Everyone is a hero in a bull market

Psychologists have identified that it is human nature to attribute our wins to our skill and our losses to our bad luck. Don't fall for this trap.

With trading and investment, luck often parades as skill, especially when a market is doing well. During a bullish run in the stock market you will often meet someone who is very happy with their ability to pick the right stocks, because they have backed one that has performed well.

But in the same way that a rising tide lifts all boats, even the rusty ones, many stocks do well in a bull market, even if they're nothing special. So the profit may have more to do with favourable big picture events at the time, such as a strong economy or falling interest rates, than with anything company specific. This really means that the person was lucky rather than skilful.

Be mindful of the old chestnut that 'everyone is a hero in a bull market'. As prices went higher and higher, they increased their investment sizes, so that when the crash came they had far more money at risk than they would have imagined just a year earlier. It ended badly. Profits tempted them in, and losses forced them out.

Listen and read very critically

Keep a critical mind when you read or hear market comments. Ask yourself:

• Does the commentator have any track record?
• Are they considering all of the factors?
• If they are pointing to influences which have been present for some time, why should they start moving the market now?
• Are they relying on hindsight?
• Are they hedging their bets?

Be a sceptic. Who is the writer? Don't listen to ill-informed, ad hoc, one-eyed, overpaid, inexperienced, sensationalist, untested, uncommitted and uninvolved people!

It is just too difficult sometimes to have a view. A commentator can gain a lot of respect if he actually said, "I don't know.' He could then continue 'because of the following...' and you know you're going to get a balanced answer. It's brave to say ' I don't know'.

Respect the market, not the experts

The power of the financial markets should be daunting, but many people are not deterred.


Why do people underestimate the difficulty of making money in the financial markets? Here are some main reasons:


1. The experts in the media

2. The widely held belief that many professionals are regularly able to beat the market

3. Some people like to trade the market because they are gamblers - usually with disastrous results.


Experts

The experts in the media promote the idea that markets are easier than they really are. A guy on TV or the newspaper says that the price is going to do this and do that, and it sounds easy. The market can be beaten.

If the media put out a continual broadcast that the market has processed all the information and that the price is right, people would get the message. But they rarely say that.

The experts and media message is that the behaviour of the market can be forecasted. It's a persistent and seductive message, and people think 'ah, I can have a go at that, I can make money out of that'.

You can't blame the average person for following what they read in the newspaper and what they're being told on TV. However, many so-called experts are just commentators or analysts who often don't have any track record and who often, to my ear, don't even make much sense.

Listen critically, rather than just accept what you're hearing or reading. You may be surprised to find that they're not really experts.

The fact that the media and their financial guesswork is entertaining and interesting doesn't necessarily mean that it's the truth.


Most professionals are not outguessing the market

Ever wonder about all the money made by the people working on Wall Street or in the City of London. Surely they know something about markets?

The truth is that very few are successfully backing their views on markets. Most of them wouldn't have a clue what the market was going to do. They make money in other ways, such as commission and mangement fees.

It's not that people working in finance don't know anything - they are usually very good, very smart people. The fact is they're making money out of sales, client relationships and by doing transactions, i.e. facilitating the whole process. They're not actually making money out of successfully predicting what's going to go up and down. They're, therefore, not a reason for you to take up punting cotton futures in your spare time.

Equally, don't be too impressed with your stockbroker just because they sound confident and know a lot of stories and figures. More information does not necessary make the market more predictable. The extra information is probably useless as the price has already adjusted for it - it has been 'priced in'. It's about as useful as playing roulette and knowing whether the roulette wheel was made in Taiwan or Korea.

The critical test is: does the broker make a living out of picking stocks? Probably not. He or she is sitting in their seat because they're getting the fees you pay them to buy and sell on your behalf. It's very easy for someone to have a view when it's with someone else's money.

Speculation is usually only successful when it is in line with the fundamentals

Speculators are often unfairly criticised. The market needs them. Speculators add important liquidity.

Those who invest in small stocks will know. Often these stocks would not have much daily turnovers if it were not for speculators. The longer term holders of these stocks do not buy or sell very often. For those wishing to find buyers or sellers of these stocks, it is a great benefit to have speculators as they are more active.

Speculators also play an important role in taking over risk that others don't want. Wheat farmers, may sell their crop well before harvest at a fixed price for a future delivery date. That way, they can remove the risk that there is a bumper season and an oversupply that forces prices lower.

Speculators are often criticised for pushing prices to unrealistic levels. This argument is flawed. In fact, speculators are usually punished when they do this, because if they are wrong about the real values, they are usually the big losers. The tech boom and bust, where perhaps it was speculators who drove prices to very high levesl, is a great example. Most of them paid very heavily when market prices crashed to a fraction of the higher levels. Though what a great opportunity it was for the more savvy investors to sell near the highs.

So, speculation is usually only successful when it is in line with the fundamentals, and when it is pushing prices to a level that more closely reflects fair value.

Aiming for higher returns without losing your pants!

During the 2007-2209 severe bear market, there were many investors who cashed out of the market, at various stages of the unfolding bear. Many were happy that their capitals were not at risk during the turbulent bear evolving early stages. They were waiting to re-enter the market when it is 'safe' again. Just as they might not have cashed out at the 'right time', likewise, they might not have re-entered the market at the 'right time'.

What defines safety for these investors? They are probably referring to not losing their existing capital. Of course, the safest place was the money market or the fixed deposits. At which point in the bear market will they re-invest into stocks? During the slippery downturn, during the ups and downs, or when the market has turned up convincingly. I suspect many such investors having 'rescued themselves' or 'cashed out' of their stocks will not put their cash back to work until the market has turned up convincingly. This means they would have lost out on the fantastic return of the market during the last 2 months.

Therein is the difference between Warren Buffett and fellow value investors, and the general crowd. They bought at the time when everyone was fearful, probably committing more money into stocks too. The few value investors who spoke on Bloomberg or CNBC during the severe downturn sharing their views that they were net buyers appeared silly in the public eyes when the stocks prices sank further. But events have since proven these value investors to be more right than wrong.

Having a good knowledge of the risk/reward ratio offered by the market is helpful. The safest time to invest is when the market is at its low. This is also the time when the downside risk is small, though not completely eliminated, but the potential for upside gain is high.

Warren Buffett was right again. He asked to 'Buy America' in October 2008 when the US and world market 'fell off the cliff' following the Lehman collapse. For those who have bought following his call, subsequent events should have ensured good returns.

How can we aim for higher returns? Here is another lesson from Warren Buffett on this. What Ben Graham did was to inspire Warren Buffett with his investment strategy of buying bargain stocks that were selling below book value regardless of the nature of the company's long-term economics. This was something Warren Buffett was able to do with great success during the 1950s and early 1960s. But he stayed with this approach long after it wasn't viable anymore - the chains of habit were too light to be felt. When he finally woke up in the late 1970s to the fact that the Graham bargain ride was over, he shifted over to the strategy of buying exceptional businesses at reasonable prices and then holding them for long periods - thereby letting the business grow in value. With the old strategy he made millions, but with the new one he made billions.

