Why I Chose Patience over Re-balancing

Investment-Rebalancing

Many financial advisors recommend re-balancing your portfolio no less often than annually to ensure the asset allocation is consistent with your risk tolerance, as illustrated in this post from Schwab.  In the past, I haven’t been one to re-balance my portfolio, so I spent some time thinking about why I haven’t followed this common advice.  Up until recently, almost all of my invested assets 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 classes.

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 portfolio to meet certain targets.  In the case of asset classes, the primary purpose of re-balancing is to maintain your target risk/reward balance.

Some people have targets that define their desired allocation across asset classes.  One common rule of thumb is that the portion of your portfolio 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 portfolio in bonds and 40% in stocks.  The goal of this rule of thumb is to decrease the volatility of your investment returns as you get older and closer to that age at which you need to draw down your assets 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 class 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 portfolio 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 assets 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 assets.

What Does Asset Allocation Do?

The chart below compares the average annual returns and risk 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 portfolio invested in stocks and the second number is the percentage in bonds.

Annual Returns for Different Asset Allocations 1980-2019

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 portfolio were higher, on average, over the historical time period.

Volatility

The green boxes correspond to the ranges between the 25th percentile and the 75th percentile.  The whiskers (lines sticking out of the boxes) correspond to the ranges from the 5th percentile to the 95th percentile.   When the box is tall and/or the whiskers are long, there is a lot of volatility.  In this case, it means that the annual return on the portfolio 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 volatility – 100% in the S&P 500 – is on the left and the one with the least volatility – 100% in bonds as measured by the Fidelity Investment Grade Bond Fund (FBNDX) – is on the right.  You can see how adding bonds to the S&P 500 reduces volatility 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 portfolio.  Over the time period studied (1980 to 2019), the S&P 500 had an average annual return of 8.7% while the Bond 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 volatility (spread between tops and bottoms of boxes and whiskers) of owning a combination of both is less than the volatility 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 portfolio goes lower than the bottom whisker for the 80% bonds portfolio.

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 portfolio with 80% bonds and 20% stocks.   The 80% bond portfolio had a negative return only 7.5% of the time while the 100% bonds portfolio had a negative return 10% of the time!  As more bonds are added to each portfolio, 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 portfolio better meets your objectives if probability of having a negative return is your risk 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 portfolio is higher than the average return on the all-bond portfolio 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 portfolio 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 probability 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 risk.

Re-balancing Can’t Be Done Blindly

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

Interest Rates

For example, interest rates are lower than they were at any point in the historical period used in the analysis above.   Over the next several years, interest rates are unlikely to decrease much further, but could stay flat or increase.  If interest rates stay flat, the returns on bond funds will tend to approach the average coupon 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 interest 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 risk (the one-sided risk that prices will go down as interest 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 portfolio, you will want to form your own opinions about the average returns and volatility of the asset classes in which you invest.  With these opinions, you can decide whether the asset allocation you’ve held historically will still provide you with the risk/reward profile you are seeking.

Re-balancing and Income Taxes

Another consideration when you are deciding whether and how often to re-balance your portfolio 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 TFSA) or tax-deferred (traditional or RRSP) 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 portfolio of 60% stocks (in an S&P 500 index fund) and 40% bonds (in FBNDX) from 1980 through 2019, you would have made the transactions shown in the chart below.

Rebalancing Stock Transactions

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 bond fund.  Similarly, the money used to purchase stocks would come from a corresponding sale of the bond fund.

In every year, you either sell some of the stock index fund or the bond 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 classes, such as stocks and bonds.   My philosophy was that I preferred to use time to provide a diversification benefit rather than an array of asset classes.  By keeping my invested assets 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.

Annual Returns - 1980-2019 - Time vs. Rebalance

It compares the volatility of the annual return on a portfolio of 100% stocks over a one-year time period with the same portfolio over five years and with a portfolio 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 classes.  The box and whiskers on the 60/40 portfolio are both shorter than the 100% stock portfolio.  That is, there was less variation from year-to-year in the annual return for the 60/40 portfolio than the 100% stock portfolio.   However, the average return (blue line) on the 60/40 portfolio is a bit lower because the 60/40 portfolio had an average annual return that was less than the 100% stock portfolio.

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 volatility and average returns of a 100% stock portfolio over five years with the volatility and average returns of a 60/40 portfolio over one year.  As can be seen, there has been less volatility 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 portfolio.  Because I didn’t anticipate that I would need to draw down my investment portfolio, I was willing to look at risk 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 portfolio 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 portfolio is a better fit for you.

What is Bitcoin: The Short and Long Answers

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The phrase “what is Bitcoin” is currently getting between ten and one hundred thousand search queries in Google per month. There is a broad spectrum of answers out there. In this exposition we’ll give an accessible answer that will help you decide if cryptocurrency is an investment that is right for you.

What is Bitcoin? … The Short Answer

Bitcoin as an investment, Man walking towards a city overlaid with bitcoin images
Time to Consider Bitcoin

The short answer is it is digital currency. Naturally, there is a long answer too. You should be aware that this is a complex subject because it touches many sophisticated topics like macroeconomics and centralized banking. Most people think of currency as what is used in their home country. In America they use US Dollars. Japan uses Yen. Other countries use Euros and Pounds. There is nothing wrong with thinking of Bitcoin as just another type of currency with the added nuance of it being purely digital.

