Market Moves

Since 1926, the average annual return on large-cap stocks has been 9.62%. This means you can bank on an average return for stocks of about 10% per year over the long term, right? Well, yes and no.

Take a look at the following chart:

So what does this mean for a stock investor? Three things immediately come to mind.

The first lesson is to stay invested. In Nassim Nicholas Taleb’s book The Black Swan: The Impact of the Highly Improbable, he recounts that over the past 30 years, the S&P 500 without reinvested dividends has returned about 9.5% per year on average. By removing the 50 worst days in the market over this 30 year period, your average annual return would have jumped to 18.2%. On the other hand, if you missed the 50 best days in the market over the last 30 years, your average annual return would have plummeted to less than 1%. Bear in mind that fifty days out of 30 years is less than 0.7% of the sample. This clearly shows that being out of the market, even for a very small percentage of the time can have a rather large impact on your portfolio’s performance. So, unless you can accurately and consistently predict when to get into or out of the stock market (also known as market timing), the best philosophy is to stay invested.

The second lesson is, if possible, to start investing early. For younger folks, it cannot be emphasized enough that to have a successful investment plan for your retirement, you must begin saving early and often. By starting early, you can smooth out the bumps created by year-to-year market swings. The more years you stay invested, the closer you can get to that average annual return of about 10%. Albert Einstein had it right when he said, “The most powerful force in the universe is compound interest.” Obviously, the longer your portfolio benefits from compounded earnings, the better.

The third lesson to be learned from the chart is to have a long time horizon. For those closer to retirement age, it is important to understand that the year-to-year variability of stock investments requires you to have a longer-term time horizon. You cannot expect that for every year after you retire, the stock market will go up exactly 9.62%. Again, by having a longer time-horizon, the impact on your portfolio of year-to-year variations in stock market returns can be reduced.

It’s easy to buy a stock.  You can listen to a hot tip, do some research, be persuaded by a broker or even throw a dart at the stock tables in the newspaper.  But how do you know when to sell?

Selling a stock is much harder because you never hear a tip at a cocktail party or from your neighbor to sell a stock.  And high-priced Wall Street analysts rarely issue sell recommendations.  In fact, Credit Suisse currently has only 19% of the stocks they cover rated “Sell,” so you shouldn’t rely on analysts for timely advice on when to sell. 

If a stock is down, it’s hard to accept and acknowledge that the money is lost.  And if a stock is up, will it go higher? 

Here are some rules for determining when to sell.

Can you give a simple, reasonable explanation of what each company that you own stock in does?  You don’t have to know the quarter to quarter earnings comparisons or the current status of their debt, but you should understand what a company does to earn its profits.  If not, sell.  I can explain quite easily what products Procter and Gamble sells to earn money.  On the other hand, there is CytRx.  Even though I can explain that they are a biotechnology company, I still don’t have any idea of what they actually do.    

Don’t get emotionally attached.  Hope and prayer will not make a stock go up.  Is a stock down because of overall market action?  Or headlines in the news that will in the long run have minimal impact?  There have often been sell-offs of drug company stocks because one drug in their pipeline didn’t pan out.  One drug is not going to make or break Pfizer or Merck. 

Is the stock down because of fraud or criminal activity on the part of the management, like Nortel or Fannie Mae?  If so, then sell. 

Be wary of a sudden shift in gears.  A company that is struggling may only falter further when it invests in areas outside its expertise.  A business in one industry the buys a company in another should be analyzed with extra scrutiny.  Are these two business lines compatible and does the acquiring company have the expertise to integrate the acquisition?  One example would be Time Warner buying AOL in 2001 and now planning a spin-off to rid itself of the business.  Clearly, shifting from one business to another could be cause for concern.

Don’t sell the winners.  People tend to sell their winners and hold on to the losers.  In my portfolio, I’ve held most positions for years.  If the company continues to increase in value, I want to continue to reap those benefits.  Also, if I sell a company I know a lot about, I have to find a replacement that I can comfortably admit I know as well or better. 

Some stick to a rule such as “double and out,” or when a stock doubles, sell it.  I don’t agree.  If your comfort level dictates that you would like to lighten the size of your position, but you still want to own the stock, sell enough to equal the amount of your original investment.