As Buffett modified his strategy aiming for higher returns in the late 1970s, we should also regularly re-appraise our philosophy and strategy, through acquisition of appropriate investing knowledge, skills, and its better execution. There is definitely a 'holy grail' in value investing; to benefit from this hugely requires a deeper understanding of its core principles and better execution by the practitioners using proven safe strategies. So far, none is better than Warren Buffett, the accomplished sage. So much has been written on his strategy and method, and we only need to emulate these.

Aiming for safety of capital with a reasonable return was the initial goal. With increasing knowledge and skill, perhaps, aiming for safety of capital and higher returns are achievable. The returns of many investors are compromised by certain knowledge they possess and certain knowledge they do not have. Of course, you may not know what you don't know. Investing is a life-long passion for some. Having a good investment philosphy and strategy is the key. There is constant learning and re-learning. Some knowledge needs to be unlearned. As Warren Buffett said, "The chains of habit are too light to be felt until they are too heavy to be broken."

Also read:
You've Sold Your Stocks. Now What?

Dollar Cost Averaging vs Simple Averaging

There is a difference between simple averaging and dollar cost averaging.

Tan Teng Boo averaged down on a stock and profited. Let us look at what he did.

This was taken from this week's icap newsletter:
"A stock that the i Capital Global Fund invested in plunged around 85% during the 2007-2009 bear market. However, instead of selling as it dropped, we bought so much more of this stock that the cost price plunged around 80% too. By now, the i Capital Global Fund is sitting on a gain of 175% on this particular stock. The reason why ICGF bought so much more was because if it was attractive at higher prices, it is even more attractive at depressed prices since the business fundamentals of the company have not changed. "

What ICGF did. http://spreadsheets.google.com/pub?key=r_MxUHLmwJhsKRpR7JklS1Q&output=html

Simple Averaging

The first point to clear up is actually the difference between dollar cost averaging and simple averaging. What Teng Boo did above was not DCA but simple averaging.

Buffett does not believe in DCA. "It does not make sense investing in stocks when the prices are high." However, Buffett will employ simple averaging, often buying a good stock he likes in large amount when its price is down for no good reasons.

DCA

Those employing DCA should learn its limitations too. It is a way to diversify risk, and is definitely not a strategy to optimise your returns. Various studies quoted that returns from lump sum investing beats those from DCA, 60% of the time.

There are risks too from DCA. If the stock price tanked due to deterioration in its fundamentals, using DCA equates to throwing good money after a lousy company and should not be employed. Also, remember that the same amount used for DCA into a stock is an opportunity cost, to investing in another stock.


The Only Reason to Simple Average or Dollar Cost Average

I did pick up a very important point. It was good to see this advice in print. For those who are investing in good high quality stocks, averaging down can be employed in ONE particular situation, when its price tanked for no good reasons. However, there is still the need to ensure that your good high quality stock's fundamentals have not deteriorated.



To summarise:

There is only one reason that justifies simple averaging or dollar cost averaging - when its price tanked for no good reasons. However, there is still the need to ensure that your good high quality stock's fundamentals have not deteriorated.

If you thought that a stock was undervalued at $34 and without the fundamentals of the company changing, the stock got unfairly beaten down.

An investor put it: "The company and its business have not changed. The only change is its share price got beaten down."

Risks of Dollar Cost Averaging

Risks of Dollar Cost Averaging
by Jim Wang Print Article Email Article Share on Facebook

This is more like a mini-Devil’s Advocate post because of the nature of the idea of dollar cost averaging. Dollar cost averaging isn’t a strategy that is meant to guarantee with any sort of high probability that you’ll generate profits from the stock market, it’s meant as a risk mitigation strategy to help weather the volatility of the stock market. That being said, some people believe that by using dollar cost averaging you can get better returns, which is incorrect and that’s the idea I’ll be tackling today.

The idea behind dollar cost averaging is that you buy smaller lots of a stock until you build up the amount that you truly want, getting a nice average purchase price that isn’t at either the peak or the valley of your period. The stock market is volatile on a daily basis but increasing in the long run so by spreading out your buys you are smoothing out the curve. Proponents advise this because you won’t run the risk of buying your whole lot at a peak thus lowering your total risk involved. This is by no means a guarantee that you’ll generate profits, just that you didn’t pay the maximum price for the share in the period you were acquiring. Now the problem comes when people believe that this means DCA is a strategy for higher returns… it’s not and here’s why.

No Peaks But No Valleys Either
Just as how you didn’t buy your shares at the peak in its price, you also didn’t buy it at its lows either. If you bought one round lot (100 shares) at 10AM, one at 1PM, and one at 3PM, you probably paid three different prices for those three hundred shares and that, of course, guarantees that your average price paid is neither the peak or the valley of the stock during that period of time. If the stock was moving upwards, you paid the least in the morning and the most in the afternoon - which was more than if you bought all three hundred shares at 10AM in the first place. Now, if the stock was falling, you saved yourself the heartache as well but there is no guarantee either way.

Multiples Buys Means Multiple Commissions
Hmmm… who is recommending that you use dollar cost averaging? Could it be the folks who stand to benefit from more trades? If you make three buy orders, you generate three times the fees and commissions than if you made only one buy order! No wonder they recommend dollar cost averaging, it means more money in their pockets.

Lots of Effort
I don’t know of many brokerages, short of something like Sharebuilder where you’re paying a premium otherwise, where you can schedule purchases by time rather than by price (limit orders) and so in order to do dollar cost averaging, you’re going to have to execute those trades pretty much manually, which quit a bit of effort (at least more than making one buy).

So remember, dollar cost averaging isn’t a trading methodology that can guarantee that you earn money, it’s only a way of smoothing out your risk. Once you remember that, dollar cost averaging isn’t all that bad if you’re willing to do the legwork.

The Pitfalls of Dollar Cost Averaging

For example:

I bought 100 shares of Microsoft at $34.00 a year ago, making my investment in Microsoft $3,400 (100 shares @ 34 = $3,400).

Now, suppose today that the price of Microsoft is just $17.00 and I have $3,400 more to invest. I buy 200 additional shares, increasing my total holdings to 300 shares (200 shares @ 17 = $3,400).

Since my total investment is $6,800, my average purchase price is now only $22.67 (6800 / 300).

The Psychology of Dollar Cost Averaging

In our example, we would look at our Microsoft holdings (before dollar cost averaging), and say - this stocks needs to double its price before I can make any profit on it. However, after dollar cost averaging, the stock needs to go up just 5.67 per share before I start to make money. This is a very heartening feeling, and one I’ve done several times. However, if you are averaging just for this warm feeling, then you need to take a hard look at the opportunity costs.

Opportunity Costs of Dollar Cost Averaging

Opportunity cost is what you forgo in order to get something else (economists call it the value of the next best alternative).

For instance, if what I really wanted to do with my second $3,400 was buy Apple stock (trading at $80) instead of Microsoft, the opportunity cost of my decision is the Apple stock. Since $3,400 translates to about 42 Apple shares, the opportunity cost of 200 Microsoft shares is 42 Apple shares.

As long as both Apple and Microsoft grow at the same rate, it doesn’t make any difference to me. It is only when Apple appreciates quicker than Microsoft do I get affected. This is key because stocks that fall tremendously may not rise as much as the rest of the market. The very fact that they fell so much shows that something is wrong with them.

The Only Reason to Dollar Cost Average

There is only one reason that justifies dollar cost averaging.

