Why I Chose Patience over Re-balancing

Many financial advisors recommend re-balancing your portfolioA group of financial instruments. no less often than annually to ensure the asset allocation is consistent with your risk tolerancePersonal preference indicating how much risk you are willing to take to achieve a higher return., as illustrated in this post from Schwab. In the past, I haven’t been one to re-balance my portfolioA group of financial instruments., so I spent some time thinking about why I haven’t followed this common advice. Up until recently, almost all of my invested assetsThe value of things the company owns and amounts it is owed have been equities, equity-based mutual funds or exchange-traded funds (ETFs). As such, I didn’t need to do any re-balancing across asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More.

In this post, I’ll explain re-balancing, its specific purpose and examples of its benefits and drawbacks. I’ll also explain my strategy (which may or may not be right for you).

What is Re-balancing?

Re-balancing is the process of buying and selling securities in your portfolioA group of financial instruments. to meet certain targets. In the case of asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More, the primary purpose of re-balancing is to maintain your target riskThe possibility that something bad will happen./reward balance.

Some people have targets that define their desired allocation across asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More. One common rule of thumb is that the portion of your portfolioA group of financial instruments. that should be in bonds is equal to your age with the rest in stocks. In my case, that would mean roughly 60% of my portfolioA group of financial instruments. in bonds and 40% in stocks. The goal of this rule of thumb is to decrease the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. of your investment returns as you get older and closer to that age at which you need to draw down your assetsThe value of things the company owns and amounts it is owed in retirement.

How Does Re-balancing Work?

The process of re-balancing is fairly simple. Periodically, such as once or twice a year, you compare the market value of your investments with your targets. If there is a significant difference between how much you own in an asset classA group of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors a... More and your target percentage, you sell the portion of your investments that is above the target and reinvest the proceeds in something different.

Let’s say your target is 75% stocks and 25% bonds. You start the year with $10,000 of investments – $7,500 in stocks and $2,500 in bonds. If stocks go up by 10% and bonds go up by 5%, your year-end balances will be $8,250 in stocks and $2,625 in bonds, for a total of $10,875. Your targets though are $8,156 of stocks (75% of $10,875) and $2,719 of bonds. To put your portfolioA group of financial instruments. back in balance, you would need to sell $94 (= $8,250 – $8,156) of stocks and buy $94 of bonds.

You can avoid selling any assetsThe value of things the company owns and amounts it is owed if you have money to add to your investments at the end of the year. Continuing the example, let’s say you have another $500 available to invest at the end of the year. That brings your total available for investment to $11,375 (= $10,875 of investments plus $500 cash). Your targets would be $8,531 (= 75% of $10,875) for stocks and $2,843 for bonds. In this case, you would buy $281 of stocks and $219 of bonds to meet your targets, eliminating the need to sell any of your assetsThe value of things the company owns and amounts it is owed.

What Does Asset Allocation Do?

The chart below compares the average annual returns and riskThe possibility that something bad will happen. profiles of several sample portfolios with different mixes between stocks and bonds. In the middle four portfolios, the first number is the percentage of the portfolioA group of financial instruments. invested in stocks and the second number is the percentage in bonds.

Average Returns

In this chart, the average annual return is represented by the blue dash. When the blue dash is higher on the chart, it means that the returns on the portfolioA group of financial instruments. were higher, on average, over the historical time period.

Volatility

The green boxes correspond to the ranges between the 25^th percentileThe value below which a stated percent of observations fall. For example, 25% of the observations fall below the value corresponding to the 25thpercentile. and the 75^th percentileThe value below which a stated percent of observations fall. For example, 25% of the observations fall below the value corresponding to the 25thpercentile.. The whiskers (lines sticking out of the boxes) correspond to the ranges from the 5^th percentileThe value below which a stated percent of observations fall. For example, 25% of the observations fall below the value corresponding to the 25thpercentile. to the 95^th percentileThe value below which a stated percent of observations fall. For example, 25% of the observations fall below the value corresponding to the 25thpercentile.. When the box is tall and/or the whiskers are long, there is a lot of volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results.. In this case, it means that the annual return on the portfolioA group of financial instruments. varied a lot from one year to the next. At the opposite end of the spectrum, when the box and whiskers are all short, the range of returns observed historically was more consistent.

Comparison of Portfolios

I have arranged the portfolios so that the one with the most volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. – 100% in the S&P 500 – is on the left and the one with the least volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. – 100% in bonds as measured by the Fidelity Investment Grade BondA form of debt issued by government entities and corporations. Fund (FBNDX) – is on the right. You can see how adding bonds to the S&P 500 reduces volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. as the height of the boxes and whiskers gets smaller as you move from left to right. At the same time, the average annual returns decrease as bonds are added to the portfolioA group of financial instruments.. Over the time period studied (1980 to 2019), the S&P 500 had an average annual return of 8.7% while the BondA form of debt issued by government entities and corporations. Fund had an average annual return of 7.2%. By comparison, returns on investment grade bonds are currently generally less than 4%.

Another Perspective

Because stocks and bonds are not 100% correlated, the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. (spread between tops and bottoms of boxes and whiskers) of owning a combination of both is less than the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. of owning just the riskier asset – stocks. As I was preparing the chart above, I noticed, though, that the bottom whisker for the 100% bonds portfolioA group of financial instruments. goes lower than the bottom whisker for the 80% bonds portfolioA group of financial instruments..

Specifically, there were more negative returns in the historical data (i.e., more years in which you would have lost money in a single year) if you owned just bonds than if you owned the portfolioA group of financial instruments. with 80% bonds and 20% stocks. The 80% bondA form of debt issued by government entities and corporations. portfolioA group of financial instruments. had a negative return only 7.5% of the time while the 100% bonds portfolioA group of financial instruments. had a negative return 10% of the time! As more bonds are added to each portfolioA group of financial instruments., the blue bar/average moves down. This downward shift actually moves the whole box and the whiskers down.

This relationship can be seen in the chart below.

The dots correspond to the portfolios in the previous chart with labels indicating the percentages of stocks in the portfolios. The horizontal or x-axis on this chart represents the average annual return. Values to the right correspond to higher average annual returns (which is good). The vertical or y-axis represents the percentage of years with a negative return. Values that are higher on the chart correspond to portfolios with more years with negative returns (which is bad).

Optimal Portfolios

“Optimal” portfolios are those that are to the right (higher return) and/or lower (fewer years with negative returns). Any time a point is further to the right and at the same level or lower than another one, that portfolioA group of financial instruments. better meets your objectives if probabilityA percentage or the equivalent fraction that falls between 0% and 100% (i.e., between 0 and 1) that represents the ratio of the number of times that the outcome meets some criteria to the number of po... More of having a negative return is your riskThe possibility that something bad will happen. metric.

More Stocks Can Be Less Risky

I have circled two pairs of dots. The ones in the lower left corner are the two I’ve mentioned above. The 20% stocks (80% bonds) point is lower than and to the right of the 0% stocks (100% bonds) point. As you’ll recall, the average return on the 20% stocks portfolioA group of financial instruments. is higher than the average return on the all-bond portfolioA group of financial instruments. so the dot is to the right (better). The percentage of the time that the annual return was less than zero was smaller for the 20% stocks portfolioA group of financial instruments. so the dot is lower (also better).