I was looking at the stock market opinion and analysis website called Seeking Alpha the other day and these were the two most popular articles:

1. The Market Bubble is About to Pop
2. Why This Rally Will Continue

The first article gave many reasons why the stock market is “headed for major trouble” and the “economy is far from being out of the woods.”  The author cited substantial long-term headwinds and the irrationality of the recent rally.  He said there will be a realization that higher-earnings will not materialize any time soon.  Slow growth and higher commodity prices were also predicted.  And he meant every word.

The second article outlined why these “green shoots” we keep hearing about will turn into plants and how “less bad” is actually pretty good.  The second author wrote about how higher than expected earnings have provided the market with positive momentum.  He also wrote that GDP growth is projected to be positive in the third quarter and more earnings “beats” could propel the market higher.  He even admitted that although growth coming out of this recession would be slow, this is already priced into the stock market.  And he also meant every word. 

It struck me as funny that the two most popular articles offered diametrically opposed opinions about whether the stock market was going to go up or down. 

Most of the information you read about the financial markets from day-to-day are often written by very intelligent and knowledgeable people, but when you add up all their intelligent, but contradictory, commentary, it tends to be just “noise.”  The information could be valuable if you are a day trader, but more often than not, focusing on this daily noise usually leads to making irrational investment decisions based simply on fear or greed. 

My opinion is that a long-term view is important.  The importance of having a long term strategy and disciplined approach to fulfilling that strategy to investing for the long-term cannot be overemphasized.  So, ignore the daily noise and stick to a strategic investment plan with a long time horizon and you’ll be better off in the long run.

Over the years of working with different types of clients, I’ve realized that they all want to work with an advisor who possesses certain qualities.   The following criteria are the qualities that a good investment manager should have.

Be accessible.  You may be a fan of voicemail but eventually you want to speak to a real person and you want to speak to someone who knows you.  I pay good money to my accountant, so when I have a question or concern, I speak to my accountant, not his clerk or receptionist. 

Tell the truth.  Do your candidates have answers to every question?  Are they truthful about what they know and more importantly, what they do not know?   Will they tell you what you need to know early on, so you won’t be unpleasantly surprised down the road?

Be knowledgeable about financial evaluation.  If a manager professes to know about investing and the market, go hear them speak or read some articles or analyses they have written.  Does what they say make sense?  Do they speak in English or financial gibberish?

Have a consistent, understandable philosophy.  The best investors in the country, people such as Peter Lynch or Warren Buffet, may have different investment philosophies.  Lynch, author of several books on investing and former manager of the Fidelity Magellan Fund, looks for undervalued growth opportunities.  Buffet, of Berkshire Hathaway fame, looks for value-oriented investments with a strong franchise.  While they have different philosophies, they share one critical ingredient: whatever their philosophy, they never detour from it.  They are disciplined in sticking to what they know best. 

Have a system of monitoring and reviewing portfolios.  The advisor should have a formal and consistent schedule for reviewing your portfolio.  One of the chief deficiencies of a stock broker or commission based advisor is that they are product-oriented and not portfolio-oriented.  They look at the investment instrument rather than the balance of the total portfolio.  Lack of balance can provide a nice bounce if a stock gets good press.  But the bounce can end in free fall when the headlines are negative.

Be reasonably priced.  The advisor’s fees should be fair to both the client and the advisor.  The SEC does not regulate how much an advisor can charge.  The SEC only specifies that the fee schedule be stated to the client.  This means that the advisor can charge whatever a client is willing to pay.

Be in the growth phase of their career.  Do you want a surgeon who is youthful (but not inexperienced), dynamic, excited about his or her profession, always learning new things and sharing his or her knowledge with others?  Or someone who is thinking about retirement, slowing down his or her practice, and not always keeping up with the latest procedure or technique?  If you want the latter, you might as well put your money under the mattress, because an investment manager needs to have all the energy of a surgeon, if not more. 

Have an exceptionally clear view of reality.  This may be the most important criterion of all.  We have heard that in the real estate market, everyone is a genius when the market is going up.  This is true with other investments.  But it takes realism to recognize that elevators go in two directions.  And knowing when to get off is as important as knowing when to get on.

Life is full of risks.  Some risks like having surgery or driving on the highway are unavoidable.  But even though some risks cannot be avoided, they can be greatly reduced by eliminating the unknown.  In the case of having surgery, you will be much better off knowing the background of your surgeon, her success rate with the operation, as well as her reputation and medical standing.  By driving defensively and knowing your route ahead of time, you reduce the risk of accidents.  By doing your homework up front and identifying the issues and eliminating the unknown, you can better understand your limitations and manage risk.