If you thought that a stock was undervalued at $34 and without the fundamentals of the company changing, the stock got unfairly beaten down.


Should you Dollar Cost Average?

Next time you are tempted to buy more stock to bring the average cost down, ask yourself one thing. Am I doing this for a warm feeling or is the stock a steal at this price?

If you answer this question honestly, you will get it right much more often.



http://investing-school.com/myth/the-pitfalls-of-dollar-cost-averaging/

Dollar cost averaging: Bull versus Bear Markets

Dollar cost averaging: Bull versus Bear Markets

This examines the multiple benefits of dollar cost averaging as a long-term investment strategy.

There are two types of markets: "bull" markets and "bear" markets. Bull markets relate to those periods when the market is trending upwards.

Conversely, bear markets are flat or downward trending. In bear markets, the tendency for most investors is to stay on the sidelines and wait for signs of a market recovery before investing. This makes sense. After all, why invest in a market which is either falling or going nowhere?

The problem, however, is that it is very difficult - many say impossible - to determine when the next bull market is about to start. In fact, it is usually only after many months of excellent returns that a bear market is declared over and a bull market officially in play. As a result, most investors sit on the sidelines for too long and therefore miss out on the substantial gains made at the very start of a bull market.

So, if it is impossible to perfectly time your investment entry point, is it better to invest near the start of the bear market - or wait until after the next bull market begins?

The answer is neither.

Adopting a "dollar cost averaging" strategy during a bear market may be one way to avoid issues of market timing. This is where you invest the same amount of money on a regular basis over a number of years.

There are two performance benefits from this approach.

• Firstly, you are not putting all your money at risk should there be a large market fall early in a bear market.
• And secondly, you are assured that a portion of your money will participate in the early gains of the next bull market.

Here's how dollar cost averaging works.

http://www.zurich.com.au/zportal/cs/ContentServer?pagename=GroupSite/Page/ThreeColumn&cid=1233198359931&p=1159692288459

Lump-sum investing beats dollar cost averaging over 60% of the time

Dollar Cost Averaging versus Lump Sum Investing?

This question actually came up last year, but I didn’t research it very much. My own thoughts were that because the markets trend upwards overall, if you are investing for a long-term period you should get your money in as soon as possible. Sure, you might run into a huge drop, but you could just as easily (in fact more easily) miss a huge rise. But this is too hand-wavy, as scientists would say. I want numbers. So I found some.

Now, wouldn’t it be nice to have a comparison of DCA vs. lump-sum investing for the past 50+ years? We could compare investing $10,000 all at once in January of 19xx, versus using DCA equally over all 12 months of that year. Wouldn’t it be even nicer if we could take into account that any money not used be put in a high-yield interest bearing account?

Well MoneyChimp did just that all the way back to 1950. The result? I used 4.25% rate for bank interest, and over 60% of the time, lump-sum investing beat dollar cost averaging. This result of DCA losing out about 2/3rds of the time is supported by historical back-testing from 1926 in this article from the Financial Planning Association: ‘Lump Sum Beats Dollar-Cost Averaging‘. (Just read the conclusion if you get bored.)

Of course, past performance does not guarantee future results. And DCA would smooth things out if your time frame is really short. I think everyone should consider the facts above and make their own decision. But I bet with the odds, and the odds are that I should invest it as a lump-sum.

Why You Should Calculate Your Net Worth

Why You Should Calculate Your Net Worth

March 13, 2007 @ 12:00 pm - Written by Trent
Categories: Getting Started
Bookmarks: del.icio.us, reddit

In today’s review of the first eight chapters of The Bogleheads’ Guide to Investing, I mention the importance of calculating your own net worth, and in the past I’ve mentioned how to calculate it.

But why is knowing your net worth important? What value does it have? Here are five reasons why you should calculate your net worth.

It provides a rule-of-thumb indicator of your overall financial health. This one number indicates your financial standing at the moment, for better or worse. How you interpret it is up to you.

It puts you in touch with all of your accounts. It’s a great way to regularly nudge yourself to check up on various investments you have and so forth.

Comparing your net worth to earlier net worth calculations lets you track your progress in a very concrete fashion. If you calculate your net worth every month, it can become a clear tracking of the state of your personal finances.

It’s a motivator. For me, it’s my primary motivator. Every single month, I work to make my net worth go up. This means keeping an eye on my spending, working to pay off my debts, and saving up over time for bigger purchases.

It’s easy. Once you’ve gathered up the basic information, you can calculate it in just a few minutes. Add up your assets, add up your debts, and subtract your debts from your assets. Done!

Now that you’re convinced that calculating your net worth is the greatest thing since sliced bread, it’s worth noting that your net worth value does have some drawbacks.

It’s very difficult to meaningfully compare it to someone else. There are so many variables in human life that comparing your net worth to someone else has very little value at all. How does your net worth compare to a child in Bulgaria, for example?

The raw number itself isn’t really all that meaningful - what matters is the change from period to period. Remember this if you are disappointed with your number, and work first on getting that percent change to a good place. If you do that, then you’ll be doing quite well.

Take some time today and calculate your net worth, then do it again in a month and see how it’s changed. You’ll probably be surprised - and you’ll also probably find yourself doing it each month because it’s a really interesting way to track your own progress.

http://www.thesimpledollar.com/2007/03/13/why-you-should-calculate-your-net-worth/

The Simple Dollar Website

The Simple Dollar

Very good website. An excellent resource. Well worth visiting for the many fantastic articles.
http://www.thesimpledollar.com/


I have listed the links to some below:
If You Buy When The Market Is Down, When Do You Sell?
The Intelligent Investor: The Investor and Market Fluctuations
Should You Follow An Investment Strategy If It Makes You Uncomfortable? I Say Never
The Stock Market Is Way Down This Year… Here’s Another Way To Think About It
(A down market isn’t a time to sell. It’s a time to buy. Look at it this way, though. You’re already stuck with this loss - there’s no way of getting out of it. On the other hand, you’re currently holding an investment that’s at a discounted value. If you’re investing for the long term - and if you’re in stocks, this really should be a long term investment - then you need to hold onto that stock, not sell. By selling it now, you’re basically asking someone else to come in and take that discounted investment from you at a nice bargain price. In the end, keep one thing in mind: stocks are a long term investment and if you sell based on what the price is doing today, this week, this month, or even this year, you’re asking for a smarter and more patient investor to take your money. Don’t sell any investment unless you have a reason for selling it, a reason not based on that day’s price.)
Basic Investing In A Down Market (Or Any Time You Feel Nervous)
The One Hour Project: Thoroughly Research A Stock
Mutual Funds Versus Individual Stock Picking: Which Is Right For You?
Two Commenters Disagree: Why Risk Is Interesting
Personal risk vs. Investment risk. What’s the point? Risk comes in a lot of different forms, and different forms of that risk monster scare different people. Any financial move you make has several aspects of risk to it. The key is to find the moves that have the least risk for you, and I think for Tristan and John, those moves in terms of a mortgage would be very different.
What To Do If You Disagree With The Simple Dollar - Or Any Other Financial Guru
Do your own research. I do some posts on basic personal finance analysis and link to other tools here and there - those are so you can look at a piece of advice yourself if you want to and decide whether it’s right and you agree with it. If you don’t understand how something works, ask - if you don’t think a number comes out right in an article, try to figure it yourself. You’ll do nothing but improve your own understanding.
Recognize that no one is absolutely right. Absolute correctness doesn’t exist in this world. If you find yourself completely disavowing someone because you disagree on a point or two with that person, you’re going to have a hard time finding someone who you can talk to, listen to, and exchange ideas with. Accept that no one is absolutely right - including yourself - and be open to new ideas.
Personal Finance Boils Down To Just Two Things…
The Bogleheads’ Guide to Investing: Chapters 1 - 8
Why You Should Calculate Your Net Worth
Nine Reasons I Keep Reading Personal Finance Books

Should I Invest Immediately After a Small Dip in the Stock Market?