Why is it Such a Hot Topic?

We have already briefly tackled the question of “what is Bitcoin.” At this point, it is worth mentioning why people are so fixated on it. There are a few reasons.

The most obvious reason is people have made lots of money with Bitcoin as an investment. Indeed, in 2017 the price shot from $5,600/coin to $19,000/coin. I owned lots of coin at this time and it was very exciting. However, what goes up, most come down. Over the year of 2018, the price of crashed to about $3,000. As of the time of writing, it has returned to about $10k, so don’t count it out yet.

Decentralization

It’s worth mentioning the other more innocuous reason why Bitcoin is such a controversial topic. That reason is decentralization. The impact that statement has on you depends on your level of knowledge with banking practices. Most countries have a central bank. In the Unites States, this is the Federal Reserve. Centralization means that the country’s currency has innate value based on the trust of the ruling government. When you give your money to a bank, it pays you interest because it invests that money to make more money. However, you are not privy to these investments and actually have no transparency as to how the bank is behaving. Historically, this has led to corruption.

The Blockchain

bitcoin blockchain
Blockchain is the Ledger of Bitcoin

Bitcoin is decentralized which means you have full transparency. Typical banks have a ledger detailing their customers’ transactions. Bitcoin has a similar concept called the Blockchain. This is the ledger of Bitcoin. Instead of it being centralized, it’s freely available to all its users. The users are given anonymous addresses and this is what creates decentralization. In the Blockchain, you can see every transaction, but you won’t know who is participating. Conceptually, this is very controversial because it takes all middlemen out of the equation. This includes the government. For this reason, some governments have made Bitcoin illegal. Denmark, Iran and Nepal have all banned it is some way.

The Controversy Continues …

The Blockchain is anonymous which makes tracing money almost impossible. This would make it very hard for litigious societies to cope with the existence of crytopcurrency. While you could theoretically hide all of your money in a wallet, you would be exposed to the fluctuations of the underlying price. The anonymity aspect of Bitcoin also makes it ideal for crime and lascivious pay outs. There are amazing upsides though. It’s free to participate and dramatically cuts down the possibility of corruption.

Why Does Bitcoin have Value?

The value is generated from simple supply and demand. People are willing to trade money for Bitcoin and this is where it derives its value. Critics claim this can be interpreted as fictitious and so it’s possible it could just vanish without a trace. The distributed nature of the Blockchain makes this very unlikely because so much actual money is tied up in it and the transparency is very high.

The Pros and Cons

Getting involved is synonymous with owning currency. Bitcoin is nothing more than a currency and its pros and cons can be compared to the US dollar. Participating doesn’t need to be an all or nothing consideration. You can buy a small amount as an investment and see how it performs. Similarly, I don’t think it’s justified to characterize Bitcoin as crazy nonsense either. In December 2018 The NYSE announced its launch of forwards and futures contracts on Bitcoin. This commitment likely signals that Bitcoin is here to stay. Let’s look at pros and cons.

Pros

  • Bitcoin is transparent. This is the nature of the distributed Blockchain.
  • Transactions are handled by computers and mathematics. This eliminates traditional labor and human emotions.
  • Bitcoin provides privacy that is currently eroding in countries like the US.

Cons

  • The exchange rate is volatile. We have seen wild swings in the value of Bitcoin in recent years, as can be seen in the chart below.  The chart compares the cumulative returns on four asset classes – bitcoin, the S&P 500 (stocks), a 20-year US Treasury mutual fund (TLT) and gold (GLD ETF). [1]  This chart highlights the high returns and extreme volatility of bitcoin compared to more familiar asset classes.

    [1] S&P 500, TLT and GLD prices from finance.yahoo.com.  Bitcoin prices from www.coindesk.com/price/bitcoin.  August 16, 2020

The line for Bitcoin fluctuates wildly while the other lines hover near the ottom of the chart

  • Bitcoin is not widely accepted.
  • Due to it’s lack of authority nobody can guarantee Bitcoin’s value. Different countries may even have a different current price for Bitcoin.

Should I get Involved ?

considering an investment
Thinking about Bitcoin

If you have read this far down you probably have a good idea as to whether you want to get involved with Bitcoin. The answer to this question hinges on how much effort you are willing to put into the learning the mechanics of it. Unless you are willing to learn more about Bitcoin wallets, exchanges, and mining efforts (all discussed below), I don’t think you should get involved. If you want to learn these fundamentals and have a dog in the fight then there is nothing wrong with that either.

Your participation is Bitcoin doesn’t need to be an all or nothing experience. There is a wide difference between liquidating your retirement account and putting it into Bitcoin and just buying and holding some Bitcoin. There are many ways that you can go deep into Bitcoin but you shouldn’t lose sight of what it is. It’s just another currency. It’s not a magic wand that pulls money out of thin air. In the following sections I’ll show you some Bitcoin basics so you can learn how to own some Bitcoin and manage your risk. Each of these topics is very dense and there is more to learn on all of them. This should demystify things a bit though.