There is a somewhat similar relationship between the 60% and 80% stocks portfolios (circled in green in the upper right). The 80% stocks point is at the same level and to the right of the 60% stocks point. As such, if average annual return and probabilityA percentage or the equivalent fraction that falls between 0% and 100% (i.e., between 0 and 1) that represents the ratio of the number of times that the outcome meets some criteria to the number of po... More of a negative return are important metrics to you, moving from 80% to 60% stocks or 20% to 0% stocks would put you in a worse position as you would have less return for the same riskThe possibility that something bad will happen..

Re-balancing Can’t Be Done Blindly

Setting a target asset allocation, such as 80% stocks and 20% bonds, allows you to target a riskThe possibility that something bad will happen./reward mix that meets with your financial goals. As I indicated, the purpose of re-balancing is to ensure that your portfolioA group of financial instruments. is consistent with your goals. However, it is important that you considering the then-current economic environment when re-balancing.

Interest Rates

For example, interestA charge for borrowing money, most often based on a percentage of the amount owed. rates are lower than they were at any point in the historical period used in the analysis above. Over the next several years, interestA charge for borrowing money, most often based on a percentage of the amount owed. rates are unlikely to decrease much further, but could stay flat or increase. If interestA charge for borrowing money, most often based on a percentage of the amount owed. rates stay flat, the returns on bondA form of debt issued by government entities and corporations. funds will tend to approach the average couponThe interest payment on a loan. rate of bonds which is in the 1% to 3% range depending on the quality and time to maturity of the bonds held. This range is much lower than the average annual return of 7.2% in the illustrations above.

If interestA charge for borrowing money, most often based on a percentage of the amount owed. rates go up, the market price of bonds will go down, lowering returns even further. As such, the risk-reward characteristics of bonds change over time. I would characterize them as having lower returns and higher riskThe possibility that something bad will happen. (the one-sided riskThe possibility that something bad will happen. that prices will go down as interestA charge for borrowing money, most often based on a percentage of the amount owed. rates go up) now than over the past 40 years.

Stock Prices

Similarly, the S&P 500 is currently close to or at its highest level ever in a period of significant economic and political uncertainty. While I don’t have a strong opinion on the likely average annual returns on the S&P 500 in the next few years, I think it is likely to be more volatile in both directions than it has in the recent past.

If you re-balance your portfolioA group of financial instruments., you will want to form your own opinions about the average returns and volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. of the asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More in which you invest. With these opinions, you can decide whether the asset allocation you’ve held historically will still provide you with the riskThe possibility that something bad will happen./reward profile you are seeking.

Re-balancing and Income Taxes

Another consideration when you are deciding whether and how often to re-balance your portfolioA group of financial instruments. is income taxes. Every time you sell a security in a taxable account, you pay income taxes on any capital gains. If you lose money on a security, the loss can offset other capital gains. On the other hand, if you own the securities in a tax-free (Roth or TFSAA type of Defined Contribution Plan available in Canada. Contributions are made with after-tax dollars, but no taxes are paid on any changes in the market value of the investments in the account or wh... More) or tax-deferred (traditional or RRSPA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More) account, re-balancing has no impact on your taxes.

Re-balancing Example

Let’s look at an example of the taxable account situation. If you targeted a portfolioA group of financial instruments. of 60% stocks (in an S&P 500 index fundA type of exchanged-traded fund (ETF) or mutual fund that invests in such a way that the returns on the fund are identical or very close to a market index. For example, an S&P 500 index fund wou... More) and 40% bonds (in FBNDX) from 1980 through 2019, you would have made the transactions shown in the chart below.

In this chart, the bars represent the amount of the transaction as a percentage of the amount of stocks held at the beginning of the year. A bar that goes above zero indicates that you would have bought stocks in that year. A bar that goes below zero indicates that you would have sold stocks in the year. The proceeds from every sale would have been used to purchase the bondA form of debt issued by government entities and corporations. fund. Similarly, the money used to purchase stocks would come from a corresponding sale of the bondA form of debt issued by government entities and corporations. fund.

In every year, you either sell some of the stock index fundA type of exchanged-traded fund (ETF) or mutual fund that invests in such a way that the returns on the fund are identical or very close to a market index. For example, an S&P 500 index fund wou... More or the bondA form of debt issued by government entities and corporations. fund. The difference between the price at which you sell a security and the price at which you buy it is called a capital gain. You pay income taxes on the amount of capital gains when they are positive. In the US, many people pay a Federal tax rate of 15% on capital gains in addition to any state income taxes. The Canadian tax rate on capital gains is of about the same order of magnitude.

Reduction in Return from Income Taxes

Income taxes, assuming a 15% tax rate, would have reduced your annual average return from 8.4% to 8.1% over the 1980-2019 time period. Put in dollar terms, you would have had just under $250,000 at the end of 2019 if you started with $10,000 in 1980 and used this asset allocation strategy if you didn’t have to pay income taxes. By comparison, you would have had about $220,000 if you had to pay income taxes on the capital gains, or 12% less.

As you consider whether re-balancing is an important component of your financial plan, you’ll want to make sure you understand the impact of any income taxes on your investments returns.

Why Only Equities?

You may have been wondering why I was invested almost solely in equities for all of my working life and not in a combination of asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More, such as stocks and bonds. My philosophy was that I preferred to use time to provide a diversificationThe reduction in volatility created by combining two or more processes (such as the prices of financial instruments) that do not have 100% correlation. benefit rather than an array of asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More. By keeping my invested assetsThe value of things the company owns and amounts it is owed in stocks, I was able to take advantage of the higher expected returns from stocks as compared to bonds.

The chart below helps to illustrate this perspective.

It compares the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. of the annual return on a portfolioA group of financial instruments. of 100% stocks over a one-year time period with the same portfolioA group of financial instruments. over five years and with a portfolioA group of financial instruments. of 60% stocks and 40% bonds over one year.

The blue bars on the first and second bars (100% stocks for one year and five years, respectively) are at the same level, meaning they had the same average annual return. Both the box and whiskers on the second bar are much more compact than the first bar, indicating that the annual returns fell in a much narrow range when considered on a five-year basis rather than a one-year basis.

Cost-Benefit Comparison

Comparison of the first and third bars highlights the cost and benefits of diversifying across asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More. The box and whiskers on the 60/40 portfolioA group of financial instruments. are both shorter than the 100% stock portfolioA group of financial instruments.. That is, there was less variation from year-to-year in the annual return for the 60/40 portfolioA group of financial instruments. than the 100% stock portfolioA group of financial instruments.. However, the average return (blue line) on the 60/40 portfolioA group of financial instruments. is a bit lower because the 60/40 portfolioA group of financial instruments. had an average annual return that was less than the 100% stock portfolioA group of financial instruments..

My Focus

The comparison on which I focused in selecting my investment strategy is the one between the second and third bars. That is, I compared the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. and average returns of a 100% stock portfolioA group of financial instruments. over five years with the volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. and average returns of a 60/40 portfolioA group of financial instruments. over one year. As can be seen, there has been less volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. in annual stock returns when considered in five-year time periods. Yet, the average return on stocks is higher than the average return on the blended portfolioA group of financial instruments.. Because I didn’t anticipate that I would need to draw down my investment portfolioA group of financial instruments., I was willing to look at riskThe possibility that something bad will happen. over longer time periods and tolerate the year-to-year fluctuations in stock prices in order to expect higher investment returns.

Your time horizon until you might need the money in your investment portfolioA group of financial instruments. and your willingness to wait out the ups and downs of the stock market are important considerations as you decide whether this strategy or a more traditional blended portfolioA group of financial instruments. is a better fit for you.