Should I Invest Immediately After a Small Dip in the Stock Market?

November 7, 2007 @ 3:00 pm -
Written by Trent
Categories: Investing, S&P 500, Stocks
Bookmarks: del.icio.us, reddit

This week, The Simple Dollar attempts to address challenging questions in personal finance by looking at both sides of the story and figuring out some of the factors you need to look at to make a decision.

Several times this year, the stock market has dipped more than 1% in a single day. If you read the advice of some writers, like in this article by Ben Stein, there is some strong encouragement out there that a dip in the stock market like that means it’s time to buy a broad-based index fund. On the other hand, if you follow the advice of other columns, like this one by Ben Stein, you’ll hear that market timing is bad.

Which is right and which is wrong? There’s not a really easy answer to this one, so let’s look at both sides.

Market’s Down? Buy!

If you look at the long term history of the stock market, stocks go up in value. There has never been a thirty year period where stocks are down, and over the entire twentieth century, the broad stock market increased in value 20,000%. Because of that, it’s reasonably safe to assume that stocks are a lucrative long-term investment.

Now, on any given day, if the stock market drops in value, you can effectively buy in at a cheaper price than the day before. Let’s say you could buy an index fund for $1,000 that included a bit of every stock on the New York Stock Exchange. Then, in one day, the market drops 4%. You can now buy that same share for $960 - it’s effectively a sale!

In other words, buying a low-cost index fund when the stock market drops is the equivalent of buying it on sale. Any time you can buy a solid long-term investment on sale - and it’s all legit - is a deal you shouldn’t pass up.

Ignore Timing and Stick With a Real Strategy

In a mathematically perfect world, the above scenario would be just fine. If the long term trend is up but the very short term trend is down, and you knew that for a fact, you really could clean up on the stock market. Unfortunately, it’s not all perfect like that.

For example, down days on the stock market have different meanings. A day where nothing much happens can be a slight down day, but devastating financial news can be a monster down day. There are all sorts of varieties of individual days on the stock market, and they may or may not be part of larger trends.

Since 1950, using the S&P 500 as an indicator, any random day has a 53.8% chance of being a positive day. There’s also a 54.1% chance that a down day will be followed by another down day and an up day will be followed by another up day. In other words, if you buy on a down day, the odds are better than half that the next day will also be a down day, which means you bought at an elevated price.

The market is effectively random on a day-to-day basis, so playing games like timing the market by buying when the market is down tend to offer not much reward (and often some loss) in exchange for the effort of playing the game. An intelligent investor will simply follow a “buy and hold” strategy or a dollar cost averaging strategy (by buying in at regular intervals, regardless of the market) and sitting back and ignoring the day-to-day changes in the stock market.

My Take

If time were not a factor, it might be a worthwhile endeavor to try the “buy when the market is down” approach over a long period of time. Due to the randomness of the day to day stock market, you wouldn’t gain a whole lot, but you might be able to eke out a small positive return, on the order of a fraction of a percent, over a long period of time (with possible bigger gains or a small loss over the shorter term).

However, the time investment to follow this strategy day in and day out would make it not worth one’s time, unless one did it on a fully automated basis.

To me, market timing makes the relatively volatile investment that is stocks even more volatile and thus not worth the time. I see no problem if you’re about to buy in and jump on board immediately after a down day, but to invest with such timing as a regular strategy probably won’t afford you much serious gain. There is perhaps a tiny gain to be made here, but not a significant one in terms of the time invested. (My comment: Agree totally. That's why I hardly ever queue when I sell or buy a stock.)

http://www.thesimpledollar.com/2007/11/07/should-i-invest-immediately-after-a-small-dip-in-the-stock-market/

Active, Passive, and Portfolio Frugality: Where Should One Start?

Active, Passive, and Portfolio Frugality: Where Should One Start?

March 10, 2009 @ 2:00 pm - Written by Trent
Categories: Frugality, Getting Started
Bookmarks: del.icio.us, reddit


One of the most common ideas expressed in personal finance books is distinguishing between three different kinds of income:

Active income is earned through your active effort - in other words, the money you make from your job. Your paycheck is active income. Income from any side businesses you have is active income. Incidental earnings, like finding money on the street, is active income, too, since you actually had to contribute effort to receive it at all.

Passive income is income that you receive without continual active effort. Income from a rental property is passive income. Book royalties are passive income. A website you set up once, put ads on, and walked away from is passive income.

Portfolio income is income that you receive from your financial investments. Interest from your savings account is portfolio income, as are dividends from your stock holdings or income from selling an investment.

What intrigues me about this division of incomes is that it lines up well with different types of frugality.

First of all, there’s active frugality. Active frugality results from continuous effort and continuous choices to save money. Using a shopping list at the grocery store is active frugality - you have to make up a shopping list each time, but you’re rewarded with the money you save on the shopping trip.

On the other hand, passive frugality is the result of simply not doing something. Choosing to continue to use a crock pot with a broken lid handle is an example of passive frugality. Wearing well-worn socks is another example. Driving your car until it completely breaks down is yet another example. Simply put, you can save a lot of money by simply using things until they’re completely used up.

A third type of frugality is what I’d call portfolio frugality. Portfolio frugality happens when you make an initial investment of time or money into something that will pay dividends slowly over a long time. Installing energy efficient lighting in your home is a form of portfolio frugality. Putting in a programmable thermostat is portfolio frugality. Putting a black cover over the windows in an unused room is portfolio frugality.

From where I sit, most of the negative reputation that frugality gets comes from active frugality (”it seems like a lot of work to save a little money”) and excessive passive frugality (”what kind of cheapskate has holes in their socks?”). Those forms of frugality tend to run more against the grain of mainstream society and meet more resistance from others.

Thus, if you’re getting started on frugality, I recommend trying out portfolio frugality and a few basic pieces of passive frugality. Do things like swapping your light bulbs out, installing a programmable thermostat, and waiting another year or two to upgrade your computer or cell phone.

As you get more and more used to the pleasures of saving money, you can continue to push things until you find your comfort level. Try out higher levels of passive frugality (can’t you get a few more miles out of those socks?) and dabble in active frugality, too (why not make a grocery list before you go? How about cutting out those stops at the fast food restaurant?). Eventually, you’ll find your own comfort level, where you see yourself saving plenty of money but not behaving in a way that makes you feel “cheap.”