Getting your Feet Wet

The easiest way to own Bitcoin is to just buy it. This is an investment and there is risk attached to it. There is risk both in the volatility of the Bitcoin currency and the security of your actual amount of Bitcoin. If you want to just buy Bitcoin, I recommend buying it on an exchange. There are many to choose from but I have the most experience with Coinbase. There, you can easily set up an account and buy a small amount of Bitcoin. Currently, one Bitcoin is worth about $10k. This doesn’t matter that much because you can own fractional amounts and $100 is probably the perfect amount to get started. Beyond this, the security of your coins is an issue too.

Wallets

wallet of crypto coins
You need a Bitcoin Wallet

I mentioned before that your Bitcoin security is an issue to be concerned with. This is where wallets come into play. A wallet stores your Bitcoin and its private key. This allows you to generate a Bitcoin address to participate in the Blockchain. Wallets are a dense subject and there are many types to choose from. The minimum that you need to know is that you should have one! Your Bitcoin is literally not safe without it.

It’s important to understand the wallet doesn’t actually hold coins. A better analogy is that it marks your place and value in the blockchain. It facilitates your participation in the blockchain by holding your private key and keeping it out of the possession of others.

An exchange can hold your Bitcoin but exchanges have been hacked before and  resulted in people completely losing their money. While it’s hard to recommend a Bitcoin wallet, it’s easier to recommend a type of wallet namely a cold storage wallet. This is the most secure type and that disconnects your private key from the internet. You can even have a paper wallet by printing out the private key.

Trading

No surprise here, trading is a complex topic. Like many assets, you can trade Bitcoin. This is risky, but here is what you should know. Trades are done by trying to predict the price. You can do this by following news about it or following the evolution of the technology supporting it. Historically, the price has been quite volatile, so you could potentially make a lot of money from it. The risk is high also.

Investing vs. Trading

It’s important to understand the subtle differences between investing and trading. You can do both simultaneously. The key difference is the amount of time you hold the asset. Trading is more speculative as you work to achieve a sequence of short term transactions that make you a profit. Vanilla investing just means you hold Bitcoin and wait for the value to go up and realize the profit in accordance to your own risk preferences.

You might hear Bitcoin investors declare they are “hodling”. This means they are holding Bitcoin long term. The misspelling is an acknowledgment of its early days where the misspelling “hodling” had widespread notoriety. 

Getting Started

To get started with trading, you can verify your identity on Coinbase and start trading immediately. Of course, this is an oversimplification. You need to develop a solid plan and strategy to be successful and realize that all traders have trades where they lose money. Here are some tips to get started trading.

  • Join an exchange like Coinbase
  • Have a wallet and never leave money on the exchange because your money could magically disappear.
  • Have a solid plan that you have researched and feel very confident with.
  • Realize that not all trades will be profitable.

Mining

mining
MMining is a way to Generate Bitcoin

Bitcoin Mining is a term you might hear thrown around quite a lot. To understand it in the most basic way you need to know that miners are participants in the Blockchain who work to synchronize the distributed nature of the Blockchain. Their reward for this is actual partial coin payout. This is a concrete way to make money. You might even hear comparisons to mining as printing money. In some ways this is true, but it’s short sighted.

Mining is a different way to profit from cryptocurrency and Bitcoin specifically. Mining is also a form of investment because you are investing capital to have a well preforming mining rig.

There is a lot of overhead to mining. The main overhead is elaborate hardware that will work to compete in the Blockchain. This is very competitive and successful mining rigs can cost thousands of dollars. It’s not uncommon for people to work in teams called “pools” where they split mining earnings. The upside to mining can be high but so is the price of entry. Here are some points to keep in mind.

  • Mining is a way you can immediately profit from cryptocurrency.
  • You will need expensive hardware to compete and be successful.
  • At this point of competition, you will likely need to work with others to be successful.

Transaction Complete

Remember cryptocurrency is a massive topic and what I have covered is only scratching the surface. The intent here is to expose you to Bitcoin and show you different risk levels at which you can participate. By now you should have a firm understanding of what it is and how you can invest.  Here are some walkaways from today:

  • Bitcoin is decentralized, digital currency.
  • The simplest way to invest is to buy it on an Exchange and hold it in a wallet.
  • There are more elaborate schemes to profit like trading and mining.
  • There are pros and cons to mining and trading. Either could lose money or make massive profits.
  • Bitcoin is not going away.
  • One way to invest is to not actually hold it, but to invest in its underlying technologies. It only stands to reason as Bitcoin grows so will these technologies.

Author

Adam Wilson is a Ph.D., professional software developer, and financial blogger. Check out more of his musings on his site: https://awesomepersonalfinance.com/

Diversification: Don’t Get Misled by these Charts

Investment Diversification: Don't Get Misled by These Charts

Diversification is an important component of any investing plan.  It assists you in limiting your risk either to a single asset class or a single security within an asset class.  However, I have seen a couple of graphs from which you could form the wrong conclusions about diversification.  In this post, I show you the charts, identify the wrong conclusion that could be drawn from them, and explain and illustrate the correct conclusion.

