Wouldn’t it be great if you could improve your investment returns by owning securities when prices are increasing and selling them before they crash? If you learn how to read stock charts, you might have a chance at doing so. People take many different strategies …
The financial news in the past week or so has been full of stories about GameStop, AMC Entertainment Holdings (AMC), Blackberry, Reddit, r/WallStreetBets, hedge funds, short squeezes, margin calls and Robinhood, among other things. Many of these stories explain parts of what is happening. However, …
Many investors limit the amount of their investments in individual companies to manage the risk in their portfolios. Others advocate holding on to stocks whose prices increase faster than the rest of your portfolio (which I’ll call stock runners) as long as the reason you bought the stock in the first place continues to hold true. I’ve taken the latter approach with my portfolio with some success.
In this post, I’ll talk about how many stocks you might want to hold in your portfolio to maintain diversification. I’ll then explain both strategies for dealing with stock runners in more detail. I’ll close with an explanation of how the strategy of holding on to stock runners worked for me and provide examples of when it wouldn’t have worked.
How Many Stocks to Hold
If you plan to invest only in individual stocks (as opposed to including mutual or exchange-traded funds in your portfolio), many advisors recommend that you make investments in at least 10 companies. Ten provides a balance between the amount of time needed to research a possibly longer list of companies to make an informed decision and creating diversification.
A Poor Performer
The goal of diversification is to reduce the impact of the poor performance of one stock on your total portfolio returns. In my post on diversification and investing, I used PG&E as an illustration. The chart below shows PG&E’s daily stock price over the 12 months prior to PG&E declaring bankruptcy in early 2019.
In the twelve months ending January 26, 2019, PG&E’s stock price dropped by 72%. From its peak in early November 2018 to its low in January 2019, it dropped by 87%.
The Benefit of More Stocks
Although diversification can’t completely protect you from such large losses, it can reduce their impact especially if you invest in companies in different industries. If the only company in which you owned stock was PG&E, you would have lost 72% of your investments in one year. If, on the other hand, you had owned an equal amount of a second stock that performed the same as the Dow Jones Industrial Average over the same time period (-6%), you would have lost 39%. The graph below shows how much you would have lost for different numbers of other companies in your portfolio.
This graph shows how quickly the adverse impact of one stock can be offset by including other companies in a portfolio. In a portfolio of five stocks (PG&E and four others that performed the same as the Dow), the 72% loss is reduced to about a 20% loss. With 10 stocks (circled in red), the loss is reduced to 12.6% which isn’t much worse than the 6% loss for the Dow Jones Industrial Average.
The curve starts to flatten out quickly at about 10 stocks, supporting the common rule of thumb that a portfolio of only individual stocks should have representation from at least 10 companies.
Options When You Own Stock Runners
There are two schools of thought about how to treat stock runners.
- One is that you should sell a portion of your holdings so that the value of your holdings in any one company is no more than 10% (one-tenth) of your total portfolio.
- The other is that you should let your winners run. The latter view is consistent with the advice of Peter Lynch, one of the most successful mutual fund managers ever, who advocates looking to buy stocks that could become ten-baggers (worth 10 times what you paid for them).
When Holding on to Stock Runners Works
I have taken the latter approach and will use two of the stocks that have been in my portfolio for close to 30 years to illustrate. Let’s say I had $100,000 to invest in 1992. I put 10% of it in each of Boeing (BA) and Neogen (NEOG) stock. I put the rest in an S&P 500 index fund. (That’s not really what I did or the amount of money I had, but the changes make the example simpler.)
Neogen performed very well between May 1992 and August 1, 2020. $1 invested in Neogen on May 1, 1992 was worth $169 on August 1, 2020! By comparison, $1 invested in 1992 in the S&P 500 was worth $8 in 2020 and $1 invested in Boeing stock in 1992 was worth $16 in 2020.
The Two Strategies
The chart below shows what would have happened if I had managed this portfolio since May 2, 1992 under the two different strategies. The purple line shows the strategy I use – buy and hold or let stock runners run. The green line shows what would have happened to the value of the portfolio if I had trimmed my positions in Neogen and Boeing once a year so that the mix was 10% in each of Neogen and Boeing and 80% in the S&P 500.