August 4, 2020August 22, 2020

7 Must-Know Stock Market Sell Signals

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 much more complex. When investors look to spend their hard earned cash on stock market investments, it is absolutely necessary that they buy stocks when they are relatively undervalued in comparison to the company or market as a whole. What investors need to assume is the fact that you make money at the price you buy at, not the price you sell. It is imperative as an investor that you understand both sides of the coin when it comes to buying and selling stocks. A breadth of knowledge in technical, fundamental, and psychological factors that affect stock prices will give you an edge.

How You Buy a Stock

Many factors can be used to help look for and find buying opportunities. When buying stocks, look for low price-to-earnings or P/E ratios relative to the industry average or a P/E ratioThe ratio of a company’s stock price (P) to its earnings per share (E). Earnings per share is approximately equal to the company’s net income divided by the number of shares it has outstanding. that is near the low of its five-year range. Find companies with strong earnings and ones that have an economic moat that will protect said earnings. Use short-, medium-, and long-term charts to identify if the stock has a history of growth. You’ll be surprised how many companies don’t make money or make less than before, and the stock chart usually reflects that. Finally look at the business you are interested in from afar. Is it growing? Does it change the world we live in positively? How does its competition look? Utilize everything you can when looking to buy stocks. Trades should be based on calculated riskThe possibility that something bad will happen.. Without that, you are gambling.

Stock Market Sell Signals

Now that we’ve discussed why we would buy a stock, let’s dive into why you should sell a stock. As the market moves, it’s important to keep an eye on how your company looks from a financial standpoint. Below we will discuss in detail some key fundamental metrics that could be used to signal that a stock is overvalued, also known as stock market sell signals.

Price-to-earnings (P/E)

The P/E ratioThe ratio of a company’s stock price (P) to its earnings per share (E). Earnings per share is approximately equal to the company’s net income divided by the number of shares it has outstanding. is used to show how expensive a stock is relative to the money it earns. The first check you can perform on any stock is to compare the stock in question’s P/E with the sector average. If the stock’s P/E is higher than the sector average, then the stock is relatively more expensive than the sector’s average and can be considered a sell signal. Some companies (typically tech companies) carry a high P/E due to the public pricing of future earnings. This is why the next step would be to compare the stocks P/E within a five-year range of its own P/E. If the stock is near the top of the five-year range, then it’s more overvalued than it has been in the last five years, which could be an indication to sell.

Next, with a word of caution we can look at the Forward P/E. I say with a word of caution because this is based on analysts’ expectations and guidance set by the company. Don’t forget these are educated guesses – they can be spot on or miss the mark completely. Typically, when the Forward P/E is higher next year than the current P/E, there is a projection of lower earnings. Most, if not all, investors should invest in companies projected to make more money quarter over quarter and year over year. This too could be used as a signal for when it’s time to sell a stock. With some simple yet advanced tactics, you can even project the stock price in a range for the next year. Want to learn how to do this? Click here: https://launchpadyourlife.com/learn-earn-retire-early-portfolio-builder/

Price-to-Book (P/B) Ratio

The price-to-book (P/B) ratio is a comparison between the market valuation and the book value of the company. A good buy point for any stock is a P/B under 1. But, when a stock’s P/B is higher than the sector average, then it’s relatively expensive. This comparison could be used to signal when to buy or sell depending on what the P/B is at, as well as how to compares to the industry average. Another word of caution – use this as a checkpoint and not a definitive buy/sell signal. Sometimes companies can window dress book value causing the P/B to appear lower than it really is, so again be cautious.

Earnings Per Share (EPS) Growth Next Year and Next 5 Years

Earnings per share (EPS) growth uses projected earnings to give us a glimpse into what may happen next year. This can also be used to understand trends. Is the company constantly growing its earnings? Is it stable, consistent growth? If the answer differs from its history, it could be one of our stock market sell signals. The importance of earnings growth is that the stock price inevitably follows earnings. Some newer companies could have growth based on expected future earnings, but the stock price generally reverts to the mean at some point – all based on the company’s actual earnings.

Debt Load Management

If a stock has a debt load, it is important to assess how management is handling it. Is management letting debt grow or paying it down faster than expected? The answer is important because a building debt load increases the interestA charge for borrowing money, most often based on a percentage of the amount owed. expenses the company will have and therefore affect the bottom line.

We want to focus on year-over-year changes in the debt/equity ratio as well as the long-term debt/equity ratio. We want these ratios to either be a low stable number relative to the industry average or we want to see that management is actively paying it down. In doing so, shareholders equity or the value of the shares you currently own will increase. When the opposite is happening, such as erratic or increasing debt loads, we should be concerned and possibly ready to sell. If you want to look at a year-over-year trend of these statistics, Charles Schwab has some great tools that come with its account. Below we can see the five-year trend in graphical form to the left, a definition of the ratio in the middle area, and the current value of the ratio to the right for a sample company.

Do you want to open a Charles Schwab account to access these awesome features? Click this link to sign up, it only takes minutes! http://www.schwab.com/public/schwab/nn/refer-prospect.html?refrid={REFID}

The Big Picture

Sometimes the best way to tell if it is time to sell a stock is to see if the story has changed.

Changes in Business

Before you ever invest in a company, it is imperative that you look at the business from every angle. It is necessary as an investor to know what you are buying and why you are buying it. You would not buy a car without test driving it, would you? Typically, you look at Consumer Reports, talk to people who have owned that car model, and look at safety ratings and mechanical flaws or misnomers. The same can be said for stocks – look for changes in the income statement, balance sheet, and statement of cashflows. When these things begin to change from your initial thesis, it may be a stock market sell signal.

Changes in Management

When management changes, it may be time to sell. Typically, stock prices fall when new management is announced because a different mindset is at the helm of the company. People may have the same goal, but different paths to reach said goal. The story can change on a multitude of levels. Even if the financials are still intact, if the story about who it is as a company or what it does has changed, it may be one of our stock market sell signals.

An example of this is the Chinese company, Lukin Coffee, which, from its financials, was poised to be the next Starbucks. It was later realized that the earnings were not as they seemed and they were forging financial documents. The stock tanked and has since been delisted from the NASDAQ. Sometimes you can see the smoke before the fire and get out of a stock, and sometimes you will have to get out while down to prevent a total loss. As a caution, though, a decrease in a stock price isn’t always a sell indicator. In fact, in some cases it may be a chance to buy more of the company’s stock. So, you’ll want to be sure to understand why the stock price has decreased.

Sector Rotation

The stock market moves in and out of sectors like the tides in the ocean based on the current point of the economic cycle. Understanding where money is moving in and out of could be used as a signal for when to sell a stock. The best way to grasp this concept is to take a step back and look at the overall economy. During times of fear, the best investments tend to be non-cyclical defensive positions like grocery stores and household goods. In a depression or economic contraction, you may not buy a new iPhone, but you will still buy bread and toothpaste for your family.

Many graphics can be found by googling ‘sector rotation’ to give you a better idea as to what are the best sectors to invest in based on the economic picture at hand. Trying to time the market tends to not be a successful strategy. The old saying goes, ‘time in the market is better than trying to time the market. Use sector rotation to either sell at right time or buy on the dips when the sectors rotate.