Diversification Fallacy #1: A Combination of Stocks and Bonds Provides a Higher Return than just Stocks

I first saw a chart[1] in a post on Schwab’s website a couple of years ago.  It is the first graph on this page.  It was prepared in 2018 and compares the cumulative return on the S&P 500 and a portfolio that is 60% stocks (as measured by the S&P 500), 35% bonds and 5% cash from 2000 to 2017.  I’m not sure why Schwab chose to use an 18-year period for this chart, other than the beginning of the time period corresponds to the turn of the century.  The portfolio is re-balanced annually.  In that chart, the total return on the re-balanced portfolio is slightly higher than the S&P 500 (167% versus 158% or 5.6% vs 5.4% per year).

My Version of Chart

Because I can’t include the Schwab chart here, I created a chart (shown below) that shows a similar result for the same time period.  It compares the cumulative returns on the S&P 500 with those of a portfolio of 60% stocks and 40% 20-year US Treasuries (using an approximation I derived for older years).  The mixed portfolio is re-balanced annually, similar to the calculations in the Schwab chart.

Cumulative returns on S&P 500 and mixed portfolio
Cumulative Returns

In this graph, the ratio of the value of the S&P 500 at each year end to its value on December 31, 1999 is shown in purple.  The blue line shows the corresponding ratios for the portfolio of 60% stocks and 40% bonds.  The S&P 500 never makes up the losses it experienced in the first few years of this 18-year time period.

Incorrect Inference about Diversification

At first glance, these charts appear to imply that you can earn more if you hold a 60%/35%/5% mix of stocks, bonds and cash (or 60% stocks/40% bonds) than if you invest in just the S&P 500.  That conclusion confused me, as bonds tend to have total returns that are lower than stocks over the long run and cash has close to no return.   If you re-balance your portfolio annually, as assumed in the graph, your total return in each year will be 60% times the return on stocks plus 35% times the return on bonds plus 5% times the return on cash.  Since the returns on bonds and cash are less than the return on stocks, I was sure that the weighted average of the returns would have to be less than the return on stocks alone.

The Reality

It wasn’t until recently that I figured out why the chart looks the way it does.  The analysis was performed in 2018, so it used the most recent complete 18-year period available.

Historical Perspective

It turns out that period was a rarity in recent history – it was one of only three 18-year periods in which bonds had a higher total return than stocks when considering all such periods from the one starting in 1975 to the one starting in 2002!  If we go back all the way to 1962, the mixed portfolio had higher returns in about a third of the 18-year periods.  The chart below illustrates this point.

18-Year Cumulative Returns for period starting in 1963

Each pair of bars corresponds to an 18-year period (the time period in the Schwab chart) starting in the year shown.  The bar on the left in each pair shows the estimated cumulative 18-year return on a portfolio of 60% stocks[2] and 40% bonds[3] that is re-balanced annually.  The bar on the right shows the corresponding return on the S&P 500 during each period.  As you can see, in most recent years, the right bar (100% stocks) has a higher return than the left bar (60% stocks and 40% bonds).  In older years, the left bar tends to be higher.

How to Use this Information

If your investment goal is to maximize your return without regard to risk, a portfolio with 100% stocks will better meet that objective more than two-thirds of the time when considering 18-year periods and an even higher percentage of the time if you consider only more recent experience.  If interest rates increase substantially at some point in the future, you might look at the longer time period for deciding whether to add bonds to your portfolio, as interest rates were higher and rose in many of the years from 1962 to 1980.  But you’ll want to wait until interest rates are a fair amount higher than their current levels before those years are relevant to your decision-making.

If, however, you want to reduce volatility, adding bonds (or other asset classes) to your portfolio can help.  My post on diversification for investments provides several illustrations about how the addition of bonds to your portfolio reduces risk, but also reduces your total return.  As you consider using other asset classes to reduce volatility, you will need to consider your time horizon for your investments.  As indicated in the chart above, there have been no 18-year periods in the time covered by the analysis in which the S&P 500 had less than a 3% annualized return or 59% compounded return.

Fallacy #2: Diversification in Rank Order Matters

When I first saw this chart from Callan[4], I thought it was very impressed with how it illustrated the benefits of diversification.

Callan Periodic Table of Investment Returns

The font is small so your probably can’t read the words and numbers, but the visual impact is terrific.  Each column is a calendar year.  Each color corresponds to a different index.  The rows correspond to the order of the returns on each index in each calendar year, with the top row showing the index with the highest return; the bottom, the lowest return.

The indices by color (in the order they appear in the first column) are:

  • Rust: S&P 500 Growth
  • Olive green: S&P 500
  • Grey: MSCI (Morgan Stanley Capital International Index) World ex US
  • Dark blue: S&P 500 Value
  • Light green: Bloomberg Barclays Aggregate US Bond Index
  • Medium blue: Bloomberg Barclays High Yield Bond Index
  • Mustard: Russel 2000 Growth
  • Brown: Russell 2000
  • Light blue: Russell 2000 Value
  • Orange: MSCI Emerging Markets

Incorrect Inference about Diversification

At first glance, it appears that there is a lot of diversification among these asset classes, as the colored boxes move up and down on the chart from year to year.