Personally, I really enjoy seeking out “portfolio frugality” options. I love doing things up front that continually save me money over the long haul without my active intervention or without any real change in my quality of life.

http://www.thesimpledollar.com/2009/03/10/active-passive-and-portfolio-frugality-where-should-one-start/

How to Manage a Windfall Successfully

Chapter 15 - How to Manage a Windfall Successfully

I didn’t expect it, but one of my favorite pieces of advice appeared in this book: if you get a huge windfall, put it in a short term investment for six months and just think about it and plan carefully what you’re going to do with it.

This is also a situation where you really should have a professional help you, as you’ve just jumped into a completely different investment category and lots of things are available to you.

http://www.thesimpledollar.com/2007/03/14/the-bogleheads-guide-to-investing-chapters-9-16/


Related Posts
The Bogleheads’ Guide to Investing: Overview
The Bogleheads’ Guide to Investing: Chapters 17 - 23
The Bogleheads’ Guide to Investing: Chapters 9 - 16


The Bogleheads’ Guide to Investing is a very detailed “starter manual” for conservative investors. The principles in this book are very fundamentally sound, but are not going to be the foundation for any “get rich quick” scheme.

Before you decide whether or not this is a good book for you, you need to ask yourself what your general investment goals really are.

If your goal is to have a shot at getting rich quickly with a lot of risk mixed in, I don’t recommend this book. You’re better off reading something like Jim Cramer’s Real Money, which is an excellent book for people who are willing to take on some significant risk and dabble in individual stock investment (and even that is fairly moderate risk compared to some investments).

On the other hand, if you’re planning on investing for the purpose of building a stable, lifelong economic backbone, I couldn’t recommend this book more highly. It’s a well-conceived explanation, from top to bottom, of an investment philosophy that will create a life full of steady gains and sustainable wealth.

http://www.thesimpledollar.com/2007/03/16/the-bogleheads-guide-to-investing-buy-or-dont-buy/

Dollar Cost Averaging for better or for worse

Dollar Cost Averaging and Market trend

Here’s the question: is this a good thing? Lots of financial advisors think that dollar cost averaging is the cat’s banana, but I’m not entirely convinced.

Uptrending market: Let’s look at a year in which the value of a stock starts at 100, goes up 10 a month until June (the peak), then stays steady for the rest of the year. You paid $134.94 per share with dollar cost averaging. If you instead bought in at the start of the year with your complete investment, then you paid only $100 per share.

Downtrending market: On the other hand, let’s look at the reverse market: the stock starts at 100, goes down 10 a month until June, then stays steady the rest of the year. If you invested it all right off the bat, you spent $100 a share for stocks now worth $50, but if you used dollar cost averaging on a monthly basis, you only paid an average of $58.66 per share.

Dollar cost averaging is good if you think there’s a good chance that the market will see turbulence or go down. It will reduce the impact of the collapse on your investing. On the other hand, dollar cost averaging doesn’t do so well if the market is going crazy.

Here is how one investor views dollar cost averaging: "Since I think the market is going to be turbulent, but not go up or down a whole lot overall in the year 20xx, I think that dollar cost averaging is fine for me in the short term."

http://www.thesimpledollar.com/2006/12/30/how-im-using-dollar-cost-averaging-for-better-or-for-worse/

Dollar Cost Averaging Stock Strategy

Stock Strategies
Dollar Cost Averaging Stock Strategy
by InvestorGuide Staff


Investors have three major concerns when buying stocks:

• making a profit on their investment,
• minimizing risk, and
• the actual rate of return they will receive (including any dividend income).

Ideally, there would be windfall profits in record time with no risk.

In the real world, investors must use stock strategies that match both their resources and skill level. The dollar cost averaging stock strategy is a great approach for people new to stock investing that minimizes risk and trends towards sound profitability - especially the longer it is used.

Basics of Dollar Cost Averaging

The dollar cost averaging stock strategy minimizes risk because it reduces the difference between the initial investment and the current market value over a long enough timeline. This is accomplished by making fixed investment amounts at predetermined times. Now this investment could be in a specific stock or perhaps even an index fund. The point is to remain committed to this investment for years and not to allow fluctuations in price to affect your buying strategy.

Knee jerk responses are common with stock investments, especially for beginners. One bad earnings report can send stock prices tumbling and cause investors to panic. This causes a sell-off that further lowers prices. But; if a person were to keep their stock and still continue buying at regular intervals, the average price of the stock should continually approach the current market value at the time of purchase at each interval. Temporary fluctuations in pricing should even out. While the stock price may be lower than the initial investment value, the ability to acquire more shares at a lower price means that the short-term decrease in average stock price should be balanced out when the share price increases. However, never confuse dollar price averaging with simple averaging.

For instance, let's say an investor purchased 1,000 shares of Microsoft stock at $40 per share at the first interval and another 1,000 shares of stock at the next for $25 a share. That would make the total investment $65,000 and the average stock price $32.50. However, this is not dollar cost averaging - it is simple averaging.

The average cost of the stock will not trend towards the current market value if you do not remain consistent in your investment strategy. Using dollar cost averaging, a person would invest a fixed amount - say $33,000 per interval. Thus, when buying the same Microsoft stock at the first interval, a person would end up with 825 shares of stock at $40/share and 1320 shares at $25 each. This adds up to 2,145 shares and an average cost of $30.75 - closer to the current market value of $25 than the simple averaging strategy.

From the example above, the one drawback to the dollar cost averaging strategy is revealed:

• while it reduces risk and lowers the difference between the average stock price and the current market value, it will not eliminate the possibility of a loss if the average price does not move fast enough.
• In fact, if an investor were to pick a stock that was on its way down and continued investing in regular intervals as advised by the dollar cost averaging strategy, the losses could add up rapidly.

While the investor may be buying more shares at each interval due to lower prices, having more shares of continually declining stock simply adds insult to injury. For this reason, an investor must have a cutoff point at which he/she ceases purchasing the stock at regular intervals. Fluctuations in market price can be absorbed and an investor can still make a healthy profit using the dollar cost averaging stock strategy but a declining stock is just a loser. Unfortunately, the dollar cost averaging strategy is most profitable on stocks that were underperforming at the time the investment plan was initiated. Therefore, the best stocks to make the most profits on are also the ones that are more likely to recover and continue trending upwards in share price. Prudent research is necessary before initiating any dollar averaging stock strategy.

Implementing a Dollar Cost Averaging Strategy

The very first step in planning to use this strategy is determining how much you can realistically afford to invest over an extended period of time. This is very important because the strategy will not reduce risk of loss effectively unless the investment amount is consistent. You will not insulate yourself against losses as effectively when a large initial investment is made and then followed by increasingly smaller amounts. In such a scenario, the gap between the average stock price and current market value will be larger and the risk for loss greater.

The next step in this or any other stock strategy should be to choose your investment carefully. Remember, you need to stay with this investment for many years for the strategy to be effective. An investor will get killed if they purchase an underperforming stock that does not recover. For this reason, combining the benefits of dollar cost averaging strategy with the diversification and reduced risk of an index fund is a prudent approach when choosing an investment.

An index fund is like a mutual fund in that it is designed to mimic the returns of prominent benchmarks such as the Dow Jones Industrial Average or the S&P 500. Investors own a fraction of each stock that makes up the index. The principle difference and benefit to investors in an index fund is that their management fees are a fraction of those charged for actively managed mutual funds. This is because index funds are passively managed. By combining the dollar cost averaging strategy with the increased diversification and reduced management/transaction fees of an index fund, an investor can maximize the profit potential and minimize risk.