Portfolio Rebalancing/Profit taking

As you build your portfolioA group of financial instruments., if you invest in great companies, then eventually the underlying stock prices should rise. As those stock prices rise, the overall percentage that it takes up of your portfolioA group of financial instruments. rises as well. For most passive investors, any one stock should not take up more than 3-5% of your overall portfolioA group of financial instruments. to avoid company specific riskThe possibility that something bad will happen..

Closing Thoughts.

Now you have some stock market sell signals! Remember that you should only invest in what you know. When things start to change, do whatever you have to in order to protect your money and continue to grow your wealth. Good luck investing!

About the Author

Brandon Smith is the owner of Launchpad Finance – a financial education source for young adults and new investors. Brandon has been studying and trading in the stock market for over 6 years now, and has been interested in the markets since he was 12 years old. After graduating from The University of Houston with a BBA-Finance, he used his passion for the stock market to start Launchpad Finance to fuel others to have a passion for stock trading, as well as grasp of the value financial literacy in one’s own path to financial freedom.

July 21, 2020September 18, 2020

Why I Don’t Hold the All Seasons Portfolio

The All Seasons PortfolioA group of financial instruments. reports amazing statistics about its returns. I’d never heard of the All Seasons PortfolioA group of financial instruments., 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 portfolioA group of financial instruments. allocated to US government bonds. In this current environment of low interestA charge for borrowing money, most often based on a percentage of the amount owed. rates, one of my followers asked my opinion of the portfolioA group of financial instruments. as an investment strategy for the near future. The answer is, as is almost always the case, it depends. However, after studying the portfolioA group of financial instruments. and relevant data, I won’t be aligning my portfolioA group of financial instruments. with the All Seasons PortfolioA group of financial instruments..

In this post, I’ll define the All Season PortfolioA group of financial instruments., talk about when each of the components of the portfolioA group of financial instruments. 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 assetsThe value of things the company owns and amounts it is owed to stay aligned with the portfolioA group of financial instruments. and the impact of income taxes on your investment returns. I’ll close with how I’ve changed my portfolioA group of financial instruments. 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 assetsThe value of things the company owns and amounts it is owed, 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 portfolioA group of financial instruments. exceed 21%![1]

Composition of Portfolio

In an interview with Robbins, Dalio described a much simpler version of the All Weather portfolioA group of financial instruments. for the rest of us. This asset allocation is called the All Seasons portfolioA group of financial instruments.. The allocation in the All Season portfolioA group of financial instruments.[2] is:

40% in Long-Term US Bonds (20+ years), using the iShares Barclays 20+ Year Treasury BondA bond issued by the US government with a fixed interest rate and a maturity of more than 10 years. fund (ticker symbol TLT)
15% in Intermediate US Bonds (7-10 years), using the iShares Barclays 7-10 Year Treasury BondA bond issued by the US government with a fixed interest rate and a maturity of more than 10 years. fund (ticker symbol IEF)
5% in Gold, using the SPDR Gold Trust (ticker symbol GLD)
5% in CommoditiesBasic goods often used as inputs to the production of other goods or services. The primary categories in which commodities fall are metals, energy, livestock and agricultural products., 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.

Economic Indicators

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 portfolioA group of financial instruments. are expected to perform well in each part of the economic cycle, according to Robbins.[3]

Growth

Inflation

Rising

Stocks

CommoditiesBasic goods often used as inputs to the production of other goods or services. The primary categories in which commodities fall are metals, energy, livestock and agricultural products.

Gold

CommoditiesBasic goods often used as inputs to the production of other goods or services. The primary categories in which commodities fall are metals, energy, livestock and agricultural products.

Gold

Falling

Treasury Bonds

Stocks

Historical Performance

According to Robbins[4], the All Seasons portfolioA group of financial instruments. 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 portfolioA group of financial instruments. had much lower volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results., with a standard deviationA standard deviation is a (slightly messy) statistical calculation that results in a positive number that measures how much the possible results differ from the average result. For those of you who ... More of 7.6%, as compared to the S&P 500 which had a standard deviationA standard deviation is a (slightly messy) statistical calculation that results in a positive number that measures how much the possible results differ from the average result. For those of you who ... More of 17%. So, at first glance, the All Seasons portfolioA group of financial instruments. seems to be a terrific option – higher return for lower riskThe possibility that something bad will happen..

My Estimate of Returns

There are many challenges to calculating the returns on the All Seasons portfolioA group of financial instruments..[5] 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 portfolioA group of financial instruments. from 1963 to 2019.

From this graph, it appears that the biggest benefit of the All Seasons portfolioA group of financial instruments. is that the non-S&P 500 asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More 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 portfolioA group of financial instruments. 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 classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More during those same years (1974, 2002 & 2008), as shown in the table below.

Asset ClassA group of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors a... More	Average Return in Years when S&P 500 Return was < -20%
S&P 500	-30.5%
7-10 Year US Treasury Bonds	8.0%
20 Year US Treasury Bonds	15.2%
Gold	33.5%

As can be seen, all three asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More 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 volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results..

Goals While Accumulating

While I was accumulating assetsThe value of things the company owns and amounts it is owed, I wanted my invested asset portfolioA group of financial instruments. 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 tolerancePersonal preference indicating how much risk you are willing to take to achieve a higher return., I point out that I did not sell any assetsThe value of things the company owns and amounts it is owed 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)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More 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 assetsThe value of things the company owns and amounts it is owed. I’ve made two changes to my asset mix to reflect the fact that I now need to spend my assetsThe value of things the company owns and amounts it is owed 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 bondA form of debt issued by government entities and corporations. fund) that mature in 3 to 5 years to my portfolioA group of financial instruments.. 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 portfolioA group of financial instruments., 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 assetsThe value of things the company owns and amounts it is owed 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 riskThe possibility that something bad will happen., but not much given the other aspects of my strategy. Therefore, I will look at the components of the All Seasons portfolioA group of financial instruments. 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 classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More perform when interestA charge for borrowing money, most often based on a percentage of the amount owed. rates are low, as they currently are.

Bonds

Returns on bonds (unless held to maturity) and bondA form of debt issued by government entities and corporations. funds have the following characteristics:

The total return is equal to the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More on the bondA form of debt issued by government entities and corporations. plus the change in market value from changes in interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More levels.
Returns are higher when interestA charge for borrowing money, most often based on a percentage of the amount owed. rates are high or are going down.
The total return is similar to the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More itself when interestA charge for borrowing money, most often based on a percentage of the amount owed. rates stay fairly stable.
Returns are lower when interestA charge for borrowing money, most often based on a percentage of the amount owed. 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 bondA bond issued by the US government with a fixed interest rate and a maturity of more than 10 years. interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More (yield) with the change in the market value of iShares Barclays 7-10 Year Treasury BondA bond issued by the US government with a fixed interest rate and a maturity of more than 10 years. 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. InterestA charge for borrowing money, most often based on a percentage of the amount owed. rates are currently quite low by historical standards. The chart below which shows the yield on the 10-year US Treasury bondA bond issued by the US government with a fixed interest rate and a maturity of more than 10 years. from 1962 to 2020. The last point on the chart is the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More on July 8, 2020 of 0.65%. It is lower than the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More at the end of any year since 1962.

For all intents and purposes, interestA charge for borrowing money, most often based on a percentage of the amount owed. 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 rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More 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 interestA charge for borrowing money, most often based on a percentage of the amount owed. 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 bondA form of debt issued by government entities and corporations. funds in the near termThe time period over which you re-pay the loan 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 bondA form of debt issued by government entities and corporations. funds to the investment portion of my portfolioA group of financial instruments.. 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.

