Returns from Investment

Stock returns

The returns from owning stocks come from 2 sources.

Cash dividends are earnings that are distributed to shareholders. (Unlike bonds, stocks do not guarantee the timing or the amount of dividends).

At any time, they can be increased, decreased or taken away altogether.

The other source of returns is capital gains. This is the main reason people buy stocks.

The value of your stock may rise when the earning prospects of the company are favourable.

And of course, your shares may also lose value if the company performs poorly.


Bond returns

The returns from owning a fixed-income security come in two forms.

There are the fixed interest payments and the final payment of principal at maturity.

Secondly, there is the potential for capital gains when you sell a bond before its maturity at a price higher than when you purchased it.

Imagine a see-saw. The price of a bond rises when the interest rates fall, and there is thus the possibility of a capital gain from a favourable movement in rates. Of course, inversely, a rise in interest rates will produce a loss.


Money market returns

Money market investments maintain a stable value, pay interest and can easily be converted into cash.

Of the three types of investments, money market instruments pay the lowest rate of return.

So why bother with them?

For the same reason that you leave large chunks of your uninvested money in fixed deposit - safety.

When you buy a money market investment, you are pretty sure you will get your money back with some interest.

The chances of losing money - whether from the government or the bank defaulting on its payment or a loss in principal value of the investment - are very low.

When you invest in a money market investment, you are taking very little risk and your expected return should reflect the amount of risk that you have taken.

When is a money market investment appropriate? When you need to use the money in a year or so, and you want to know that the money will be there with few surprises.

Risks of Investments

Stock risk.

As a group, stocks generally move up and down in value more than any other type of investment in the short-term.

People are usually afraid of purchasing stocks because they hear about bear markets, corporate scandals and stock market crashes.

But this should be a concern only to investors who need their money back within a few years.

In fact, over the longer-term, you stand a greater risk of losing money if you don't invest in stock.

Unlike money market securities, stocks are high risk investments in the short-term but are lower risk investments in the long term.



Bond risk.

Besides interest rate risk, bonds have default risk.

Default risk refers to the possibility that the borrower will not make the promised payments.

This risk is almost non-existent for government bonds, but for many other issuers such as private companies, the risk of default is very real.


Money market risk.

Beware of inflation.

The longer you leave your money in fixed deposit, the higher the risk of inflation eating away the purchasing power of your money.

Money market investments are safest when the money is needed in the short-term.

The very same safe investments become high risk the longer they stay invested.


Stocks are on the opposite track. They are high risk investments in the short-term, but are lower risk investments in the long term:

Fixed deposit
1yr = Low risk 10 yrs = High risk

Stocks
1 yr = High risk 10 yrs = Low risk

Major types of Investments

Major types of Investments



Main types

1. Stocks or equities

2. Bonds or fixed income securities

3. Money market investments



Derivatives

1. Options

2. Futures



Unit trusts

1. Money market funds

2. Bond funds

3. Equity funds

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Bonds or fixed income securities

Bonds are loans issued by companies and governments to borrow money, and they have two main characteristics:

1. They have lifespan greater than 12 months at the time of issue.
2. They typically promise to make fixed interest payments according to a given schedule.

Bonds are hence also called fixed income securities.

Bonds have their own unique terms: Suppose you buy bonds with a face value of $10,000. These bonds mature in 2 years and pay 4% interest annually. The 4% interest equates to $400 a year. The face value of the bond, or the principal amount of $10,000 will be returned to you when the bond matures in 2 years.

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Money market securities

Money market securities are similar to bonds except that they are short-term investments. They have two main characteristics:

1. They are loans issued by companies and government to borrow money.
2. They mature in less than a year from the time they are sold, which means that the loan must be repaid within a year.

Some of the most common money market securities include

• Treasury Bills (issued by the government and considered the safest investments around),
• fixed deposits,
• bank savings accounts and
• certificates of deposits.

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Properties

The outright ownership of real estate has long been considered as a sound long-term investment, carrying with it a goodly amount of protection against inflation.

Unfortunately, real-estate values are also subject to wide fluctuations; serious erros can be made in location, price paid, etc.; there are pitfalls in salesmen's wiles.

Finally, diversification is not practical for the investor of moderate means, except by various types of participations with others and with the special hazards that attach to new floatations.

This too is a field not without risk. As the usual advice given to investors: "Be sure it's yours before you go into it."