The Benefit of Keeping Stock Runners
From 1992 until mid-2008, there really wasn’t much difference in the results of the two portfolios. Since then, both Boeing and Neogen have significantly outperformed the S&P 500. The purple line therefore moved above the green line and has consistently stayed higher. On August 1, 2020, the purple line shows that the buy-and-hold portfolio had a value of $2.5 million. The trimmed portfolio (green line) had a value of just over $1.5 million on the same date or only 60% as much.
Boeing had particularly poor results in the 10 months starting in October 2019. Its price on August 1, 2020 was only slightly more than half of what it was on October 1, 2019. Similarly, Neogen hit a high of 200 times its May 1, 1992 price in April 2018. You can see these peaks in the purple line in the chart. Even with these significant declines in Boeing’s and Neogen’s prices recently, the buy-and-hold strategy produced 66% higher returns. If I had been able to anticipate these decreases and thinned my positions in these two companies in 2018 or 2019, my net worth on August 1, 2020 would have been even higher.
I caution that this example is somewhat extreme. There are very few stocks, such as Neogen, that have produced such consistently high returns. Nonetheless, the illustration highlights the benefits and risks of letting your stock runners run.
When Trimming Your Positions is Better
Before you get too excited about the buy-and-hold strategy, you should know that you can’t use it blindly. I’ll use the examples of General Electric (GE) and Pacific Gas & Electric (PG&E). I owned GE for a while and have a family member who owned PG&E, so am familiar with both companies. From May 1, 1992 through early 2017, GE significantly outperformed the S&P 500 (increasing in price by a factor of 30 vs. 5.5) and PG&E produced roughly market returns, but was considered a reliable stock with a generous dividend. Starting in 2017, both companies encountered financial difficulties and lost substantial portions of their market value.
The chart below shows the same comparison as above – buy-and-hold vs. trimming your positions – using GE and PG&E in place of Neogen and Boeing.
While the companies were doing well (up to the 2008 financial crisis), the buy-and-hold strategy produced better returns. For the next 8 or 10 years, the two portfolios performed similarly. Once the two companies encountered difficulties, though, in 2017, the annual trimming strategy started to outperform.
The conclusion that I draw from these illustrations is that, as long as you think a company can outperform the market, you will likely be better off letting your stock runners run. However, if something changes at the company, you will likely be better off trimming the larger positions in your portfolio, at a minimum, or selling all of your stock in the company. This conclusion reinforces the points Peter Lynch made in his book, One Up on Wall Street, that you should know the story behind every stock you own. Brandon Smith makes a similar recommendation in his guest post for me that changes in a company’s management, market or financial position can be important sell signals.
Many financial advisors recommend re-balancing your portfolio no less often than annually to ensure the asset allocation is consistent with your risk tolerance, as illustrated in this post from Schwab. In the past, I haven’t been one to re-balance my portfolio, so I spent some …
Before we talk about the specific indicators that would signify stock market sell signals, we must understand why we bought each stock in the first place. The simple theory of ‘buy low, sell high’ seems practically very easy, but the reality of the situation is …
The All Seasons Portfolio reports amazing statistics about its returns. I’d never heard of the All Seasons Portfolio, so had to check it out. As I’ll discuss in more detail, it is an asset allocation strategy with more than 50% of the portfolio allocated to US government bonds. In this current environment of low interest rates, one of my followers asked my opinion of the portfolio as an investment strategy for the near future. The answer is, as is almost always the case, it depends. However, after studying the portfolio and relevant data, I won’t be aligning my portfolio with the All Seasons Portfolio.
In this post, I’ll define the All Season Portfolio, talk about when each of the components of the portfolio is expected to perform well and provide a wide variety of statistics regarding its historical performance. I’ll also talk about the need to re-balance assets to stay aligned with the portfolio and the impact of income taxes on your investment returns. I’ll close with how I’ve changed my portfolio based on this analysis.
All Seasons Portfolio
Ray Dalio is an extremely successful hedge fund manager. If you have more than $5 billion in investable assets, he might consider accepting you as a client. His fund is famous for the All Weather investment strategy. According to Tony Robbins, in his book MONEY Master the Game, the annual returns on the All Weather portfolio exceed 21%!