Gold

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 interestA charge for borrowing money, most often based on a percentage of the amount owed. rates are flat or rising. The chart below shows how I defined historical periods as having interestA charge for borrowing money, most often based on a percentage of the amount owed. rates that are either flat or rising.

The line is the same line shown in the 10-Year Treasury Interest RateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More chart above. I have shaded periods in which interestA charge for borrowing money, most often based on a percentage of the amount owed. rates have been relatively stable in blue. The time periods in which interestA charge for borrowing money, most often based on a percentage of the amount owed. 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[6][7].

Looking back to the 1970s, gold prices were generally up quite significantly when interestA charge for borrowing money, most often based on a percentage of the amount owed. 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 interestA charge for borrowing money, most often based on a percentage of the amount owed. 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.

Gold Funds

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[8] (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.

Commodities

I wasn’t able to get a long history of returns on commoditiesBasic goods often used as inputs to the production of other goods or services. The primary categories in which commodities fall are metals, energy, livestock and agricultural products., 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 classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More for which I could approximate returns from 1963 to 2019[9].

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 portfolioA group of financial instruments..

I am particularly interested in how these asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More perform when interestA charge for borrowing money, most often based on a percentage of the amount owed. 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 rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More 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%.

Re-Balancing

The performance metrics reported by Robbins and others assume that you maintain the target mix in each asset classA group of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors a... More. To accomplish that, you need re-balance regularly. That is, you need to to sell asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More that have appreciated the most (or depreciated the least) and buy asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More 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 portfolioA group of financial instruments.. Your portfolioA group of financial instruments. 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.

Gold	Sell $44
CommoditiesBasic goods often used as inputs to the production of other goods or services. The primary categories in which commodities fall are metals, energy, livestock and agricultural products.	Buy $28
Stocks	Sell $451
Medium TermThe time period over which you re-pay the loan Bonds	Buy $399
Long TermThe time period over which you re-pay the loan Bonds	Buy $67

To attain the high returns reported by Robbins, I suspect you need to re-balance the portfolioA group of financial instruments. fairly often. In my calculations, I assumed annual re-balancing on the first of each year. How often you re-balance the portfolioA group of financial instruments. depends on your personal preference, but should generally be more often when the prices of one or more of the asset classesGroups of similar investments or things you can buy with the expectation they will hold their value, generate income and/or increase in value. The three primary asset classes used by many investors ... More 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 basisThe amount you paid for something. 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 portfolioA group of financial instruments. 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 portfolioA group of financial instruments. 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 riskThe possibility that something bad will happen. that the stock market will have a significant downturn. Although holding several years of expenses in cash lowers the return on my total assetsThe value of things the company owns and amounts it is owed, I find it a much easier and less risky strategy than introducing bondA form of debt issued by government entities and corporations. funds into my portfolioA group of financial instruments.. 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 portfolioA group of financial instruments. into gold as suggested by the All Seasons portfolioA group of financial instruments. (15% if I use gold as a substitute for commoditiesBasic goods often used as inputs to the production of other goods or services. The primary categories in which commodities fall are metals, energy, livestock and agricultural products., too). Rather, I plan to initially invest 1% to 2% of my portfolioA group of financial instruments. in gold and add to that position as I gain more comfort and experience investing in it.

Footnotes

[1] Robbins, Tony, MONEY Master the Game, Simon & Schuster Paperbacks, 2014, p. 391-392.

[2] “Robbins’ All-Seasons PortfolioA group of financial instruments..” TuringTrader.com, https://www.turingtrader.com/robbins-all-seasons/. Accessed July 5, 2020.

[3] Robbins, op. cit., p. 390

[4] Robbins, op. cit., p. 395.

[5] 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 portfolioA group of financial instruments.. As such, I am not able to replicate his calculations. In fact, I found another source for returns on the All Seasons portfolioA group of financial instruments. 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.

[6] “Historical Gold Prices.” CMI Gold & Silver, Inc, https://onlygold.com/gold-prices/historical-gold-prices/, Accessed July 7, 2020.

[7] “Gold Prices.” World Gold Council, https://www.gold.org/goldhub/data/gold-prices, Accessed July 8, 2020

[8] “Bringing the gold market to investors.” State Street Global Advisors, https://www.spdrgoldshares.com/. Accessed July 8, 2020.

[9] As indicated above, the returns I calculated for the All Seasons portfolioA group of financial instruments. are not as high as were calculated by Robbins.

June 23, 2020August 24, 2020

Selecting Stocks with a Score

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 9 of the ratios, his analysis indicates that the company’s stock is likely to do well. My husband is primarily a value investorSomeone who buys stocks because they think that the price is lower than it should be based on the financial fundamentals of the company.. The appeal of the Piotroski score to my husband is that it focuses on value stocks and, while it relies heavily on statistical analysis, it isn’t a black box.

In this post, I’ll identify the group of stocks to which the Piotroski score applies. I’ll then briefly explain the financial ratios that determine the score. I’ll close with a specific example of a stock I bought solely using the Piotroski score and provide some general guidance on applying the results of the score.

Book-to-Market Ratio

What is It?

The book-to-market (BM) ratio is a financial ratio. The numerator is the book value of the company. This value is shown on the balance sheet in the company’s financial statements and is usually reported as “Shareholders’ Equity.”

The denominator of the ratio is the total market value of the company on the evaluation date as the financial statements. The total market value is the stock price multiplied by the number of shares outstanding and is also called the market capitalization.

In mathematical terms,

Piotroski waits for the financial statements to be published for a particular year end to get the book value. He then looks up the market capitalization on the evaluation date of the financial statements for use in the ratio.

Piotroski’s Criterion

In his paper, Piotroski identifies value stocks as companies that have BM Ratios in the highest quintile (highest 20%) of traded stocks. These stocks have high book values relative to their market capitalization. Looked at from the other perspective, these stocks have low market capitalizations (and therefore low stock prices) relative to their book value.

Recall that the book value is the company’s assetsThe value of things the company owns and amounts it is owed minus its liabilities. In theory, if the company were liquidated on the evaluation date of the financials, shareholders would get their portion of the Shareholders’ Equity, based on the proportion of shares owned. Therefore, a BM ratio of 1.00 means that the market capitalization of the stock is equal to the Shareholders’ Equity.

By comparison, the cut-off for the highest quintile of BM ratios[1] across all stocks reported in the ValueLine Analyzer Plus on May 29, 2020 is 1.47. The book values per share of these companies are almost 50% higher than their stock prices! You can see why Piotroski might consider these stocks to be potentially good values at their current prices.

Why Might It Be High?

There are at least two reasons that the BM ratio might be high.

First, the market may perceive that either assetsThe value of things the company owns and amounts it is owed are overvalued or liabilities are undervalued. Both of these situations would cause the reported book value to be higher than its true amount.

For example, some companies have not fully funded their pension plans. That means that the estimated present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More of the future pension benefits is more than the liabilityWhen used as a noun, the amount you owe to someone else. When used as an adjective, an insurance coverage that protects you when you cause damage or injury to someone else or their property. on the balance sheet. Companies disclose these differences in the Notes to Financial Statements. If the liabilityWhen used as a noun, the amount you owe to someone else. When used as an adjective, an insurance coverage that protects you when you cause damage or injury to someone else or their property. for pension benefits is understated, it will cause the company’s book value to be overstated.