The Reality

It wasn’t until I plotted the returns (using roughly the same colors) on a line chart that the true lack of diversification became apparent.

Annual returns from 1997 to 2017 for funds in Callan chart

Even though the order of the indices changes, as shown in the Callan chart, most of them actually move substantially in sync.  For example, the MSCI Emerging Markets Index moves all over the Callan chart not because it adds diversification but because its returns are much more volatile.  In 14 of the 20 years in the Callan chart, the MSCI Emerging Markets Index is either at the top or the bottom.  It moves in the same direction as most of the other indices, it just makes bigger moves.

Correlations

The goal of adding new asset classes to your portfolio is to increase diversificationAsset classes are diversifying when they have negative or even small positive correlation.  I provide a detailed explanation of correlation and diversification in this post.  The chart below shows the correlations between each pair of indices in the Callan chart.

Correlations between funds in Callan chart

High positive correlations are highlighted in red (as that means they aren’t diversifying).  Medium positive correlations are shown in yellow and small positive and negative correlations (the ones we are seeking) are in green.

It becomes quickly apparent that the only asset class that is diversifying over this time period is US bonds (Bloomberg Barclays (BB) Aggregate US Bond Index).  If you look at the line graph above, I have made the line for the Bloomberg Barclays Aggregate US Bond Index a bit thicker than the others to help you see its lack of correlation with the other investment classes.

Different Insights

While I found the diversification message misleading in this chart, I still found value in the data itself.

Investment-Grade Bonds add Diversification

First, as discussed above, the diversification benefit of investment-grade bonds relative to all of the stock indices is quite evident.  Interestingly, high-yield bonds are highly correlated with stocks, so don’t add diversification.

Asset Classes Show Risk-Reward Balance

Second, I calculated the average annual return and the standard deviations of those returns.  As shown in the chart below, the different indices are spread widely along the spectrum that balances risk and reward.

Average and standard deviations of returns on funds in Callan chart

Specifically, the Bloomberg Barclay Aggregate US Bond Index is in the lower left corner indicating it has a lower average return than all of the other asset classes over this time period but also has the lowest risk as measured by the standard deviation of the annual returns.  By comparison, the MSCI Emerging Markets Index has both the highest annual average return and the highest risk, as it is in the upper right corner of the chart.  All of the other indices fall in the middle on both average return and risk.

Selecting Asset Classes for Your Portfolio

As you are choosing the asset classes in which you want to invest, you need to consider all three of average annual return, risk and diversification benefits.  For example, if you have a very long time horizon and can tolerate the ups and downs of the returns, the historical data indicates that investing primarily in the Emerging Markets index would maximize your return.

If you have a shorter time horizon or are less able to watch the value of your investments go up and down, you might want to invest in something with a lower return, such as one of the stock indices.  If you have even lower risk tolerance or a shorter time horizon, you might want to add something like the Aggregate US Bond Index to your portfolio.  It is important to recognize, though, that adding the less volatile asset classes to your portfolio, even if they are diversifying, will lower the expected annual return on your portfolio at the same time it is lowering your risk.

Caution about Using Past Findings in the Future

In closing, I caution you that the time period covered by the Callan charts corresponds to a time period during which interest rates were relatively low and generally decreasing.  During the time period from 1997 to 2017, the highest yield on the 10-year US Treasury on a year-ending date was 6.7% at the end of 1999.    It decreased to 1.7% at the end of 2014 and increased very slightly to 2.7% by the end of 2017.  By comparison, it hit a high of 12.7% at the end of 1981 and is currently (August 2020) below 1%.  Neither extreme is covered by this time period.

The relatively stable returns on the Bloomberg Barclay Aggregate US Bond Fund Index may be more representative of the time period included in the analysis and may understate the overall volatility of that index over a longer period of time.  Similarly, the other indices may behave differently in other interest rate environments.

I suggest using the information in this post to enhance your understanding of the returns, volatility and diversification benefit of the different asset classes.  You’ll want to supplement this information with your views on future economic environments before making any investment decisions.

[1] I am not able to include the chart directly in this post as I am not willing to accept the conditions that would be required by Schwab to get its permission.

[2] As measured by the S&P 500.

[3] As measured by the iShares 20+ Year Treasury Bond Fund ETF starting in 2002 and my approximation of those returns for prior years.  I note that the Schwab chart uses the Bloomberg Barclays U.S. Aggregate Bond Index for bonds and the FTSE Treasury Bill 3 Month Index for cash.  I don’t not have access to that information.  Because I used a government bond index that tends to provide lower returns than a corporate bond index, I used 40% weight to bonds and ignored the cash component.

[4] Used with permission.  https://www.callan.com/?s=2017+Periodic+Table.  August 8, 2020.

7 Must-Know Stock Market Sell Signals

7 Must-Know Stock Market Sell Signals: How to Avoid Selling a Stock Too Soon or Too Late

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 ratio 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 risk. 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 ratio 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 interest 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.