To handle your money and investing successfully, some fundamental homework is also needed. First, take stock of your financial fitness. A few evenings at the kitchen table with a year’s worth of cancelled checks, credit card receipts and ATM  withdrawal slips will provide you with enough information to create your balance sheet and income statement. This hard knowledge of facts and figures will help you determine a rational plan for budgeting, planning and investing.

Money is intimidating. Making decisions about money is even scarier. In your home, on your job or in your business, you make decisions all the time without hesitation. You control, to the best of your ability, your fate. You strive to have the freedom to make decisions about the direction your life is going, how you spend your days, how you spend your money.

We’ve all taken risks at one time or another and succeeded. The risks were controlled. We try to avoid stupid decisions. We do our homework. But so much falls through the cracks when it comes to money. 

It’s all a matter of knowledge. That doesn’t mean knowing the answer to every question. It means knowing to ask questions. It means eliminating as much of the unknown as possible.  And when in doubt, subject your proposed investment to the following tests:

The Risk Test: If you awaken at night, concerned about the safety and permanence of your investment, you have assumed too much risk. Hype, glamour and excitement in investments more often than not are the result of smoke and mirrors. At different stages in your life, some risk may be acceptable. It will depend upon many factors including your net worth – there is no substitute for wealth – and your emotional capacity to weather uncertainty.

The Gambling Test: If you have the urge to gamble with your money and wish to speculate, take $300, go to a casino and get it out of your system. The stock market is neither a savings bank nor a casino substitute. Investing requires diligence, patience and discipline.

The Broken Egg Test: No matter how wonderful an opportunity sounds, never place all your assets in one basket. Diversification is the magic word. Every portfolio must be diversified to reduce the overall risk. To buy one municipal bond or one stock is foolish. If you can only afford that one investment, you don’t belong investing. Some mutual funds though, can satisfy many investment needs of the small investor. A quality fund with stable management, a good history, and reasonable operating expenses is inherently diversified even for those who are investing a small amount of principal.

The Microwave Test: If you spent as much time organizing, planning and learning about your money and investments as purchasing a microwave, you would be in good shape. The purchase of a microwave is a $100 decision that only affects the speed at which you can make a melted cheese sandwich. Yet, many people will be easily swayed to plunk down $10,000 because of a slick, high pressure sales pitch about an investment they know nothing about. The Internet, libraries, bookstores, magazines and cable TV are crammed with information on investing. Money magazine is another good place to get a feel for the language and basics of investing.

The Professional Test: When you are ill, you seek medical advice. When you are stymied with your tax return, you seek an accountant. When you need financial assistance, find a good financial advisor. Follow the same steps to find a financial advisor as you would a dentist. Ask your friends for referrals. Check the advisor’s credentials. Ask for references.

The Final Test: Preserve your capital. Keep pace with inflation and protect your purchasing power. Don’t expect miracles and home runs overnight. Don’t do anything that doesn’t make sense and feel right.

The mere thought of investing may seem risky to you. Investing and risk need not be synonymous. But risk is relative. Doing nothing is very risky. Doing your homework, following these straightforward rules, and expanding your knowledge reduces risk dramatically.

As we get on in life, we become a bit more concerned about protecting what we’ve worked so hard to save. After all, the older we get, the less chance we have of earning back our nest egg if we gamble and lose.

That is one reason many of us feel more comfortable with investments in companies that not only earn real money, but pay good dividends to shareholders (rather than simply have all our holdings in so called growth companies that don’t pay dividends and expect us to live on the profit from increasing stock prices).

Investing in dividend producing companies is a good strategy backed up by statistics. From 1926 through this spring, for instance, almost half of the total return of the S&P 500 has come from dividends. Those of us in the dividend school have seen an average annual return during all of those years of 9.5%, with 4% of that from dividends. Not too shabby. It’s sort of like getting a rent check for the property we own.

Those numbers reflect the overall average in all markets, up and down. Most recently, we’ve seen and read about more down stock prices than up, so how does that play into things? Well, nobody likes to see a drop in their own portfolios, but I, for one, feel much better when I see that, even though the market may not want to pay me the full value of what I think a particular stock is worth right now, at least the company that issued that stock is paying me my share of its profits while I wait for better stock market times.