Finally, pick an interval that you can be consistent with for years into the future. A weekly interval will work but it is probably best to make it monthly or even quarterly. Longer intervals are better because they reduce the expense of multiple transaction fees and also allow you to buy larger numbers of stock with each purchase.

Dollar cost averaging

Dollar cost averaging

From Wikipedia, the free encyclopedia


Dollar cost averaging is a timing strategy of investing equal dollar amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio.

• By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high.
• The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.

In dollar cost averaging, the investor decides on three parameters:

• the fixed amount of money invested each time, and
• investment frequency, and
• the time horizon over which all of the investments are made.

With a shorter time horizon, the strategy behaves more like lump sum investing.

One study has found that the best time horizons when investing in the stock market in terms of balancing return and risk have been 6 or 12 months.


Criticism of DCA Risk Reduction Theory

Pro: While some financial advisors such as Suze Orman claim that DCA reduces exposure to certain forms of Financial risk associated with making a single large purchase.
Con: Others such as Timothy Middleton claim DCA is nothing more than a marketing gimmick and not a sound investment strategy.

Pro: Others supporting the strategy suggest the aim of DCA is to invest a set amount; the same amount you would have had you invested a lump sum.
Con: Middleton claims that DCA is a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once.

Studies of real market performance, models, and theoretical analysis of the strategy have shown that:

• DCA is associated with lower overall returns, and,
• DCA does not even meaningfully reduce risk when compared to other strategies, even including a completely random investment strategy.

(Buffett does not believe in dollar cost averaging. Why buy stocks when the prices are high? Buy when the stocks are offered at a bargain.. and always!)

Post-mortem on your actions during the 2007 - 2009 severe bear market

What were you doing during the 2007-2009 severe bear market?

Let us look at the many possible actions one may have taken.

Sold totally at the beginning of the bear market.

Sold partially at the beginning of the bear market.

Sold totally at the middle of the bear market.

Sold partially at the middle of the bear market.

Sold totally during the Lehman crash in Oct. 2008

Sold partially during the Lehman crash in Oct. 2008

Sold totally after the Lehman crash.

Sold partially after the Lehman crash.

Bought more at beginning of the bear market.

Bought more in the middle of the bear market.

Bought more during the Lehman crash.

Bought more after the Lehman crash.

Kept you existing portfolio and ignored the market.

Went for a long vacation (2 years!).

Stop monitoring your stock prices.

Continuously monitoring your stock prices.

Stop monitoring the fundamentals of your stocks.

Continuously monitoring the news for fundamentals of your stocks.

Continuously relating the falling price to the returns of your stock (Wow, so cheap and getting cheaper).

Rebalancing your stock at regular intervals.

Continuously following Bloomberg and CNBC for developing news.

Ignoring Bloomberg and CNBC.

Following the gurus' opinions in investing: Marc Faber, Nouriemi, Soros, Buffett, Teng Boo, etc.

Ignoring the gurus.

Following the various blogs: "Ze Moola", "Fusion", "Samgoss", "Same gang" etc.

Ignoring the various blogs.

How were you emotionally?

• Were you fearful when the prices tumbled?


• Were you indifferent when the prices tumbled?


• Were you happy when the prices tumbled?

What were your thoughts driving the above emotions?

• Were these thoughts based on objective facts?


• Were these thoughts emotionally driven?

Etc., etc.


There are many more specific actions you may recall. Anyway, which of these are most productive and which of these are totally non-productive and perhaps even destructive?

The recent 2007 - 2009 severe bear market offered a wonderful opportunity for you to review your actions during that period and reappraise your investing philosophy and strategy. Lessons learned will be of benefit for a lifetime. Well worth doing a post-mortem on what you did the last 2 years in your investing.

Cheers.

How can you improve your investment returns in stocks?

The adage, "Buy low and Sell high" and pocket the profit, is well known. I like to also remember it this way: "Never buy high and Never sell low".

The subsequent discussion applies to investing in high quality good stocks bought at a bargain only.

How can the average investor improves his investment returns in stocks? More specifically how can an average investor improves his return to 10% annually? Even better, to above 15% annually and consistently? Let us examine some factors affecting investment returns.


1. Stock selection

This is important. You wish to have a stock that gives you a good total sustainable return over many years. You will need to invest in those stocks with a high ROE of at least 15% or more. Also, these stocks should have good earnings growth (EPS growth) that is consistent and sustainable. Such companies run businesses with a huge competitive advantage over their competitors with a large moat.


2. Buy when the selected stock is selling at a low price.

This is the better way to get superior return - the potential return is higher with concomitant lower risk. Invest in "value stocks". A good portfolio should always have cash available to benefit from a bear market or a correction or panic sell in a bull market/or a specific stock.

Here is a recent illustration from icap. to emphasize this point:

"This pleasant result is due to the “Intelligently Eclectic” value investing style that Capital Dynamics has adopted for the last 21 years. What does it mean in practical terms ? A stock that the i Capital Global Fund invested in plunged around 85% during the 2007-2009 bear market. However, instead of selling as it dropped, we bought so much more of this stock that the cost price plunged around 80% too. By now, the i Capital Global Fund is sitting on a gain of 175% on this particular stock. The reason why ICGF bought so much more was because if it was attractive at higher prices, it is even more attractive at depressed prices since the business fundamentals of the company have not changed. "


3. Taking profit

Profit should be realised from sales of stocks in the following situations:
(I) when the stock is obviously overpriced, or
(II) when the sale of the stock frees the capital to be reinvested into another stock with potentially better return.

Not taking profit in the above situations can harm your portfolio and compromise its returns. In other circumstances, let the winners run.

Underperforming stocks should also be sold early. Hanging onto underperforming stocks is costly too. There is the opportunity cost that the capital can be better employed for higher return. Also, hanging onto these lack-lustre stocks reduces the overall return of your portfolio.


4. Reducing serious loss

When the fundamentals of a stock have deteriorated, sell to protect your portfolio. This decision should be make quickly based on the facts and situations, in order to keep your losses small.


5. Diversify, but not overdoing it

According to Buffett, adding the 7th stock to the portfolio reduces the return without reducing the overall non-systemic risk. of the portfolio. Select the best 6 stocks. If you need to add money to your portfolio, buy more of these preexisting stocks when they are offered at a good or bargain price. If you identify a better stock to invest, perhaps, this should replace one of the preexisting stocks in the portfolio.


6. Asset allocate according to your risk taking ability

It is perplexing to know of investors whose days are affected by the swings in the market. You should not bet your total networth into the stock market. Allocate the amount that you are willing to risk.

Many long-term investors are always riding on a significant amount of gains. This means that they will only lose their capital in very unlikely extreme situations.

Here is an example to illustrate this point.

"After investing more than £2 bln in Barclays Plc, two years ago, Temasek, the well-known investment arm of Singapore, recently sold its stake in the British bank at a big loss."

Sometimes you made a serious mistake, or events turned against you, and there is no way to redeem this without taking a big loss. The only protection here is you have allocated your allocate asset appropriately such that this "black swan" phenomenon won't harm you irreparably. Hopefully this will not 'stopped out' in your investing.