Composition of Portfolio
In an interview with Robbins, Dalio described a much simpler version of the All Weather portfolio for the rest of us. This asset allocation is called the All Seasons portfolio. The allocation in the All Season portfolio is:
- 40% in Long-Term US Bonds (20+ years), using the iShares Barclays 20+ Year Treasury Bond fund (ticker symbol TLT)
- 15% in Intermediate US Bonds (7-10 years), using the iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF)
- 7.5% in Gold, using the SPDR Gold Trust (ticker symbol GLD)
- 7.5% in Commodities, using the PowerShares DB Commodity Index Tracking fund (ticker symbol DBC)
- 30% in the S&P 500
This allocation is illustrated in the pie chart below.
The portfolio’s name, All Seasons, refers not to the four seasons of the calendar year but to four indicators of the economic cycle. These four indicators are:
- Higher than expected growth (often measured using gross domestic product or GDP)
- Lower than expected growth
- Higher than expected inflation (often measured using the consumer price index or CPI)
- Lower than expected inflation
I note that there is overlap between the first pair of characteristics and the second pair. That is, a period of higher than expected growth can have either higher or lower than expected inflation.
The chart below shows which of the five components of the portfolio are expected to perform well in each part of the economic cycle, according to Robbins.
According to Robbins, the All Seasons portfolio had a compounded annual average return of 9.7%, net of fees, from 1984 to 2013. By comparison, I calculate the corresponding value for the S&P 500 to be 8.4%. In addition, the All Seasons portfolio had much lower volatility, with a standard deviation of 7.6%, as compared to the S&P 500 which had a standard deviation of 17%. So, at first glance, the All Seasons portfolio seems to be a terrific option – higher return for lower risk.
My Estimate of Returns
There are many challenges to calculating the returns on the All Seasons portfolio. I made many assumptions to better understand the returns, so do not consider the statistics I’ve calculated as accurate, but I think they are close enough to be informative.
The chart below shows the annual returns on the S&P 500 and my approximation of the returns on the All Seasons portfolio from 1963 to 2019.
From this graph, it appears that the biggest benefit of the All Seasons portfolio is that the non-S&P 500 asset classes diversify away a substantial portion of the significant negative returns on the S&P 500. For example, in the three years in which the S&P 500 had returns worse than -20%, I approximated that the All Seasons portfolio lost an average of only 0.1%!
Returns by Asset Class
I wasn’t able to get a long enough history of Commodity price data, but was able to calculate the average return on the three other asset classes during those same years (1974, 2002 & 2008), as shown in the table below.
|Asset Class||Average Return in Years when S&P 500 Return was < -20%|
|7-10 Year US Treasury Bonds||8.0%|
|20 Year US Treasury Bonds||15.2%|
As can be seen, all three asset classes had positive returns in those three years, with Gold having the most significant increase.
My Investing Goals
I retired a little over two years ago, so have changed my investing goals to make sure I can meet my cash needs as I don’t have any earned income to cover my expenses. Specifically, now that I’ve switched from the accumulation phase to the spending phase, I have less tolerance for volatility.
Goals While Accumulating
While I was accumulating assets, I wanted my invested asset portfolio to produce returns that were at least as high as the overall market. I use the S&P 500 as my metric for market performance. During that time, I was quite willing to tolerate the ups and downs of the market because I was diversifying my risk over time. As a confirmation of my risk tolerance, I point out that I did not sell any assets during any of the market “crashes.”
My first market crash was October 19, 1987. I can still remember being in the office that day. The internet was not available to the general public, so our news came from TV and radio. One of the senior people in the office had a TV in his office, though I suspect it had just the over-the-air channels as very few people had cable TV then either. He told everyone what was happening in the market. I asked him whether he was going to move his 401(k) money out of the market into a safer fund. His advice was that it was already too late and that I should just hang on for the ride. That was one of the best pieces of investing advice I’ve ever gotten. I didn’t sell during that crash and haven’t sold during any of the crashes since.
Goals While Retired
Now that I’m retired, I am drawing down my assets. I’ve made two changes to my asset mix to reflect the fact that I now need to spend my assets rather than add to them.