If I don’t need the money right now, I have the opportunity to reinvest the dividends right back into the company in the form of more stock, and, if the price of the stock is a bit lower due to overselling, even better. I get a good discount on what I believe is a great company and I pay for it with the money they gave me. Who couldn’t like that?

I can tell you lots of things about increasing shareholder value and complex investment strategies, but a simpler explanation is that, for those whose high-rolling days are past, or for those who don’t have the stomach for it, dividends have a nice way of smoothing out the bumps in the road. Moreover, if we reinvest those dividends in good times and bad, compound growth really makes a difference. For example, $100 invested in the S&P BMI World Index between 1989 and 2007 grew to $318.50 without dividends reinvested, but grew to $468.50 with dividend reinvestment. Imagine, the index improved about 47% more, just by reinvesting dividends.

With careful selection, monitoring and rebalancing, a portfolio comprised of dividend paying stocks could provide you with both income and growth, while taking less risk than most non-dividend growth-only stock portfolios. Given the uncertainty of the current stock market environment, wouldn’t an investor sleep better at night having a portfolio that offered substantial appreciation opportunities as well as a predictable stream of income?

In the current weak economy, or even when the economy gets stronger, are you getting angry when your credit card bank stings you the interest charge, plus an extra $30 to $45, even when you are one day late making a credit card payment? Your indignation is righteous, but what can you do? Some say not much, but here are a few suggestions to help keep more of your money, and make you feel better, too:

• First of all, if you don’t use electronic on-line bill pay already, start doing so. In today’s technological economy, it’s pretty easy. Most banks will be happy to show you how. Make sure that some payment goes to your credit cards on the day before the due date and those onerous charges will become a thing of the past.
• Secondly, if you are not quite ready for on-line payments, at least put a big red reminder on your calendar a week before your payments are due. Remember, even the minimum payment is enough to avoid the penalty fee.
• Third, and you know you’ve heard this before, no credit card debt is good credit card debt. Credit card issuers charge more than organized crime loan sharks. So, start leaving your credit cards at home, so it isn’t so easy to add more debt. Then start paying down your card balances. You know you should. We know the economy needs consumers to resume consuming more, but that doesn’t necessarily mean it all has to be you.
• Finally, here’s a strategy that could cause credit card issuing banks to rethink punitive penalties altogether: Make the card issuing banks share in the pain of their actions. How? Well, you know the bank only makes money when you charge things. So, what if everyone decided that each time they received a late penalty, they vowed not to use that bank’s card for 60 days? In other words, if you get a late penalty, you put that card in your dresser drawer for two months. Imagine if everyone did this? Wow, not only do the card banks cease to profit from their predatory policies, but you get to feel your own power as a consumer. Try it, but also, do you part by not being late in the first place.

With the economy still a way off from returning to consistent positive growth, the last things we need are headlines about honest investors losing what’s left of their money to crooked financial advisors with Ponzi schemes. So, exactly how do you protect yourself from this added insult to injury? Here are three simple, but effective questions to keep in mind when reviewing your advisors, or hiring new ones:

• Does your advisor “self clear”, producing all reports of your transactions within his/her own company? The downside to this is that there is no third party involved to provide trading records, making it very easy for fraud. The notorious Bernie Madoff self cleared, so when he wanted to show stock purchases for his clients, he simply made them up.
• Does your advisor house, or custody, the money and investments with a third party, or is your hard earned money kept at his/her own firm? Many small or independent investment advisory firms are actually safer in this regard, because they house your money in large institutions such as Charles Schwab or Fidelity. These housing institutions produce and send you their own monthly reports, separate and apart from those provided by your investment advisor, providing you with third party reports to check against your advisory reports. Again, when there is another firm involved, you can verify that your advisor’s reports are real, not made up.
• Have you noticed a sudden increase in the number of monthly transactions in your account? This may be due to something called “churning”, where your advisor is increasing the amount of buying and selling to increase commissions. Having an advisor who is fee-based, rather than commission based, is one way to minimize this risk. Another protective move is to check you statements periodically to insure that there is consistency month to month. If you have stated high risk-high reward objectives, then all this extra activity may be warranted. However, if you have specified caretaker treatment in order to protect you retirement nest egg, then lots of buying and selling could be a big red flag.

Keeping these tips in mind when reviewing your current advisors or hiring a new one will help protect your hard earned money.