7. So far so good. The hardest part: getting wired like Buffett and Teng Boo!

To invest like what Teng Boo did in ICGF, you need to be knowledgeable and able to execute 'coldly' (or cooly) without being affected by emotions. These are among the harder skills to master. Have you wondered what drives this blogger to write on investing? Through writing, rather than lurking, you can focus on the facts and solidify your knowledge, philosophy and strategy.

Admittedly, there is no single philosophy or strategy; but you should have one to guide your investing. It prevents you from over-reacting to emotions and circumstances, that may harm your portfolio and investing returns. As this discussion assumes the portfolio contains only good quality stocks, it prevents you from "Buying high and Selling low" due to falling prices in the market. It may allow you to benefit hugely from the volatilities and follies of the market; making volality your friend.

Understanding and mastering this field of behavioural finance is yet another challenge to higher investment returns for me.

Review of potential past KLSE market returns

In 1997, this KLCI touched the low of 300 points briefly. Today, the KLCI is about 1,100. From 1997 to 2009, the KLCI has compounded at 11.4% per year over the 12 year period. To achieve this 11.4% return. The KLCI was a low of 850 at end of 2008; giving a CAGR of 9.93% over the last 12 years. To achieve these returns, you would have to have invested a lump sum at the trough of the market in 1997.


What of the performance of the average investors?

This is the average guy. He is the guy who invests regularly whenever his savings allow him. He is not among those who achieved the 11.4% compound annual return.

Let us make this assumption to facilitate some calculations. His dollar cost averaging over 12 years approximates to a lump sum investment in the market from KLCI 700 to KLCI 1100 over 6 years. His gain is the equivalent of compounding annually at 7.82% over 12 years. When the market was at its low at end of 2008 (KLCI of 850), his CAGR over 12 years was 3.29%. (KLCI 700 is chosen as it is the average of the trough KLCI of 300 in 1997 and present KLCI of 1100.)

How can this average investor improves on his investment returns? More specifically how can he improves this return to 10% annually? Or, to above 15% annually and consistently?


---


Return Rate (Discount Rate / CAGR) Calculator
http://www.moneychimp.com/calculator/discount_rate_calculator.htm


Total return from a stock
= (Capital appreciation + Dividend + Profit from Sale of Stock)/Amount Invested
= (Capital appreciation + Dividend + Profit from Sale of Stock)/(Value of Stock + Cash)


Total return from a portfolio
= (Capital appreciation + Dividend + Profit from Sale of Stocks)/Amount Invested
= (Capital appreciation + Dividend + Profit from Sale of Stocks)/(Total Value of Portfolio + Cash)

Lessons from the recent severe bear market

Reviewing my investing of the last 1 year.

What I did right.

1. Investing in good quality stocks. These stocks were down in the bear market, but the majority have rebounded, some higher than before.

2. Investing when the price is low. Using PE, average PE and the PE range as a guide, and buying when the PE is at a discount to the average PE.

3. Keeping my investments to those businesses that I can understand, that is within my circle of competence.

4. Buying when the market is low.

5. Buying when a particular stock is sold down for various reasons other than to deteriorating fundamentals.

6. Not buying lousy companies. (Best avoided, short term gain, long term pain)

7. Not buying good quality stocks that are trading at high prices.

8. Selling certain stocks in certain sectors where the business will be challenging in a recession.

9. Selling certain stocks in certain sectors that were fairly or highly priced to reduce the amount of money at risk in the portfolio when the downturn was clearly established.

10. By not selling stocks that were priced at below 'fair value' during the severe downturn, despite the continuing falling price.

11. Not timing the market. Holding onto good quality stocks bought at bargain for the long-term in my portfolio even during the severe downturn. The biggest return has already occurred in the recent upturn of stock prices.

12. By averaging up or down in my purchases of good quality stocks. Both these actions are safe. By always buying more shares in the stocks at lower prices, and buying less shares when the stocks were at higher prices.

13. By investing big in a good quality stock that I am confident of its value when it was offered at a bargain.

14. By always buying at a bargain, or at a fair price. Never, never, never and never at high price.

15. Believing in myself and my valuation.

16. Ignoring the noises in the market.

17. Having a sum of cash for investing opportunities.




What I did wrong.

1. Looking at the price of a stock, rather than the business and the financial statements of the stocks.

2. Reacting emotionally to falling prices. (Not easy, but can be overcomed if I focus on the fundamentals of the company).

3. Not selling some stocks early in the downturn. (But then this would be market timing which I feel is an impossible strategy for one to profit from consistently.)

4. Selling some good quality stocks when the major fall in prices had occurred. (This action has the effect of reducing the amount of money in the portfolio at risk in a down market, but then also harmed the return of the portfolio in a up market. Most gains in a portfolio are derived by buying or holding stocks in a down market before the change in trend than by selling stocks in a high market before the change in trend. Moreover, the prices of these good quality stocks had since rebounded. It would have been better to hold or add.)

5. Not buying more stocks in March. (To do so, I will need to focus less on the prices of the shares and more on the fundamentals of the business.)




What I hope to do the next 12 months

1. Do the same

2. Reinvest the dividends, just as before.

3. Allocate more capital on a regular basis to increase the portfolio, just as before.

4. Continue to rebalance the portfolio at regular intervals, just as before.

5. Continue to maintain a focussed portfolio with little diversification. Eight (8) stocks in this portfolio will account for 80% of the total value of the portfolio, just as before.

6. Continue to invest a meaningful sum with Tan Teng Boo's managed funds, just as before.

7. Always keep enough cash for opportunistic investing when the occasions arise, just as before.

8. ...

Investment Strategy and Superior Returns

"Style investing," where money managers rotate between small and large, and value and growth stocks, is all rage on Wall Street.

Historical data seem to imply that:

• small stocks outperform large stocks and
• value stocks outperform growth stocks

Yet the historical returns on these investment styles may not represent their future returns at all.

• The superior performance of small stocks over large stocks depends crucially on whether the 1975-1983 period is included.
• Furthermore, the superior performance of value stocks over growth stocks may not be inherent to the industry they are in but merely reflect fluctuations in investor enthusiasm about certain sectors.

All these implies that the average investor will do best by diversifying into all stock sectors.

• Trying to catch styles as they move in and out of favor not only is difficult but also is quite risky and costly.
• Hot sectors or investment styles can lull investors into a trap.
• When a sector reaches an extreme valuation level, such as the technology issues did at the end of the technology bull market, reducing its allocation will improve your returns.

An investor can use the lessons of history to avoid getting caught in the next technology, stock or market bubble.

Also read:

Bubbles: Does history guide us?
Bubble lessons never go out of style

IPOs and Superior Returns

IPOs always have fascinated investors. New companies are launched with enthusiasm and hope that they can turn into the next Microsoft or Intel.

Historically,

• The large demand for IPOs means that most IPOs will "pop" in price after they are released into the secondary market, offering investors who bought the stock at the offering price immediate gains.
• For this reason, many investors seek to obtain as many shares in IPOs as possible, so underwriting firms ration the shares to brokerage firms and instituional investors.

A study by Forbes magazine of the long-term returns on IPOs from 1990 to 2000 showed that investing in IPOs at their OFFERING price beat the S&P 500 Index by 4% per year.