Debt to Capital Ratios

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 portfolio, 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 portfolio rises as well. For most passive investors, any one stock should not take up more than 3-5% of your overall portfolio to avoid company specific risk.

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.

Why I Don’t Hold the All Seasons Portfolio

All-Seasons Portfolio

The All Seasons Portfolio reports amazing statistics about its returns.  I’d never heard of the All Seasons Portfolio, so had to check it out.  As I’ll discuss in more detail, it is an asset allocation strategy with more than 50% of the portfolio allocated to US government bonds.  In this current environment of low interest rates, one of my followers asked my opinion of the portfolio as an investment strategy for the near future.  The answer is, as is almost always the case, it depends.  However, after studying the portfolio and relevant data, I won’t be aligning my portfolio with the All Seasons Portfolio.

In this post, I’ll define the All Season Portfolio, talk about when each of the components of the portfolio is expected to perform well and provide a wide variety of statistics regarding its historical performance.  I’ll also talk about the need to re-balance assets to stay aligned with the portfolio and the impact of income taxes on your investment returns.  I’ll close with how I’ve changed my portfolio based on this analysis.

All Seasons Portfolio

Ray Dalio is an extremely successful hedge fund manager.  If you have more than $5 billion in investable assets, he might consider accepting you as a client.  His fund is famous for the All Weather investment strategy.  According to Tony Robbins, in his book MONEY Master the Game, the annual returns on the All Weather portfolio exceed 21%![1]

Composition of Portfolio

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

  • 40% in Long-Term US Bonds (20+ years), using the iShares Barclays 20+ Year Treasury Bond fund (ticker symbol TLT)
  • 15% in Intermediate US Bonds (7-10 years), using the iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF)
  • 5% in Gold, using the SPDR Gold Trust (ticker symbol GLD)
  • 5% in Commodities, using the PowerShares DB Commodity Index Tracking fund (ticker symbol DBC)
  • 30% in the S&P 500

This allocation is illustrated in the pie chart below.

All Seasons portfolio Asset Allocation

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:

  1. Higher than expected growth (often measured using gross domestic product or GDP)
  2. Lower than expected growth
  3. Higher than expected inflation (often measured using the consumer price index or CPI)
  4. Lower than expected inflation

I note that there is overlap between the first pair of characteristics and the second pair.  That is, a period of higher than expected growth can have either higher or lower than expected inflation.

The chart below shows which of the five components of the portfolio are expected to perform well in each part of the economic cycle, according to Robbins.[3]

GrowthInflation
Rising

Stocks

Commodities

Gold

Commodities

Gold

FallingTreasury Bonds

Treasury Bonds

Stocks

Historical Performance

According to Robbins[4], the All Seasons portfolio had a compounded annual average return of 9.7%, net of fees, from 1984 to 2013.  By comparison, I calculate the corresponding value for the S&P 500 to be 8.4%.  In addition, the All Seasons portfolio had much lower volatility, with a standard deviation of 7.6%, as compared to the S&P 500 which had a standard deviation of 17%.  So, at first glance, the All Seasons portfolio seems to be a terrific option – higher return for lower risk.

My Estimate of Returns

There are many challenges to calculating the returns on the All Seasons portfolio.[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 portfolio from 1963 to 2019.

Annual returns on S&P 500 and All Seasons portfolio

From this graph, it appears that the biggest benefit of the All Seasons portfolio is that the non-S&P 500 asset classes diversify away a substantial portion of the significant negative returns on the S&P 500.  For example, in the three years in which the S&P 500 had returns worse than -20%, I approximated that the All Seasons portfolio lost an average of only 0.1%!

Returns by Asset Class

I wasn’t able to get a long enough history of Commodity price data, but was able to calculate the average return on the three other asset classes during those same years (1974, 2002 & 2008), as shown in the table below.

Asset ClassAverage Return in Years when S&P 500 Return was < -20%
S&P 500-30.5%
7-10 Year US Treasury Bonds8.0%
20 Year US Treasury Bonds15.2%
Gold33.5%

As can be seen, all three asset classes had positive returns in those three years, with Gold having the most significant increase.

My Investing Goals

I retired a little over two years ago, so have changed my investing goals to make sure I can meet my cash needs as I don’t have any earned income to cover my expenses.  Specifically, now that I’ve switched from the accumulation phase to the spending phase, I have less tolerance for volatility.

Goals While Accumulating

While I was accumulating assets, I wanted my invested asset portfolio to produce returns that were at least as high as the overall market.  I use the S&P 500 as my metric for market performance.  During that time, I was quite willing to tolerate the ups and downs of the market because I was diversifying my risk over time.  As a confirmation of my risk tolerance, I point out that I did not sell any assets during any of the market “crashes.”

My first market crash was October 19, 1987.  I can still remember being in the office that day.  The internet was not available to the general public, so our news came from TV and radio.  One of the senior people in the office had a TV in his office, though I suspect it had just the over-the-air channels as very few people had cable TV then either.  He told everyone what was happening in the market.  I asked him whether he was going to move his 401(k) money out of the market into a safer fund.  His advice was that it was already too late and that I should just hang on for the ride.  That was one of the best pieces of investing advice I’ve ever gotten.  I didn’t sell during that crash and haven’t sold during any of the crashes since.