Second, financial theory tells us that the market value of a company’s stock is equal to its book value plus the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More of future profits. If the market perceives that the company is unlikely to make money in the future, the market capitalization will be less than the book value.

The Piotroski score focuses on companies in the second category. That is, it attempts to identify companies that will be profitable in the future from among all of the companies that the market thinks will have negative future profits.

Piotroski Score

The Piotroski score is calculated as the sum of a set of 9 values of 1 or 0. There are 9 criteria in the calculation, in addition to the BM ratio being in the highest quintile. The process assigns a 1 if a company’s financial statement values meet each criterion and a 0 if it does not. As such, companies that meet 8 or 9 of the criteria are considered more likely to have above market average performance.

The 9 criteria are listed below:

Return on assetsThe value of things the company owns and amounts it is owed (ROA) = Net income / Total assetsThe value of things the company owns and amounts it is owed at beginning of year > 0
ROA this year > ROA last year
Cash flow from operations > 0
Cash flow from operations > net income
Long-term debt / Total assetsThe value of things the company owns and amounts it is owed this year < Long-term debt / Total assetsThe value of things the company owns and amounts it is owed last year
Current ratioCurrent assets divided by current liabilities. Current assets are amounts that are expected to be received or converted to cash by the company within one year. Similarly, current liabilities are due t... More this year > current ratioCurrent assets divided by current liabilities. Current assets are amounts that are expected to be received or converted to cash by the company within one year. Similarly, current liabilities are due t... More last year
Shares outstanding this year <= shares outstanding last year
Gross marginRevenues minus operating expenses. this year > gross marginRevenues minus operating expenses. last year
Total sales / Total assetsThe value of things the company owns and amounts it is owed this year > Total sales / Total assetsThe value of things the company owns and amounts it is owed last year

Piotroski performed his analysis using data from companies’ financial statements from 1976 to 1996. The average of the one-year returns for the companies with scores of 8 or 9 was 7.5 percentage points higher than the average for all companies with high BM ratios and 13.5 percentage points higher than the average for the market as a whole.

How to Calculate It

If you are familiar with reading financial statements, you can calculate the Piotroski score yourself using the formulas above. Or, you could extract the key ratios from a source, such as ValueLine, Tiingo or Bloomberg, all three of which require subscriptions. I use the latter approach as I have a subscription to ValueLine that I use for a variety of purposes.

An easier option is to use a Piotroski calculator or screener. I’ve never used any of these tools, but I used Google to find a couple free options you might try.

Old School Value – This Excel spreadsheet will calculate and show you how a company does on each of the 9 tests and the total score.
ChartMill – This screener lets you identify stocks based on their Piotroski score. As such, it helps you find stocks with scores of 8 or 9, but does not show you the details of the underlying calculation.

I suggest being careful to check the documentation of any of these tools to make sure that the descriptions of the 9 tests are the same as I’ve included above (which I took directly from Piotroski’s paper). In poking around on-line, I found more than one site that did not correctly specify the nine tests.

My Experience Selecting Stocks with a Score

Although I’ve looked at stocks using the Piotroski score several times, I’ve made only one purchase using it as my primary buying criterion. I purchased FUJIFILMS (FUJIY) in March 2012. At the time, FUJIY had a BM Ratio of about 1.40, as compared to a market average BM ratio of about 0.5. It had a Piotroski score of 8, having failed the test for an increase in gross marginRevenues minus operating expenses..

For many, many years, FUJIY’s biggest product was film for cameras. With the advent of the digital camera, its market shrank rapidly. In the year before I purchased the stock, its price decreased by 32%. As I was looking at the company, it was transitioning its business from camera film to other types of related products, including medical imaging and, more recently, office products with its purchase of Xerox. With a good story and a high Piotroski score, I decided to buy the stock.

It turns out I was a little early in buying the stock. In the 12 months after I bought the stock, it decreased by 19% while the S&P 500 increased by 13%. However, if I had bought it a year later, my total return would have been much better over both the short and long termThe time period over which you re-pay the loan, as shown in the table below.

	Total Return starting in March 2013
	1 Year	2 Years	Until June 2020
FUJIFILMS	+51%	+84%	+171%
S&P 500	+22%	+36%	+110%

So, even though my returns were lower than the market average because I bought the stock too early in the company’s turnaround, I correctly decided to keep it after its first year of poor performance. That is, if I had sold the stock one year after I purchased it and bought an S&P 500 index fundA type of exchanged-traded fund (ETF) or mutual fund that invests in such a way that the returns on the fund are identical or very close to a market index. For example, an S&P 500 index fund wou... More, I would have been worse off.

Caution

As with any investing strategy, it is important that you understand the assumptions underlying the Piotroski score. I also recommend that you understand the story behind the company you are considering for investment, as described in my post on buying stocks based on their financial fundamentals. There are companies that may have a Piotroski score of 8 or 9 that don’t have a good turn-around story, such as the one I described for FUJIY. In those cases, you may not want to rely solely on the Piotroski score.

[1] Calculated in this case as Book Value Per Share at most recent fiscal year end divided by Price on May 29, 2020, so not exactly equal to the ratio as calculated by Piotroski.

June 9, 2020August 24, 2020

Picking Stocks Using Pictures

Technical analysts select companies for their portfolioA group of financial instruments. 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 are based in large part on these patterns and less on the financial fundamentals of the company. Every technical analyst has a favorite set of graphs he or she likes to review and their own thresholds that determine when to buy or sell a particular stock.

I’ve done just a little trading based on technical analysis, so asked Rick Lage, a family friend who has much more experience with this approach, to help me out. In this post, I will provide some background on Rick and provide explanations of the graphs he uses. I’ll also provide some insights on who I think is best suited for this type of trading.

Rick’s Story

Rick’s Background

“I was first introduced to the stock market in a Junior High School math class. I made my first trade with a stockbroker about 6 years after graduating from High School.

My interestA charge for borrowing money, most often based on a percentage of the amount owed. in the stock market never faded. I was always focused on this platform to make money. Unfortunately losing money was a regular occurrence for many years in the beginning, with not many gains to be proud of.

My interestA charge for borrowing money, most often based on a percentage of the amount owed. peaked in 1999 when I attended my first stock trading event in Las Vegas, known as the TradersExpo[1]. TradersExpo provides a wealth of information available for the beginner to the pro, including hardware, trading software, classroom instruction and more.

I personally have never been a day traderSomeone who buys and sells stocks, often holding them for a few hours or days rather than for a longer period of time. Day traders, more often than not, rely on technical analysis as the primary facto... More. Swing trading is more my definition. I do touch base with my stock watch list daily. It’s always managed and checking my technical indicators is a must.”

Rick’s Goals

“I stock trade for the challenge; not so much for the fun or success. If there is success the fun will follow. There will be losses. No doubt. But you learn how to manage those losses. You have no choice. Technical trading is my science.”

Rick’s Advice to New Traders

Rick says, “I have tried hard to never complicate the trade. There are many technical indicators, so don’t get overwhelmed. I pick stocks that have the momentum. Pick your favorite few indicators and go with those.”

Rick’s Tools

Rick’s favorite indicators are

Simple Moving Averages using 9 and 180 days (SMA 9 and SMA 180)
Price and Volume Charts
Relative Strength Index (RSI)
Moving Average Convergence Divergence (MACD)
Heikin-Ashi bar chart

I will provide brief introductions to each of these indicators, illustrating each with two stocks – Apple and Shopify. A graph of Apple’s stock prices from January 1, 2018 through mid-May 2020 is shown below. It had some ups and downs in price in 2018 and 2019, followed by a significant decrease and recovery so far in 2020.

