been Through A Bear Market?
by Ana Gonzalez Ribeiro, (Contact Author Biography)

Ana Gonzalez Ribeiro holds an MBA with honors in Finance and works as an Account Administrator and Freelance Writer. She has published articles in The Hispanic Outlook on Higher Education, New Mexico Woman, Spotlight on Recovery Magazine and The Loop Newsletter for College Forward. She is also a regular contributing writer specializing in business-related issues for Alaska Business Monthly. She worked for The Volunteer Center of United Way Westchester as a writer for the Youth Volunteer Guidebook 2008-2009 and served as Treasurer for the Society for Hispanic MBAs. During her spare time, she enjoys collecting stamps, reading biographies, staying up to date on business-related trends and working as a Notary Public and signing agent.

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