- Instead of having a six-month emergency fund in cash, I now have several years of expenses in cash.
- I’ve added a few individual corporate bonds (to be clear, not a bond fund) that mature in 3 to 5 years to my portfolio. When these bonds mature, they will add to my cash balance to cover my expenses in those years.
For the rest of my invested asset portfolio, I’ve maintained the same goal – meet or beat the S&P 500.
By having several years of expenses in cash, I know I won’t have to sell any assets during any market turmoil, such as we are experiencing now. As discussed in my post on reacting to the most recent crash, the market has historically recovered in less than five years (excluding the crash of 1929) and has higher than average returns during the recovery phase. As such, I don’t want to have to sell stocks when markets are down.
How I Evaluate the All Seasons Portfolio
As I said, my goal is to earn a return close to or higher than the return on the S&P 500. I would be willing to take a small reduction in return for less risk, but not much given the other aspects of my strategy. Therefore, I will look at the components of the All Seasons portfolio relative to what I can earn if I just invest in the S&P 500.
In particular, I am interested to see how these asset classes perform when interest rates are low, as they currently are.
Returns on bonds (unless held to maturity) and bond funds have the following characteristics:
- The total return is equal to the interest rate on the bond plus the change in market value from changes in interest rate levels.
- Returns are higher when interest rates are high or are going down.
- The total return is similar to the interest rate itself when interest rates stay fairly stable.
- Returns are lower when interest rates are low or are increasing.
Bond Returns vs. Interest Rate Changes
This relationship can be seen in the chart below which compares the change in the 10-year US Treasury bond interest rate (yield) with the change in the market value of iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF) in each year from 2003 through 2019.
What Can Happen from Here
We are currently in the last situation listed above. Interest rates are currently quite low by historical standards. The chart below which shows the yield on the 10-year US Treasury bond from 1962 to 2020. The last point on the chart is the interest rate on July 8, 2020 of 0.65%. It is lower than the interest rate at the end of any year since 1962.
For all intents and purposes, interest rates can do one of two things from their current levels – stay about the same or go up. If they stay the same, the return on bonds funds will be about the same as the interest rate on the bonds – currently less than 1% for 10-Year US Treasury bonds and less than 1.5% for 30-Year US Treasury bonds. If interest rates go up, the market value of the bonds will go down and returns will be even lower.
As such, I don’t believe the returns on bonds or bond funds in the near term will be high enough to be consistent with my investing objectives. I will continue to buy individual corporate bonds that mature in the next few years to ensure that I have cash available to meet my expenses. But, I do not plan to add any bond funds to the investment portion of my portfolio. If I were younger and the time until I needed to draw down my investments to cover my expenses was longer, I wouldn’t invest in bonds at all in the current environment.
I am particularly interested in how gold has behaved, as it isn’t something I’ve studied much. For the current environment, I’m interested in how gold behaves when interest rates are flat or rising. The chart below shows how I defined historical periods as having interest rates that are either flat or rising.
The line is the same line shown in the 10-Year Treasury Interest Rate chart above. I have shaded periods in which interest rates have been relatively stable in blue. The time periods in which interest rates have increased are highlighted in green.
The chart below has the same time periods shaded as the previous chart, but the blue line shows the percentage change in the price of gold between 1971 (when the price of gold was no longer set by the US government) and today.
Looking back to the 1970s, gold prices were generally up quite significantly when interest rates were either relatively flat and when they increased. While the increases in price were not as large in the period from 2003 to 2006, another time period when interest rates were flat, as in the 1970s, annual price increases were still generally in the 10% to 30% range, much higher than would be expected on the S&P 500. Only in the most recent flat period are changes in gold prices not as consistently high.
Buying gold means that you have to find a way to take delivery of it or pay to have it stored. One article about the All Seasons fund suggested investing in SPDR Gold Shares (ticker symbol GLD) which is an exchange-traded fund (ETF) physically backed by gold. I compared the changes in prices of this ETF with the changes in the price of gold. Although they generally track each other, as shown in the chart below, they are not a perfect match. Nonetheless, this ETF appears to be a much easier alternative for investing in gold than buying gold itself.