Shopify had a steadier increase in 2018 and 2019, but much more volatilityThe possibility that something will deviate from its expected or average value, including both good and bad results. so far in 2020, as illustrated in the graph below.

Simple Moving Averages (SMA 180 and 9)

In this context, a simple moving average (SMA) is the average of the closing prices for the past n days, where n is specified by the person making the chart. In Rick’s case, he looks at the 180-day simple moving average and the 9-day simple moving average. For the former, he takes the average of the closing prices for the previous 180 days; for the latter, the average of the closing prices for the previous 9 days.

SMA Charts

Technical analysts add their favorite SMA lines to the chart of the stock’s price. For illustration, I’ve added the SMA 180 and SMA 9 lines to the Shopify and Apple stock price charts below.

SMA Indicators

Technical analysts then look at the crossing points on the chart to provide buy and sell indications. For example, a technical analyst might look at when the closing price line (black in these charts) goes up through the SMA 180 line (blue in these charts) and call it a buy signal or an indication of a time to buy a stock. You can see an example of a buy signal, using this method, for Shopify around May 1, 2019, as indicated by the green circle. The buy signals for Apple are much more frequent using this criterion, two of which are indicated with green circles.

Similarly, a technical analyst might look at when the SMA 9 line (yellow/orange in these charts) goes down through the SMA 180 line and call it a sell signal. Using this criterion, there was a clear sell signal for Apple in early November 2018, as indicated by the red circle.

Every technical analyst has his or her favorite time periods for SMA lines. In addition, each technical analyst selects his or her own criteria for buy and sell signals based on those SMA lines. The shorter the time period associated with the SMA, the more often buy and sell transactions will be indicated. When I use SMA graphs to inform my buy and sell decisions, I use fairly long time periods as I am a long-term investor. By comparison, some people trade in and out of stocks several times a day, so use very short time periods, such as minutes or hours.

Price and Volume

A price and volume chart shows plots of both the price of a stock and its volume on a daily basis, color-coded to indicate whether the stock price went up or down each day. The graph below is a price and volume chart for Shopify.

The upper chart has rectangles (called boxes), sometimes with lines sticking out of them (called whiskers). The combination of the boxes and whiskers is often called a candle. There is one candle for each trading day.

Price & Volume Indicators

A red box indicates that the price was lower at the end of the day than at the end of the previous day; a green box, higher. Green boxes can be interpreted as follows:

The bottom of the box is the opening price.
The top of the box is the closing price.
The bottom of any whisker sticking down from the box is the lowest price on that day. If there is no downward whisker, the lowest daily price and the opening price were the same.
The top of any whisker sticking up from the box is the highest price on that day. If there is no upward whisker, the highest daily price and the closing price were the same.

Red boxes can be similarly interpreted, but the opening price is the top of the box and the closing price is the bottom of the box.

The lower section of the chart shows the number of shares traded each day. If the bar is green, the stock price went up that day, while red corresponds to down.

Technical analysts use these charts to identify trends. A really tall green bar in the lower section green is an indication that a lot of people think the stock will go up so are buying. Many technical analysts consider this a buy signal. Similarly, a really tall red bar is considered by some to be a sell signal. My sense is that you need to be very quick to respond using this type of strategy, as you don’t want to sell a stock after everyone has already sold it and the price has dropped or buy it after the price has increased.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is intended to measure whether a company’s stock is in an over-bought or over-sold position. If it is over-sold, it is a buy signal; if over-bought, a sell signal. The RSI is one of a broad class of measures called oscillators, all of which are intended to evaluate whether the market is over-bought or over-sold.

The RSI is determined based on a moving average of recent gains and the moving average of recent losses. The value of the RSI is scaled so it always falls between 0 and 100.

The RSI was developed by J. Welles Wilder. He considers the market over-bought when RSI is greater than 70 and oversold when it is below 30. There are many other ways in which the RSI chart can be used to identify trends and inform trading decisions that are outside the scope of this post.

The chart below shows the RSI for Apple (blue) and Shopify (orange).

The red horizontal line corresponds to RSI equal 70, Wilder’s over-bought signal. The green line is Wilder’s over-sold signal at RSI equals 30.

In this chart, there are several times when both stocks were over-bought. That is, the RSI for both stocks goes above the red line. Apple was considered slightly over-sold a few times, when the blue line crossed below the green line. By comparison, Shopify’s RSI came close to indicating that it was over-sold a few times, but never went below the green line.

Moving Average Convergence Divergence

The Moving Average Convergence Divergence indicator (MACD) is similar to the Simple Moving Average indicator discussed above. However, it uses an exponentially weighted moving average (EMA) instead of a simple moving average. A simple moving average gives the same weight to each observation. An exponentially weighted moving average gives more weight to more recent observations. MACD can use any period – minutes, hours, days, etc. For this illustration, I will set the period equal to a day. If you are trading more often, you’ll want to replace “day” in the explanation below with “hour” or “minute.”

The MACD was defined by its designer as the 12-day moving average (EMA 12) minus the 26-day moving average (EMA 26). MACD is compared to its own 9-day moving average to determine buy and sell signals. As with the simple moving average, the MACD crossing its 9-day moving average in the upward direction is a buy signal. When MACD falls below its 9-day moving average, it is a sell signal.

MACD Charts

The graph below shows Shopify’s daily closing prices along with the EMA 12 and EMA 26 lines in orange and green, respectively, starting on February 1, 2020.

This next chart shows the corresponding values of MACD (black) and its 9-day moving average (green).

If you compare the two graphs, you can see that MACD goes below the 0 line on the second chart on April 1, 2020. This transition is consistent with the orange line crossing above the green line on the first chart on the same date.

MACD Indicators

When Shopify’s MACD is bullish, its MACD is greater than its 9-day moving average or the black line is above the green line in the second chart above. This situation has been seen several times in the past few months – for short periods starting on February 11, March 23 and May 4 and a longer period starting on April 9.

The Apple MACD chart, shown below, has gone back and forth between bullish and bearish (black line below the green line) much more often in the past few months. It sometimes changes from bearish to bullish and back again on almost a daily basis.

The “convergence” and “divergence” part of MACD’s name refers to how the MACD behaves relative to the price. The relationship is somewhat complicated, so I suggest you refer to one of the sources I mention below if you are interested in this feature of MACD charts.

Heikin-Ashi bar chart

Also known as a Heikin-Ashi candlestick chart, the Heikin-Ashi bar chart is similar to the price part of the Price-Volume chart described above. However, instead of using the actual high, low, open and close prices, all four of the points on the candle are calculated in a different manner. The purpose of the adjustments is to make a chart that makes identifying trends easier. I refer you to one of the resources below to learn the details of how these values are adjusted.

Heikin-Ashi Charts

The charts below show the Heikin-Ashi charts for Shopify and Apple for the past six months.

As mentioned, they look a lot like Price charts, except the boxes corresponding to the adjusted open and close and the whiskers corresponding to the adjusted high and low. The boxes are colored green when the adjusted close is higher than the previous adjusted close and red otherwise.