Managing gold in your portfolio

Managing gold in your portfolio


Gold has an extensive history of maintaining its value. Still, gold like all investments involve risk. Gold prices have historically seen strong fluctuations.


One reason for fluctuating prices is that the value of a bullion coin or a gold unit trust is directly affected by the current spot or market price of bullion. This price fluctuates daily and can be affected by a multitude of factors such as the perceived scarcity of gold, current demand, market sentiment and economic factors. Therefore, the price of your gold investment can go down as well as up in value.


Second, like all prices, the gold price reflects not only the inherent value of gold, but also the relative strengths of the currency in which it is quoted. For example, the dollar price of gold may increase more in percentage terms than the sterling price, to the extent that the change in price is a reflection of dollar weakness (in this case, against sterling) rather than an intrinsic change in gold market fundamentals. So if you purchase a gold investment in US dollars and the US dollar has increased by 20% by the time you sell it 12 months later, your investment would have fallen in value by 20% - regardless of any change in gold market fundamentals.


The strength of the US dollar during the two decades between 1980 and 2000 was an important reason why the gold price did not perform well during those years. It was in part the rapid rise in the dollar that hurt the dollar gold price. Another reason for gold's poor performance between 1980 and 2000 was the success of the world's central bankers in fighting inflation. Gold's role as a hedge againts inflation can be one of the main reasons that people buy it.



Despite the volatility of gold prices and its sensitivity to fundamental factors, the diversification benefits of gold in a portfolio are backed by strong evidence. Ibbotson Associates, a leading authority on asset allocation, performed a study with respect to the portfolio diversification benefits of gold, silver and platinum bullion covering a 33 year period from February 1971 to December 2004. Ibbotson determined that of the seven types of assets covered in the study, the precious metals asset class is the only one with a negative correlation to other asset classes. What this means is that precious metals perform best during the years that traditional asset classes such as stocks and bonds had negative returns. Ibbotson determined that investors can potentially improve their portfolio risk-reward performance by including precious metals with allocations of between 7.1% and 15.7% for conservative to aggressive portfolios respectively.



Historically, gold has produced excellent long-term gains during up cycles; however, it may not be suitable for everyone. You should acquire a good understanding of gold products before you invest. Since all investments including gold can decline in value, you should have adequate cash reserves and disposable income before considering a precious metal investment.



In the end, speculating in gold should be avoided at all cost by most conservative investors. Speculting involves short-term trading and the early withdrawal from accounts or securities can result in substantial penalties or fees - in addition to any decrease in gold prices due to fundamental factors.

Ref: Make Money Work For You by Keon Chee & Ben Fok

How to invest in gold?

How to invest in gold?

Investors who wish to invest in gold can do so in 5 ways:
1. Gold bullion bars and coins
2. Gold certificates
3. Gold mining shares
4. Gold unit trusts
5. Gold derivatives

Prices for all these investment options are available daily from banks and brokerages.

Buy gold!

The standard policy of people all over the world who mistrust their currency has been to buy and hold gold.

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Here are some historical data from Intelligent Investor by Benjamin Graham:

The price of gold in the open market rose from $35 per ounce over 35 years to $48 in early 1972 - a rise of only 35%. But during all this time, the holder of gold received no income return on his capital, and instead incurred some annual expense from storage. Obviously, between 1937 - 1972, money earning interest in a saving bank, in spite of the rise in the general price level, was better than investing in gold.

It was obvious that during that period, the near-complete failure of gold to protect against a loss in the purchasing power of the dollar must cast doubt on the ability of the ordinary investor to protect himself against inflation by putting his money in either gold or "other things."

Very few readers will find the swimming safe and easy investing in gold.

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There were others who pointed out that there were years when gold showed robust ability to outpace inflation. A tiny allocation to this metal (say, 2% of your total assets) is too small to hurt your overall returns when gold does poorly. But when gold does well, its return are often so spectacular - sometimes exceeding 100%.

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Bargains abound in the stock markets

http://www.raymondjames.com/inv_strat.htm



In conclusion, we received a plethora of questions regarding the quote we used last week from The Wall Street Journal (WSJ) that there are currently one in ten listed companies trading for less than the value of the cash and marketable securities on their balance sheets. To proof test this statement we ran a similar screen and found more companies than the WSJ did. Of course the screen they must have used was similar to ours in that “net debt” on the balance sheet was excluded. When we included “net debt” we come away with a much smaller number. Still, this exercise goes to show that “things” are overdone on the downside and people like Warren Buffett are taking notice. Verily, when investors en masse attempt to adjust their portfolios toward more conservative investments, there is a negative feedback loop that leads to a decline in the price of less liquid assets, which in turn begets even more selling pressure, causing an overshoot on the downside. And that, ladies and gentlemen, is where we are currently.