I wasn’t able to get a long history of returns on commodities, but the table I provide earlier from Robbins’ book indicates that they are expected to behave in a manner similar to gold.
Overall Portfolio Evaluation
The chart below summarizes the annual average returns (on a compounded basis) for each of the asset classes for which I could approximate returns from 1963 to 2019.
Over this time period, it appears that Gold has had returns similar to that of the S&P 500, but the returns on US Treasuries have dragged down my estimate of the returns on the All Seasons portfolio.
I am particularly interested in how these asset classes perform when interest rates are either flat or increasing. The chart below illustrates these returns using the same approximations as above.
In average in both rising and flat interest rate environments, gold has historical outperformed the S&P 500. By comparison. both categories of bonds have underperformed and, in fact, have had average returns during those periods of roughly 0%.
The performance metrics reported by Robbins and others assume that you maintain the target mix in each asset class. To accomplish that, you need re-balance regularly. That is, you need to to sell asset classes that have appreciated the most (or depreciated the least) and buy asset classes that have not performed as well.
What is Re-Balancing
Let’s look at an example. At the beginning of a year, you invest $10,000 using the All Seasons portfolio. Your portfolio looks like this:
If your one-year returns were similar to those in 2019, your end of year asset allocation (light green) would not be the same as your target (dark green), as shown in the graph below.
To reach the target allocation, you would need to make the following changes.
|Medium Term Bonds||Buy $399|
|Long Term Bonds||Buy $67|
To attain the high returns reported by Robbins, I suspect you need to re-balance the portfolio fairly often. In my calculations, I assumed annual re-balancing on the first of each year. How often you re-balance the portfolio depends on your personal preference, but should generally be more often when the prices of one or more of the asset classes is changing rapidly and no less often than annually.
Impact of Income Taxes
It is better to own portfolios you need to re-balance regularly in a tax-free or tax-deferred account. Otherwise, you will need to pay income taxes on the net of your capital gains and capital losses. 401(k)s and IRAs are the most common tax-free and tax-deferred accounts in the US. The Canadian counterparts are TFSAs and RRSPs.
Continuing the example above, you sell $44 of gold and $451 of stocks for a total of $495. Without going into the details of the calculation, your cost basis for these two sales combined is $387, for a realized capital gain of $108. Many Americans have a 10% tax rate on capital gains which corresponds to $11 on the capital gain of $108. These taxes reduce your total return by 0.1 percentage point. That might not sound like much, but it can add up. If you make a $10,000 investment in this portfolio and taxes reduce your return from 10.0% to 9.9%, you will have $5,000 less after 30 years. That’s half of the amount of your initial investment!
Changes I’ll Make to My Portfolio
The analysis presented in this post has refined my thinking about my portfolio in two ways.
First, I have confirmed my past thinking that I can maintain a substantial cash position, supplemented by some individual bonds held to maturity, as a hedge against the risk that the stock market will have a significant downturn. Although holding several years of expenses in cash lowers the return on my total assets, I find it a much easier and less risky strategy than introducing bond funds into my portfolio. That is, although the return on money market funds where I hold my cash is low, it isn’t much lower than the current returns on US treasury or even high-quality corporate bonds. With the significant potential that the market price of bonds will go down, I am more comfortable with my cash position.
Second, I have invested in the SPDR Gold Trust (ticker symbol GLD). I don’t plan to immediately move as much as the 7.5% of my portfolio into gold as suggested by the All Seasons portfolio (15% if I use gold as a substitute for commodities, too). Rather, I plan to initially invest 1% to 2% of my portfolio in gold and add to that position as I gain more comfort and experience investing in it.
 Robbins, Tony, MONEY Master the Game, Simon & Schuster Paperbacks, 2014, p. 391-392.
 Robbins, op. cit., p. 390
 Robbins, op. cit., p. 395.
 There are many components of the calculation of returns, including assumptions regarding frequency of reinvestment and fees and the choice sources of data used to calculate the returns of the components of the portfolio. As such, I am not able to replicate his calculations. In fact, I found another source for returns on the All Seasons portfolio that, in the single year for which details were provided both sources, shows a return that was 3 percentage points higher than reported by Robbins.