However, many investors forget that most IPOs utterly fail to live up to their promise after they are issued. A study by Tim Loughran and Jay Ritter followed every operating company (almost 5000) that went public between 1970 and 1990.

• Those who bought at the market price on the first day of trading and held the stock for 5 years reaped an average annual return of 11%.
• Those who invested in companies of the same size on the same days that the IPOs were purchased gave investors a 14% annual return.
• And these data do not include the IPO price collapse in 2001.

High Dividend Yields and Superior Returns

Another favourite value-based criterion for choosing stocks is dividend yields.

More recent studies by James O'Shaughnessy have shown that from the period 1951-1996, the 50 highest dividend-yielding stocks had a 1.5% higher annual return among large capitalization stocks.

In another study, a strategy based on the highest yielding stocks in the DJIA outperformed the market.

The correlation between the dividend yield and return can be explained in part by taxes. Stocks with higher dividend yields must offer higher before-tax returns to compensate shareholders for the tax differences.

It should also be noted that most current studies, like O'Shaughnessy's, exclude utility stocks, which as a group have by far the highest dividend yield but have vastly underperformed the market over the past decade.

(Another point to note: for a stock that is paying fixed dividend, the high dividend yield reflects a lower price of the stock and a low dividend yield reflects a higher price of the stock. Therefore, dividend yield fluctuates along a range. Dividend yield can be usefully employed as another tool for valuing the stock.)

Value Stocks and Superior Returns

Stocks that exhibit low P/B and low PE ratios are often called value stocks.

Those with high PE and P/B ratios are called growth stocks.

Prior to the 1980s, value stocks often were called cyclic stocks because low PE stocks often were found in industries whose profits were tied closely to the business cycle. With the growth of style investing, equity managers who specialised in these stocks were uncomfortable with the cyclic moniker and greatly preferred the term value.

• Value stocks are concentrated in oil, motor, finance and most utilities.
  
• Growth stocks are concentrated in the high-technology industries such as drugs, telecommunications, and computers.
  
• Of the 10 largest U.S. based corporations at the end of 2001, 7 can be regarded as growth stocks (GE, Microsoft, Pfizer, Wal-Mart, Intel, IBM, and Johnson & Johnson), whereas only 2 (Exxon Mobil and Citigroup) are value stocks; AIG can go either way depending on the criteria used for selection.

A study summarising the compound annual returns on stocks from 1963 through 2000 ranked on the basis of both capitalization and book-to-market ratios appear to confirm Graham and Dodd's emphasis on value-based investing.

• Historical returns on value stocks have surpassed those of growth stocks, and this outperformance is especially true among smaller stocks.
• The smallest value stocks returned 23.26% per year, the highest of any of the 25 categories analysed, whereas the smallest growth stocks returned only 6.41%, the lowest of any category.
• As firms become larger, the difference between the returns on value and growth stocks becomes much smaller.
• The largest value stocks returned 13.59% per year, whereas the largest growth stocks returned about 10.28%.

One theory about why growth stocks have underperformed value stocks is behavioural: Investors get overexcited about the growth prospects of firms with rapidly rising earnings and bid them up excessively. "Story book stocks" such as Intel or Microsoft, which in the past provided fantastic returns, capture the fancy of investors, whereas firms providing solid earnings with unexciting growth rates are neglected.

Another more economically based reason is that value stocks have higher dividends, and dividends are taxed at a higher rate than capital gains. As a result, value stocks must have higher returns to compensate for their higher taxability. However, tax factors cannot explain the wide spreads between small value and growth stocks.

The differences in the return between large growth and large value stocks appears to wax and wane over long cycles.

• Growth stocks gained in the late 1960s and peaked in December 1972, when the "nifty fifty" hit their highs.
• When investors dumped the nifty fifty, growth stocks went into a long bear market relative to value stocks. One of the reasons for this was the surge in oil stocks, which are classified as value stocks, when OPEC caused petroleum prices to soar.
• From 1982 onward, growth stocks gained relative to value stocks, soaring in the technology boom of 1990-2000, only to fall again when the euphoria subsided.
• In fact, large growth stocks have outperformed large value stocks in about half the years since 1963.

BARRA, Inc., a California-based stock research firm, has divided the firms in the S&P 500 Stock Index into two groups of growth and value stocks with equal value on the basis of the firm's market-to-book ratio. Using the ratio of the cumulative return on these two large capitalization growth and value indexes since Dec 31, 1974, when the indexes were first formulated:

• On the basis of capital appreciation alone, growth stocks, with a 11.06% annual return, beat value stocks by 0.31% over this 37-year period.
• However, these value stocks have dividend yields that are about 2 % above that of growth stocks. When dividend yields are included to find total cumulative returns, value stocks' return of 15.6% per year outperformed growth stocks by about 1.9%.
• However, for taxable investors, the difference between the cumulative returns on S&P growth and value stocks has been very slight over the past 27 years, a difference of only 0.69%.

Furthermore, the unprecedented volatility of growth stocks relative to value stocks in recent years has played havoc with historical data.

• For someone who began investing in 1975, the technology bubble of the late 1990s sent after-tax growth returns higher than after-tax value returns from September 1999 through September 2000.
• Once the bubble popped, however, growth stock returns fell back below those of value stocks very quickly.

It should be noted that beginning the growth and value series in 1975 is very favourable for value stocks.

• Large value stocks crushed large growth stocks from 1975 through 1977, when soaring oil prices sent the price of oil and resource firms (which are always ranked as value stocks) skyrocketing.
• Since August 1982, when the great bull market began, cumulative returns for growth and value investors have been almost identiacal, even after the growth stock collapse of 2000-2001.

Also read:

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.

Price-to-book ratios and Superior Returns

PE ratios are not the only value-based criterion for buying stocks. A number of academic papers, begining with Dennis Stattman's in 1980 and culminating in the paper by Eugene Fama and Ken French in 1992, have suggested that price-to-book P/B ratios may be even more significant than PE ratios in predicting future cross-sectional stock returns.

Like PE ratios, Graham and Dodd considered book value to be an important factor in determining returns. More than 60 years ago, they wrote:

We suggest rather forcibly that the book value deserves at least a fleeting glance by the public before it buys or sells shares in a business undertaking..... Let the stock buyer, if he lays any claim to intelligence, at least be able to tell himself, first, how much he is actually paying for the business, and secondly, what he is actually getting for his money in terms of tangible resources.

Low PE stocks and Superior Returns

In the late 1970s, Sanjoy Basu, building on the work of S.F. Nicholson in 1960, discovered that stocks with low PE ratios have significantly higher returns than stocks with high PE ratios.

This would not have surprised Benjamin Graham and David Dodd, who in their clasic 1934 text, Security Analysis, argued that a necessary condition for investing in common stock was a reasonable ratio of market price to average earnings. They stated:

Hence we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 16 times their averge earnings are likely to lose considerably money in the long run.

Yet even Benjamin Graham must have felt a need to be flexible on the issue of what constituted an excessive PE ratio. In their second edition, written in 1940, the same sentence appears with the number 20 substituted for 16 as the upper limit of a reasonable PE ratio.

What types of PE ratios are justified in today's economy?