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P.S. – “Strikingly, today’s conditions bear quite a close resemblance to what Graham described in the abyss of the Great Depression. Regardless of how much further it might (or might not) drop, the stock market now abounds with so many bargains it’s hard to avoid stepping on them. Out of 9,194 stocks tracked by Standard & Poor’s Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year – or at levels less than half the long-term average valuation of the stock market as a whole. Nearly one in 10, or 876 stocks, trade below the value of their per-share holdings of cash – an even greater proportion than Graham found in 1932.” (The WSJ the week of October 6, 2008.)

Ref:

Business Valuations versus Stock-Market Valuations (2) - an illustration
"The company is worth more dead than alive." The A&P Example

The Investor and Market Fluctuations - Summary

Summary:

1. The most realistic distinction between the investor and the speculator is found in their attitude toward stock market movements.
2. The speculator's primary interest lies in anticipating and profiting from the market fluctuations.
3. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices.
4. Market movements are important to the investor in a practical sense, because they alternatively create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.
5. It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities.
6. On the whole, it may be better for the investor to do his stock buying whenever he has money to put in stocks, EXCEPT when the general market level is much higher than can be justified by well-established standards of value.
7. If he wants to be shrewd, he can look for the ever present bargain opportunities in individual securities.
8. Aside from forecasting the movements of the general market, much effort and ability are dircted on Wall Street toward selecting stocks or industrial groups that in matter of price will "do better" than the rest over a FAIRLY SHORT PERIOD IN THE FUTURE. Logical as this endeavor may seem, we do not believe it is suited to the needs or temperament of the true investor - particularly since he would be competing with a large number of stock market traders and first class financial analysts who are trying to do the same thing.
9. As in all other activities that emphasize price movements first and underlying values second, the work of many intelligent minds constantly engaged in this field tends to be self-neutralizing and self-defeating over the years.
10. The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizeable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored.
11. The investor should never buy a stock BECAUSE it has gone up or sell one BECAUSE it has gone down.
12. The investor would not be far wrong, if this motto read more simply: "Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop."

An Added Consideration.

1. The shareholder judges whether his own investment has been successful in terms both of dividends received and of the long-range trend of the average market value.
2. The same criteria should logically be applied in testing the effectiveness of a company's management and the soundness of its attitude toward the owners of the business.
3. For as yet, there is no accepted technique or approach by which management is brought to the bar of market opinion. On the contrary, managements have always insisted that they have no responsibility OF ANY KIND for what happens to the market value of their share.
4. It is true, of course, that they are NOT accountable for those FLUCTUATIONS in price which, bear no relationship to underlying conditions and values.
5. But it is only the lack of alertness and intelligence among the rank and file of shareholders that permits this immunity to extend to the entire realm of market quotations, including the permanent establishment of a depreciated and unsatisfactory price level. (This is now known as "corporate governance."
6. Good managements produce a good average market price, and bad managements produce bad market prices.

Ref:

The Investor and Market Fluctuations in Intelligent Investor by Benjamin Graham

Benjamin Graham's 113 wise words

This may well be the single most important paragraph in Graham's entire book.

In these 113 words Graham summarised his lifetime of experience.

If you keep them close at hand and let them guide you throughout your investing life, you will survive whatever the markets throw at you.

"The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.* Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement."


* Only to the extent that it suits his book" means "only to the extent that the price is favorable enough to justify selling the stocks." In traditional brokerge lingo, the "book" is an investor's ledger of holdings and trade.

Business Valuations versus Stock-Market Valuations (2) - an illustration

"The company is worth more dead than alive."


The A&P Example

This example combines many aspects of corporate and investment experience. It involves the Great Atlantic & Pacific Tea Co. Here is the story:

1929: First traded on the "Curb" market, now the American Stock Exchange

1929: Sold as high as 494
1932: Declined to 104, although the company's earnings were nearly as large in that generally catastrophic year as previously.
1936: The range was between 111 and 131.
1938: In business recession and bear market. Fell to a new low of 36

The $36 price was extraordinary.