 “Historical Gold Prices.” CMI Gold & Silver, Inc, https://onlygold.com/gold-prices/historical-gold-prices/, Accessed July 7, 2020.
 As indicated above, the returns I calculated for the All Seasons portfolio are not as high as were calculated by Robbins.
A friend of mine really likes selecting stocks with a score, the Piotroski score in particular. Briefly, Professor Piotroski created a set of nine financial ratios that contribute to the score. If a company meets a certain criterion and has favorable results on 8 or …
Technical analysts select companies for their portfolios based on patterns in stock prices. That is, it allows them to enhance their process of picking stocks by using pictures. This approach is very different from some of the others I’ve discussed, as buy and sell decisions …
Stocks are a common choice for many investors. There are two types of stocks – preferred and common. Because most investors buy common stocks, they will be the subject of this post. I’ll talk about what you need to know about stocks before you buy them, including:
- Stocks and how they work.
- The price you will pay.
- The risks of owning stocks.
- Approaches people use for selecting stocks.
- How stock are taxed.
- When you might consider buying stocks.
- How to buy a stock.
What are Stocks?
Stocks are ownership interests in companies. They are sometimes called equities or shares. When you buy a stock, you receive a certificate that indicates the number of shares you own. If you buy your investments through a brokerage firm, it will hold your certificates for you. If you buy them directly, you will usually receive the certificate (and will want to maintain it in an extremely safe place as it is your only proof that you own the stock). Some companies track their stock’s owners electronically, so you may not always get a physical certificate.
How Do Stocks Work?
Companies sell stock as a way to raise money. The company receives the amount paid for the shares of stock when they are issued, minus a fee paid to the investment banker that assists with the sale. The process of issuing stock is called a public offering. The first time a company offers its shares to the public, it is called an initial public offering (IPO).
After the stock has been sold by the company, the stockholder has the following interactions with the company:
- It receives any dividends paid by the company.
- It gets to vote on matters brought before shareholders at least annually. These issues include election of directors, advisory input on executive compensation, selection of auditors and other matters.
- It has the option to sell the stock back to the company if the company decides to repurchase some of its stock.
In addition to these benefits of owning stock, you also can sell it at the then-current market price at any time.
Why Companies Care About Their Stock Prices
Interestingly, after the stock has been sold by the company, future sales of the stock do not impact the finances of the company other than its impact on executive compensation. That is, if you buy stock in a company other than when it is issued, you pay for the stock and the proceeds go to the seller (who isn’t the company)!
You might wonder, then, why a company might care about its stock price. That’s where executive compensation comes in! Many directors and senior executives at publicly traded companies have a portion of their compensation either paid in stock or determined based on the price of the company’s stock. When the leadership owns a lot of stock or is paid based on the stock price, it has a strong incentive to act in a way that will increase the price of the stock. As such, with appropriate incentive compensation for directors and executives, their interests are more closely aligned with yours (i.e., you both want the price of the company’s stock to go up).
What Price Will I Pay?
The price you will pay for a stock is the amount that the person selling the stock is willing to take in payment. Finance theory asserts that the price of a stock should be the present value of the cash flows you will receive as the owner of a stock.
In my post on bonds, I explain present values. They apply fairly easily to the price of a bond, as the cash flows to the owner of a bond are fairly clear – the coupons or interest payments and the return of the principal on a known date.
By comparison, the cash flows to the owner of a stock are much more uncertain. There are two types of cash flows to the owner of a stock – dividends and the money you receive when you sell the stock.
Dividends are amounts paid by the company to stockholders. Many companies pay dividends every quarter or every year. In most cases, the amount of these dividends stay fairly constant or increase a little bit every year. The company, though, is under no obligation to pay dividends and can decide at any time to stop paying them. As such, while many people assume that dividends will continue to be paid, there is more uncertainty in whether they will be paid than there is with bond interest.
Proceeds from the Sale of the Stock
The owner of the stock will receive an amount equal to the number of shares sold times the price per share at the time of sale. This cash flow has two components of uncertainty to it.
- You don’t know when you will sell it. You therefore don’t know for how long you need to discount this cash flow to calculate the present value.