Heikin-Ashi Indicators

Here are some of the indicators people review when using Heikin-Ashi charts:

Longer boxes are indicative of trends. In the charts above, you can see that the Apple chart tends to have longer boxes than the Shopify chart.
When there is no whisker on one end of the box, the trend is even stronger. For example, neither the Apple nor Shopify charts have upward whiskers on the red boxes from mid-February to mid-March 2020. This time period corresponds to the time period highlighted by the red arrow on the chart below when both stocks’ prices were going down.

Similarly, almost none of the green bars in the last month of the Heishen Ashi chart have downward whiskers, corresponding to the time period in the price chart indicated by the green arrow.

Time periods when the boxes are short, have both whiskers and change color often are indicators of changes. For example, the Apple Heikin-Ashi chart from mid-January to mid-February shows several bars of alternating colors. Apple’s price changed from an upward trend to a downward trend in this period, as shown in the purple circle in the chart below. Identifying turning points is very important in deciding when to buy and sell stocks.

Who Can Use Technical Analysis

Technical analysis isn’t for everyone. It requires people who (a) have the ability to focus on markets fairly closely every day in the case of swing traders or all day in the case of day traders, (b) are happy with growing their portfolioA group of financial instruments. with a large number of small “wins,” and (c) have a solid understanding of the charts being used.

Time Commitment

Unlike many other investment strategies, many day traders and swing traders do not consider a company’s financial fundamentals in their buy decisions. Instead, they monitor the patterns in their charts. Without the comfort of believing that the companies they own have sound fundamentals, it is important that they follow their charts consistently so they can quickly sell any positions that are not meeting expectations.

Lots of Small Wins

In my post on financial fundamentals, I talk about Peter Lynch’s concept of a 10-bagger – a stock whose value is at least 10 times what you paid for it. In that paradigm, the goal is to attain better-than-market-average returns by getting average returns on most of the positions in your portfolioA group of financial instruments. and big gains on one or two positions.

By comparison, the goal of day traders and swing traders is to make a very small amount of money on every trade, but to make lots and lots of those trades. If you earn 0.1% on average on every trading day, it compounds to just over 20% a year!

For many of us, buying and selling with gains of less than 0.1% per security seems really small and might not seem worthwhile. As such, you need to be willing to be happy with lots of little wins rather than a 10-bagger if you want to be a day traderSomeone who buys and sells stocks, often holding them for a few hours or days rather than for a longer period of time. Day traders, more often than not, rely on technical analysis as the primary facto... More or swing traderSomeone who buys and sells stocks, often holding them for a few days or weeks rather than for a longer period of time. Swing traders, more often than not, rely on technical analysis as the primary fac... More.

Understand the Charts

One of the requirements of using technical analysis is to make sure you understand how to interpret the charts correctly. For example, Southwest Airlines (ticker: LUV) has done very poorly recently from the impact of COVID-19. The plot below shows its closing stock price from February 15, 2020 through May 20, 2020.

As can be seen, the last stock price on the graph (about $29) is almost exactly half of the stock price in mid-February (peaked at $58.54). As such, while it has had a few days on which the price increased, the overall trend has been down.

The RSI chart is shown below. Remember that an RSI value of less than 30 is an indication that it might be time to buy the stock.

In this example, there was a buy signal when the RSI crossed below the green line (30) on February 25. The closing stock price on that day was $49.66. If you had bought the stock on that date, you would have lost 41% in the subsequent three months as the stock was at $29 on May 20, 2020.

As you can see, interpreting charts takes time and expertise. If you are willing to invest the time to learn all of the nuances of each type of chart and monitor your positions, technical analysis might be the right investing strategy for you.

There’s a lot more to know about each of these indicators than I’ve provided in this post. Here are a few links to other sources of information to learn more.

Stock Charts
Technical Analysis for the Trading Professional by Constance Brown, McGraw-Hill Education, 2^nd Edition, 2012.
Investopedia

How I Use Technical Analysis

I primarily rely on analysis of the underlying fundamentals of a company when I purchase individual stocks. Once I make the decision to buy a stock, I look at the charts to evaluate whether the timing is good for a purchase. If the consensus of the charts I review indicates that the position is over-bought (i.e., price is too high), I will wait to see if the price decreases before buying.

In addition, I use technical analysis in my Roth IRAA personal retirement savings plan available in the US. There are two types of IRA:
• Traditional - No taxes are paid on the contributions or any changes in the market value of the investments ... More, where there are no capital gains taxes on trades so more frequent trading isn’t adversely impacted. I follow a large handful of industry ETFs using technical analysis and buy and sell them as each one appears to be doing well. Because I am trading in industry exchange-traded funds (ETFs) and not individual stocks, I feel comfortable looking at my positions once a week. My thought is that industries aren’t likely to experience sudden weaknesses not seen throughout the market in shorter time frames.

When I pay sufficient attention to the positions in my Roth IRAA personal retirement savings plan available in the US. There are two types of IRA:
• Traditional - No taxes are paid on the contributions or any changes in the market value of the investments ... More, I tend to get about or slightly above market-average performance. However, when I don’t look at my positions and re-balance regularly, I find that my performance suffers which just confirms my first point in the previous section that using technical analysis requires time and diligence.

[1] There are now TradersExpo events held regularly in many cities (subject to change by the coronavirus).

November 5, 2019August 20, 2020

What You Need to Know About Stocks

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).

Stockholder-Company Interactions

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 valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More 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 bondA form of debt issued by government entities and corporations., as the cash flows to the owner of a bondA form of debt issued by government entities and corporations. are fairly clear – the coupons or interestA charge for borrowing money, most often based on a percentage of the amount owed. payments and the return of the principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More 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

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 bondA form of debt issued by government entities and corporations. interestA charge for borrowing money, most often based on a percentage of the amount owed..

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 valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More.
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.

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 bondA form of debt issued by government entities and corporations. principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More. 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 principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More 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 rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More used for discounting in the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More calculation to increase. When the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More increases, present values (estimates of the price) will go down.

Company Changes

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 ratioThe ratio of a company’s stock price (P) to its earnings per share (E). Earnings per share is approximately equal to the company’s net income divided by the number of shares it has outstanding.. 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

Increased Risk

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 rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More is used in the present valueThe value today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time, t, between th... More calculation. This concept is illustrated in my post on bonds in the graph that shows how interestA charge for borrowing money, most often based on a percentage of the amount owed. rates on bonds increase as the credit rating of the company goes down. Recall that lower credit ratings correspond to higher riskThe possibility that something bad will happen.. 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.

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 fundaments and stock prices of companies to decide whether and when to buy and sell them.

Technical Analysis

Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks. Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

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.

Investing Clubs

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

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 dividendA distribution of either cash or stock by a company to its shareholders..
When you sell your ownership interestA charge for borrowing money, most often based on a percentage of the amount owed. in the stock.

The total amount of the dividendA distribution of either cash or stock by a company to its shareholders. 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?

Understand 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.

Be Willing and Able to Understand the Risks

You should also not buy stocks if you can’t afford to lose some or all of your principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:
• Credit cards: The amount of purchases you have made but not paid on your credit card ... More. 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 portfolioA group of financial instruments. 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 portfolioA group of financial instruments. 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.

Market Timing

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 termThe time period over which you re-pay the loan 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 fundA type of exchanged-traded fund (ETF) or mutual fund that invests in such a way that the returns on the fund are identical or very close to a market index. For example, an S&P 500 index fund wou... More 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.

Limit Orders

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.

Market Orders

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.

Transaction Fees

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.