It meant that the preferred and common shares were together selling for $126 million.

The company had just reported that it held $85 million in cash alone and a working capital (or net current assets) of $134 million.

A&P was the largest retail enterprise in America, if not in the world, with a continuous and impressive record of large earnings for many years.

Yet, in 1938 this outstanding business was considered on Wall Street to be worth less than its current assets alone - which means less as a going concern than if it were liquidated.
(Better dead than alive!)

Why?

First, because there were threats of special taxes on chain stores.
Second, because net profits had fallen off in the previous year.
Third, because the general market was depressed.

The first of these reasons was an exaggerated and eventually groundless fear; the other two were typical of temporary influences.

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Let us assume that the investor had bought A&P common in 1937 at, say, 12 x its five-year average earnings, or about $80.

We are far from asserting that the ensuing decline to 36 was of no importance to him.

He would have been well advised to scrutinize the picture with some care, to see whether he had made any miscalculations.

But if the results of his study were reassuring - as they should have been - he was entitled then

• to disregard the market decline as a temporary vagary of finance,
• unless he had the funds and the courage to take advantage of it by buying more than the bargain basis offered.

SEQUEL AND REFLECTIONS.

1939: A&P shares advanced to 117 1/2.

This was 3 x the low price of 1938 and well above the average of 1937.

Such a turnabout in the behaviour of common stocks is by no means uncommon, but in the case of A&P, it was more striking than most.

1949-1961: The grocery chain's shares rose with the general market.

1961: The split-up stock (10 for 1) reached a high of 70 1/2 which was equivalent to 705 for the 1938 shares.

This price of 70 1/2 was remarkable for the fact it was 30 times the earnings of 1961.

Such a PE ratio - which compares with 23x for the DJIA in that year - must have implied expectations of a brilliant growth in earnings.

This optimism had no justification in the company's earnings record in the preceding years, and it proved completely wrong. Instead of advancing rapidly, the course of earnings in the ensuing period was generally downward.

1962: The year after the 70 1/2 high the price fell by more than half to 34.

But this time the shares did not have the bargain quality that they showed at the low quotation in 1938.

1970: The price fell to another low of 21 1/2/
1972: The price was 18, having reported the first quaterly deficit in its history.

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We see in this history how wide can be the vicissitudes of a major American enterprise in little more than a single generation, and also with what miscalculations and excesses of optimism and pessimism the public has valued its shares.

In 1938 the business was really being given away, with no takers.

In 1961, the public was clamoring for the shares at a ridiculously high price.

After that came a quick loss of half the market value, and some years later a substantial further decline.

In the meantime, the company was to turn from an outstanding to a mediocre earnings performer; its profit in the boom-year 1968 was to be less than in 1958; it had paid a series of confusing small stock dividends not warranted by the current additions to surplus; and so forth.

A&P was a larger company in 1961 and 1972 than in 1938, but not as well-run, not as profitable, and not as attractive.

1999: At year-end, its share price was $27.875
2000: $7.00
2001: $23.78
2002: $8.06

Although some accounting irregularities later came to light at A&P, it defied all logic to believe that the value of a relatively stable business like groceries could fall by three-fourths in one year, triple the next year, then drop by two-thirds the year after that.

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There are two chief morals to this story.

The first is that the stock market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors.

The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse.


The investor need not watch his companies performance like a hawk; but he should give it a good, hard look from time to time.


Ref: Intelligent Investor by Benjamin Graham

Growth Stocks Paradox

David Durand, "Growh Stocks and the Petersburg Paradox," The Journal of Finance, vol. XII, no. 3, September, 1957, pp. 348-363.

This classic article compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin.

Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an investor should (in theory) be willing to pay an infinite price for its shares.

Why, then, has no stock ever sold for a price of infinity dollars per share?

Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows, and the higher the cost of even a tiny miscalculation becomes.

Book Value (Net Asset Value)

Synonyms:
Net asset value
Book value
Balance sheet value
Tangible-asset value
Net worth

= Total value of a company's physical and financial assets minus all its liabilities.

It can be calculated using the balance sheets in a company's annual and quarterly reprots.

From total shareholders' equity, subtract all "soft" assets such as goodwill, trademarks, and other intangibles.

Divide by the fully diluted number of shares outstanding to arrive at book value per share.

Business Valuations versus Stock-Market Valuations

The impact of market fluctuations upon the investor's true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses.