- It is impossible to predict the price of a stock in the future.
I find figuring out when to sell a stock one of the hardest aspects of investing. I can get excited about investing in a company, but waffle on when to sell. Brandon Smith, founder of Launchpad Finance, provides seven indicators that it is time to sell a stock in this post. These indicators are important if you decide to let your winning stocks run rather than trim your positions in them.
What are the Risks?
The biggest risk of buying a stock is that its value could decrease. At the extreme, a company could go bankrupt. In a bankruptcy, creditors (e.g., employees and vendors) are paid first. If there is money left after creditors have been paid, then the remaining funds are used to re-pay a portion of any bond principal. By definition, there isn’t enough money to pay all of the creditors and bondholders when there is a bankruptcy. As such, the bondholders will not get all of their principal re-paid and there will be no money left after payment has been made to bondholders and creditors. When there is no money left in the company, the stock becomes worthless.
Any of the following factors (and others) can cause the price of the stock to go down.
Economic Conditions Change
Changes in economic conditions can cause the interest rate used for discounting in the present value calculation to increase. When the interest rate increases, present values (estimates of the price) will go down.
Something changes at the company that causes other investors to believe that the company’s profits will be less than previously expected. One simple way that some investors estimate the price of a company’s stock is to multiply the company’s earnings by a factor, called the price-to-earnings ratio or P/E ratio. Although P/E ratios aren’t constant over time, the price of a stock goes down when its earnings either decrease or are forecast to be lower than expected in the future. For more about P/E ratios and how a company calculates and reports on its earnings, check out this post
Changes either in the economy or at the company can cause investors to think that the future profits of the company are more uncertain, i.e., riskier. When a cash flow is perceived to be riskier, a higher interest rate is used in the present value calculation. This concept is illustrated in my post on bonds in the graph that shows how interest rates on bonds increase as the credit rating of the company goes down. Recall that lower credit ratings correspond to higher risk. The same concept applies to stock prices. The prices of riskier stocks are less than the prices of less risky stocks if all other things are equal.
Trends in the Market
In January 2021, the price of several companies’ stock sky-rocketed initially triggered by retail investors buying stocks in which institutional investors had taken big bets that the price would go up. Those stock prices may go down just as quickly as they went up. It is important to understand why a stock price is increasing before you buy.
How Do People Decide What to Buy?
There are a number of approaches investors use to decide in which companies to buy stocks and when to buy and sell them. I will discuss several of them in future posts.
Reasonable Price Investing
Reasonable price investors look at the financial fundamentals and stock prices of companies to decide whether and when to buy and sell them.
Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks. To do so, they read stock charts. Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.
Some investors focus on companies who issue dividends.
Rather than invest in individual companies, some investors purchase either mutual or exchange-traded funds. Under this approach, the investor relies on the fund managers to select the companies and determine when to buy and sell each position.
A great way to get started with investing or expand your research is to join an investing club. They provide the opportunity to pool your money with other investors to buy positions in individual companies that the group has resourced. In addition, you get to know other people with interests similar to yours.
Turnaround plays (companies that have struggled but are about to become successful) can produce some of the highest returns in the market. However, identifying companies that will actually be successful under their new strategies is difficult. As such, investing in turnaround plays can also be quite risky. The Piotroski score is one tool that can be helpful in identifying companies that are more likely to produce above-market-average returns.
How are Stocks Taxed?
There are two ways in which stocks can impact your income taxes:
- When you receive a dividend.
- When you sell your ownership interest in the stock.
The total amount of the dividend is subject to tax. The difference between the proceeds of selling the stock and the amount you paid for the stock is called a realized capital gain or loss. It is gain if the sale proceeds is more than the purchase amount and a loss if the sale proceeds are less than the purchase amount.
In the US, realized capital gains and losses on stocks you have owned for more than a year are added to dividends. For most people, the sum of these two amounts is taxed at 15%. For stocks owned for less than a year, the realized capital gains are taxed at your ordinary tax rate (i.e., the rate you pay on your wages).
In Canada, dividends and half of your realized capital gains are added to your wages. The total of those amounts is subject to your ordinary income tax rate.
When Should I Buy Stocks?