Goals While Retired

Now that I’m retired, I am drawing down my assets.  I’ve made two changes to my asset mix to reflect the fact that I now need to spend my assets rather than add to them.

  1. Instead of having a six-month emergency fund in cash, I now have several years of expenses in cash.
  2. I’ve added a few individual corporate bonds (to be clear, not a bond fund) that mature in 3 to 5 years to my portfolio. When these bonds mature, they will add to my cash balance to cover my expenses in those years.

For the rest of my invested asset portfolio, I’ve maintained the same goal – meet or beat the S&P 500.

By having several years of expenses in cash, I know I won’t have to sell any assets during any market turmoil, such as we are experiencing now.  As discussed in my post on reacting to the most recent crash, the market has historically recovered in less than five years (excluding the crash of 1929) and has higher than average returns during the recovery phase.  As such, I don’t want to have to sell stocks when markets are down.

How I Evaluate the All Seasons Portfolio

As I said, my goal is to earn a return close to or higher than the return on the S&P 500.  I would be willing to take a small reduction in return for less risk, but not much given the other aspects of my strategy.  Therefore, I will look at the components of the All Seasons portfolio relative to what I can earn if I just invest in the S&P 500.

In particular, I am interested to see how these asset classes perform when interest rates are low, as they currently are.

Bonds

Returns on bonds (unless held to maturity) and bond funds have the following characteristics:

  • The total return is equal to the interest rate on the bond plus the change in market value from changes in interest rate levels.
  • Returns are higher when interest rates are high or are going down.
  • The total return is similar to the interest rate itself when interest rates stay fairly stable.
  • Returns are lower when interest rates are low or are increasing.

Bond Returns vs. Interest Rate Changes

This relationship can be seen in the chart below which compares the change in the 10-year US Treasury bond interest rate (yield) with the change in the market value of iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF) in each year from 2003 through 2019.

Change in Price goes down when yield on 10-Year Treasury goes up

What Can Happen from Here

We are currently in the last situation listed above.  Interest rates are currently quite low by historical standards.  The chart below which shows the yield on the 10-year US Treasury bond from 1962 to 2020.  The last point on the chart is the interest rate on July 8, 2020 of 0.65%.  It is lower than the interest rate at the end of any year since 1962.

10-Year Treasury Rate from 1962 to 2019 with single major peak in 1981

For all intents and purposes, interest rates can do one of two things from their current levels – stay about the same or go up.  If they stay the same, the return on bonds funds will be about the same as the interest rate on the bonds – currently less than 1% for 10-Year US Treasury bonds and less than 1.5% for 30-Year US Treasury bonds.  If interest rates go up, the market value of the bonds will go down and returns will be even lower.

As such, I don’t believe the returns on bonds or bond funds in the near term will be high enough to be consistent with my investing objectives.  I will continue to buy individual corporate bonds that mature in the next few years to ensure that I have cash available to meet my expenses.  But, I do not plan to add any bond funds to the investment portion of my portfolio.   If I were younger and the time until I needed to draw down my investments to cover my expenses was longer, I wouldn’t invest in bonds at all in the current environment.

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 interest rates are flat or rising.  The chart below shows how I defined historical periods as having interest rates that are either flat or rising.

10-Year Treasury Interest Rate rose from 1962-1967 and 1977-1980 and was flat from 1968-1977, 2004-2007 and 2013-2018

The line is the same line shown in the 10-Year Treasury Interest Rate chart above.  I have shaded periods in which interest rates have been relatively stable in blue.  The time periods in which interest rates have increased are highlighted in green.

The chart below has the same time periods shaded as the previous chart, but the blue line shows the percentage change in the price of gold between 1971 (when the price of gold was no longer set by the US government) and today[6][7].

Gold prices increased in most years in which interest rates were flat or rising

Looking back to the 1970s, gold prices were generally up quite significantly when interest rates were either relatively flat and when they increased.  While the increases in price were not as large in the period from 2003 to 2006, another time period when interest rates were flat, as in the 1970s, annual price increases were still generally in the 10% to 30% range, much higher than would be expected on the S&P 500.  Only in the most recent flat period are changes in gold prices not as consistently high.

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.

very close match between gold and GLD ETF price changes from 2005 to 2019

Commodities

I wasn’t able to get a long history of returns on commodities, but the table I provide earlier from Robbins’ book indicates that they are expected to behave in a manner similar to gold.

Overall Portfolio Evaluation

The chart below summarizes the annual average returns (on a compounded basis) for each of the asset classes for which I could approximate returns from 1963 to 2019[9].

Average returns from 1962-2019 on S&P 500 (7%), Gold (7%), 7-10 Year Treasuries (3%), 20-Year Treasuries (4%) and All Seasons Portfolio (6%)

Over this time period, it appears that Gold has had returns similar to that of the S&P 500, but the returns on US Treasuries have dragged down my estimate of the returns on the All Seasons portfolio.