The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice.

(1) As a minority shareholder or silent partner in a private business.

Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets.

He would usually determine the value of such a private business interest by calculating his share of the net worth as shown in the most recent balance sheet.

(2) As a common-stock investor.

He holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment - when the market is open, that is - and often is far removed from the balance sheet value.

(Stocks now exist, for the most part, in purely electronic form and thus have become even easier to trade than they were in Graham's day).

The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner.

The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or "balance sheet value"). [# Book Value (Net Asset Value) ]

In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.



A factor of prime importance in present-day investing.

The whole structure of stock-market quotations contains a built-in contradiction.

The better a company's record and prospects, the less relationship the price of its shares will have to their book value.

But the greater the premium above book value, the less certain the basis of determining its intrinsic value - i.e , the more this "value" will depend on the changing moods and measurements of the stock market.

Thus, we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares.

This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be - at least as compared with the unspectacular middle-grade issues.

(What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)

The argument made above should explain the often erratic price behaviour of our most successful and impressive enterprises.

For example
- IBM (International Business Machines).
The price of its shares fell from 607 to 300 in seven months in 1962-63; after two splits its price fell from 387 to 219 in 1970.
-Xerox - an even more impressive earnings gainer in recent decades - fell from 171 to 87 in 1962-63, and from 116 to 65 in 1970.

These striking losses did not indicate any doubt about the future long term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.



The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks.

If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value - say, at not more than 1/3 (one-third) above that figure.

Purchases made at such levels, or lower, may with logic be regarded as related to the company's balance sheet, and as having a justification or support independent of the fluctuating market prices.

The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it.




A caution.

A stock does not become a sound investment merely because it can be bought at close to its asset value.

The investor should demand, in addition,
1. a satisfactory ratio of earnings to price (PE),
2. a sufficiently strong financial position, and
3. the prospect that its earnings will at least be maintained over the years.

This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions.

Once the investor is willing to forego brilliant prospects - i.e., better than average expected growth - he will have no difficulty in finding a wide selection of issues meeting these criteria.

(In the present market situation, may stocks meet this asset-value criterion. Many sell below their tangible-asset value. Many are now available at prices reasonably close to their asset values.)

The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets.

As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market.

More than that, at times he can use these vagaries to play the master game of buying low and selling high.


Ref: Intelligent Investor by Benjamin Graham

Market Fluctuations of the Investor's Portfolio

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

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

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

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

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

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

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

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

But what about the longer term and wider changes?

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

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

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

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

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

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

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

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

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

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Note carefuly what Graham is saying here.

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

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

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


Ref: The Intelligent Investor by Benjamin Graham

"Formula Investment Plans"

In the early years of the stock-market rise that began in 1949-50, considerable interest was attracted to various methods of taking advantage of the stock market's cycle.

These have been known as "formula investment plans."

The essence of all such plans - except the simple case of dollar averaging - is that the investor automatically does some selling of common stocks when the market advances substantially.

In many of them, a very large rise in the market level would result in the sale of all common-stock holdings; others provided for retention of a minor proportion of equities under all circumstances.

This approach had the double appeal of sounding logical (and conservative) and of showing excellent results when applied RETROSPECTIVELY to the stock market over many years in the past. Unfortunately, its vogue grew greatest at the very time when it was destined to work least well.

Many of the "formula planners" found themselves entirely or nearly out of the stock market at some level in the middle 1950s. True, they had realized excellent profits, but in a broad sense the market "ran away" from them thereafter, and their formulas gave them little opportunity to buy back a common stock position.

(Many of these "formula planners" would have sold all their stocks at the end of 1954, after the US stock market rose 52.6%, the second highest yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled.)

There is a similarity between the experience of those adopting the formula-investing approach in the early 1950s and those who embraced the purely mechanical version of the Dow theory some 20 years earlier.

In both cases, the advent of popularity marked almost the exact moment when the system ceased to work well.

We have had a like discomfiting experience with our own "central value method" of determining indicated buying and selling levels of the Dow Jones Industrial Average.

The moral seems to be that any approach to moneymaking in the stock market, which can be easily described and followed by a lot of people is by its terms too simple and too each to last.

"All things excellent are as difficult as they are rare."

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Easy ways to make money in the stock market fade for two reasons:

• the natural tendency of trends to reverse over time, or "regress to the mean", and,
• the rapid adoption of the stock-picking scheme by large numbers of people, who pile in and spoil all the fun of those who got there first.