The most important consideration in determining when to buy stocks is that you understand how stocks work. One of the messages I wished I had given our children is to invest only in things you understand. If you don’t understand stocks, you don’t want to invest in them.
Understand the Companies or Funds
You also want to make sure you understand the particular company or fund you are purchasing. One of the biggest investing mistakes I made was when I was quite young and didn’t understand the business of the company whose stock I owned.
My parents gave me some shares of a company called Wang Laboratories. In the 1970s and early 1980s, Wang was one of the leaders in the market for dedicated word processors. Picture a desktop computer with a monitor that’s only software was Microsoft Word, only much harder to use. That was Wang’s biggest product. At one time, the stock price was $42. Not understanding that PCs were entering the market and would be able to do so much more than a dedicated word processor, I was oblivious.
As the stock started going down, I sold a few shares in the high $30s. When the stock dropped to $18, I told myself I would sell the rest when it got back to $21. It never did. A year or so later, the stock was completely worthless. Fortunately, I was young enough that I had a lot of time to recover and learn from this mistake.
Understand and Be Able to Take the Risk
You should also not buy stocks if you can’t afford to lose some or all of your principal. Even though only a few companies go bankrupt, such as Wang, the price of individual stocks can be quite volatile. As discussed in my post on diversification, you can reduce the chances that your portfolio will have a decline in value by either owning a large number of stocks or owning them for a long time. Nonetheless, you might find that the value of your portfolio is less than the amount you invested especially over short periods of time when you invest in stocks. If you want to invest in stocks, you need to be willing to tolerate those ups and downs in value both mentally and financially.
There is an old investing adage, “Buy low, sell high.” In principle, it is a great strategy. In practice, though, it is hard to identify the peaks and valleys in either the market as a whole or an individual stock.
People who invest over very short time frames – hours or days – often use technical analysis to try to identify very short-term highs and lows to create gains. I anticipate that most of my followers, though, will be investing for the long term and not day trading. While you will want to select stocks that are expected to produce a return commensurate with their riskiness, it is very difficult to time the market.
That is, my suggestion for new investors with long-term investment horizons (e.g., for retirement or your young children’s college expenses) is to buy stocks or mutual funds you understand and think are likely to appreciate whenever you have the time and money available to do so. If you happen to buy a fundamentally sound stock or index fund just before its price drops, it will be difficult to hang on but it is likely to increase in the price by the time you need to sell it.
As Chris @MoneyStir learned when he reviewed the post I wrote about whether he should pre-pay his mortgage, a fall in the stock market right after he started using his extra cash to buy stocks on a monthly basis was actually good for him! While he lost money at first on his first few month’s investments, the ones he made over the next several months were at a lower stock price and produced a higher-than-average return over his investment horizon. The process of buying stocks periodically, such as every month, is called dollar-cost averaging.
How and Where Do I Buy Stocks?
You can buy stocks, mutual funds and ETFs at any brokerage firm. This article by Invested Wallet provides details on how to open an account at a brokerage firm.
Once you have an account, you need to know the name of the company or its symbol (usually 2-5 letters that can be found using Google or Yahoo Finance, for example), how many shares you want to buy and whether you want to set the price at which you purchase the stocks, use dollar-cost averaging to purchase them over a period of time or buy them at the market price.
If you determine you want to buy a stock at a particular price, it is called a limit order. The advantage of a limit order is you know exactly how much you will pay. The disadvantages of a limit order are:
- You might pay more than you have to if the stock price is lower at the time you place your order.
- You might not buy the stock if no one is interested in selling the stock at a price that is a low as your desired purchase price.
If you place a market order, you will buy the stock at whatever price sellers are willing to take for their stock at the moment you place your order. In some cases, you may end up paying more than you want for a stock if the price jumps up right at the time you place your order. The advantages of a market order are (1) you know you will own the stock and (2) you know you are getting the best price available at the time you buy the stock.
Many of the major brokerage firms have recently announced that they will no longer charge you each time you purchase or sell a stock. Some firms charge you small transaction fees, such as $4.95, each time you place a buy or sell order. Other firms have higher charges. You’ll want to consider the fees when you select a brokerage firm.