Buy Low Sell High Approach

We are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them.

Can he benefit from them after they have taken place - i.e. by buying after each major decline and selling out after each major advance?

The fluctuations of the market over a period of many years prior to 1950 lent considerable encouragement to that idea.

In fact, a classic definition of a "shrewd investor " was "one who bought in a bear market when everyone else was selling, and sold out in a bull market when everyone else was buying."

Between 1897 and 1949, there were ten complete market cycles, running from bear-market low to bull-market high and back to bear-market low.

• Six of these took no longer than 4 years,
• four ran for 6 or 7 years, and
• one - the famous "new era" cycle of 1921 -1932 - lasted 11 years.

The percentage of advance from the lows to highs ranged from 44% to 500%, with most between about 50% and 100%.

The percentage of subsequent declines ranged from 24% to 80%, with most found between 40% and 50%. (It should be remembered that a decline of 50% fully offsets a preceding advance of 100%)

Nearly all the bull markets had a number of well-defined characteristics in common, such as

(1) a historically high price level,
(2) high price/earnings PE ratio,
(3) low dividend yields as against bond yields,
(4) much speculation on margin, and
(5) many offerings of new common-stock issues of poor quality.

Thus to the student of stock-market history it appeared that the intelligent investor should have been able to identify the recurrent bear and bull markets, to buy in the former and sell in the latter, and to do so for the most part at reasonably short intervals of time.

Various methods were developed for determining buying and selling levels of the general market, based on either value factors or percentage movements of prices or both.

But we must point out that even prior to the unprecedented bull market that began in 1949, there were sufficient variations in the successive market cycles to complicate and sometimes frustrate the desirable process of buying low and selling high.

The most notable of these departures, of course, was the great bull market of the late 1920s, which threw all calculations badly out of gear.

Even in 1949, therefore, it was by no means a certainty that the investor could base his financial policies and procedures mainly on the endeavor to buy at low levels in bear markets and to sell out at high levels in bull markets.

It turned out, in the sequel, that the opposite was true. The market's behaviour in the past 20 years has not followed the former pattern, nor obeyed what once were well-established danger signals, nor permitted its successful exploitation by applying old rules for buying low and selling high.

Whether the old, fairly regular bull-and-bear market pattern will eventually return we do not know.

But it seems unrealistic to us for the investor to endeavor to base his present policy on the classic formula - i.e., to wait for demonstrable bear-market levels before buying any common stocks.

Our recommended policy has, however, made provision for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock prices appears less or more attractive by value standards.



Ref: Intelligent Investor by Benjamin Graham

Buy Low Sell High

How Low Can Stocks Go?

How Low Can Stocks Go?
http://www.fool.com/investing/value/2008/10/18/how-low-can-stocks-go.aspx

Morgan Housel

October 18, 2008

Between Oct. 6 and Oct. 10, the Dow Jones Industrial Average dropped nearly 2,000 points. If it kept falling at that rate, the index would hit zero in less than a month.

Of course, we won't see zero. No matter how ugly markets get, the pain we saw these past few weeks can't continue for long.

But here's the bad news: Zero may be out of the question, but that doesn't mean stocks won't plummet from here. In fact, they could fall much, much further.

And history agrees.

What goes up ... The history of long-term market downturns is pretty abysmal. When times are bad, markets don't just get drunk with fear -- they start downing vodka shots of fear.

At times like this, nobody wants to own stocks. Their palms begin to sweat every time they watch CNBC. They bury their heads in the hope that the pain will go away. They throw in the towel and sell stocks indiscriminately. In short, it gets ugly.

Just how ugly? Have a look at the average P/E ratio of the entire S&P 500 index over these three periods of market mayhem:

Period
Average S&P 500 P/E Ratio
1977-1982....8.27 times
1947-1951....7.78 times
1940-1942....9.01 times

Compare that to the average P/E ratio today of around 20 times and a seven-year average of more than 24 times, and it's pretty apparent that stocks could fall much, much further than they already have, just by returning to the lows they historically hover around during downturns.

Assuming earnings stay flat, revisiting those historically low levels could easily mean a nearly 50% decline from here. For the Dow Jones Industrial Average, that'd correlate to roughly Dow 5,000 -- give or take. Of course, I'm not predicting, warning, or forecasting -- I'm just taking a long look at history.

But what if it did happen? What would happen to individual stocks? Here's what a few popular names would look like trading at P/E ratios of 8:

Company
One-Year Decline ...... Further Decline From Current Levels With P/E of 8

Yahoo! (Nasdaq: YHOO)
(51%)....(56%)

Apple (Nasdaq: AAPL)
(40%)....(60%)

Bank of America (NYSE: BAC)
(48%)....(62%)

Adobe (Nasdaq: ADBE)
(39%)....(56%)

Starbucks (Nasdaq: SBUX)
(60%)....(52%)

Pfizer (NYSE: PFE)
(27%)....(37%)

Schlumberger (NYSE: SLB)
(52%)....(33%)

Look scary? It is. And it could easily happen.

But here's the silver lining: Every one of those stocks -- heck, the overwhelming majority of stocks -- are worth much more than a measly 8 times earnings. The only thing that pushes the average stock to such embarrassing levels is an overdose of panic, rather than a good reading on what the company might actually be worth.

Be brave As difficult as it is right now, following the "this too will pass" philosophy really does work. No matter how bad it gets, things will eventually recover. Those brave enough to dive in when no one else dares to touch stocks are the ones who end up scoring the multibagger returns.

Need proof? Think about the best times you could have bought stocks in the past:

• after the economy recovered from oil shocks in the '70s,
• after the magnificent market crash of 1987, after global financial markets seized up in 1998, and
• after the 9/11 attacks that shook markets to the core.

As plainly obvious as it is in hindsight, the best buying opportunities come when investors are scared out of their wits and threaten to give up on markets altogether.

And that's exactly where we are.

Pick what side you'd like to be on The next few years are likely to be quite a ride. On the other hand, the history of the market shows that gloomy, volatile periods also provide once-in-a-lifetime opportunities that can earn ridiculous returns as rationality gets back on track.

If you need a few ideas, our team at Motley Fool Inside Value is sifting through the market rubble to find those opportunities. To see what they're recommending right now, click here to try the service free for 30 days. There's no obligation to subscribe.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Pfizer and Bank of America are Motley Fool Income Investor recommendations. Starbucks and Pfizer are Inside Value picks. Starbucks and Apple are Stock Advisor picks. The Fool owns shares of Starbucks and Pfizer. The Motley Fool is investor writing for investors.
Legal Information. © 1995-2008 The Motley Fool. All rights reserved.

Market Fluctuations as a Guide to Investment Decisions

What does the past record promises the investor - in either:

• the form of long-term appreciation of a portfolio held relatively unchanged through successive rises and declines, or,
• in the possibilities of buying near bear-market lows and selling not too far below bull-market highs.

Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings.

There are two possible ways by which he may try to do this:

• the way of timing and
• the way of pricing.

By timing we mean the endeavor to anticipate the action of the stock market - to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward.

By pricing, we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.

A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.



We are convinced that the intelligent investor can derive satisfactory results from pricing of either type.

We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator's financial results.

This distinction may seem rather tenuous to the layman, and it is not commonly accepted on Wall Street.

As a matter of business practice, or perhaps of thoroughgoing conviction, the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts.

Pretensions of stock-market forecasting or timing.

The investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking. Yet in many cases he pays attention to them and even acts upon them. Why?

Because he has been persuaded that it is important for him to form some opinion of the future course of the stock market, and because he feels that the brokerage or service forecast is at least more dependable than this own.

*

A great deal of brain power goes into this field and undoubtedly some people can make money by being good stock market analysts.

But it is absurd to think that the general public can ever make money out of market forecasts.

For who will buy when the general public, at a given signal, rushes to sell out at a profit?

If you, the reader, expect to get rich over the yers by following some system or leadership in market forecasting, you must be expecting to try to do what countless others are aiming at, and to be able to do it better than your numerous competitors in the market.

There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.

Timing is of Psychological importance to the speculator

There is one aspect of the "timing" philosophy which seems to have escaped everyone's notice.

Timing is of great psychological importance to the speculators because he wants to make his profit in a hurry. The idea of waiting a year before his stock moves up is repugnant to him.

But a waiting period, as such, is of no consequence to the investor.

What advantage is there to him in having his money uninveted until he receives some (presumably) trustworthy signal that the time has come to buy?

He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income.

What this means is that timing is of no real value to the investor unless it coincides with pricing - that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

Ref: Intelligent Investor by Benjamin Graham