I am particularly interested in how these asset classes perform when interest rates are either flat or increasing.  The chart below illustrates these returns using the same approximations as above.

Average annual returns when interest rates were rising and flat

In average in both rising and flat interest rate environments, gold has historical outperformed the S&P 500.  By comparison. both categories of bonds have underperformed and, in fact, have had average returns during those periods of roughly 0%.

Re-Balancing

The performance metrics reported by Robbins and others assume that you maintain the target mix in each asset class.  To accomplish that, you need re-balance regularly. That is, you need to to sell asset classes that have appreciated the most (or depreciated the least) and buy asset classes that have not performed as well.

What is Re-Balancing

Let’s look at an example.  At the beginning of a year, you invest $10,000 using the All Seasons portfolio.  Your portfolio looks like this:

Allocation of $10,000 using All Seasons portfolio

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.

End of year results compared to target for 2019 under the All Seasons portfolio

To reach the target allocation, you would need to make the following changes.

GoldSell $44
CommoditiesBuy $28
StocksSell $451
Medium Term BondsBuy $399
Long Term BondsBuy $67

To attain the high returns reported by Robbins, I suspect you need to re-balance the portfolio fairly often.  In my calculations, I assumed annual re-balancing on the first of each year.  How often you re-balance the portfolio depends on your personal preference, but should generally be more often when the prices of one or more of the asset classes is changing rapidly and no less often than annually.

Impact of Income Taxes

It is better to own portfolios you need to re-balance regularly in a tax-free or tax-deferred account.  Otherwise, you will need to pay income taxes on the net of your capital gains and capital losses.  401(k)s and IRAs are the most common tax-free and tax-deferred accounts in the US.  The Canadian counterparts are TFSAs and RRSPs.

Continuing the example above, you sell $44 of gold and $451 of stocks for a total of $495.  Without going into the details of the calculation, your cost basis for these two sales combined is $387, for a realized capital gain of $108.  Many Americans have a 10% tax rate on capital gains which corresponds to $11 on the capital gain of $108.  These taxes reduce your total return by 0.1 percentage point.  That might not sound like much, but it can add up.  If you make a $10,000 investment in this portfolio and taxes reduce your return from 10.0% to 9.9%, you will have $5,000 less after 30 years.  That’s half of the amount of your initial investment!

Changes I’ll Make to My Portfolio

The analysis presented in this post has refined my thinking about my portfolio in two ways.

First, I have confirmed my past thinking that I can maintain a substantial cash position, supplemented by some individual bonds held to maturity, as a hedge against the risk that the stock market will have a significant downturn.  Although holding several years of expenses in cash lowers the return on my total assets, I find it a much easier and less risky strategy than introducing bond funds into my portfolio.  That is, although the return on money market funds where I hold my cash is low, it isn’t much lower than the current returns on US treasury or even high-quality corporate bonds.  With the significant potential that the market price of bonds will go down, I am more comfortable with my cash position.

Second, I have invested in the SPDR Gold Trust (ticker symbol GLD).  I don’t plan to immediately move as much as the 7.5% of my portfolio into gold as suggested by the All Seasons portfolio (15% if I use gold as a substitute for commodities, too).   Rather, I plan to initially invest 1% to 2% of my portfolio in gold and add to that position as I gain more comfort and experience investing in it.

Footnotes

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

[2] “Robbins’ All-Seasons Portfolio.” 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 portfolio.  As such, I am not able to replicate his calculations.  In fact, I found another source for returns on the All Seasons portfolio that, in the single year for which details were provided both sources, shows a return that was 3 percentage points higher than reported by Robbins.

[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 portfolio are not as high as were calculated by Robbins.

Selecting Stocks with a Score

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 investor. 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,

BM Ratio = Book Value divided by Market Capitalization

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 assets 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 assets 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 value of the future pension benefits is more than the liability on the balance sheet. Companies disclose these differences in the Notes to Financial Statements. If the liability 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 value 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:

  1. Return on assets (ROA) = Net income / Total assets at beginning of year > 0
  2. ROA this year > ROA last year
  3. Cash flow from operations > 0
  4. Cash flow from operations > net income
  5. Long-term debt / Total assets this year < Long-term debt / Total assets last year
  6. Current ratio this year > current ratio last year
  7. Shares outstanding this year <= shares outstanding last year
  8. Gross margin this year > gross margin last year
  9. Total sales / Total assets this year > Total sales / Total assets 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 margin.

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 term, as shown in the table below.

Total Return starting in March 2013
1 Year2 YearsUntil 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 fund, 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.

Picking Stocks Using Pictures

Picking Stocks Using Pictures

Technical analysts select companies for their portfolio 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 interest 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 interest 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 trader. 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.

Apple stock price from 2018 to 2020, starts at about 150, goes to 200, back to 150 by early 2019, over 300 by early 2020, down below 250 in March 2020, back above 300

Shopify had a steadier increase in 2018 and 2019, but much more volatility so far in 2020, as illustrated in the graph below.

Shopify stock price from 2018 to 2020. Starts around 100, goes to 400 in mid-2019, down to 300 by end of 2019, above 500 in March 2020, down to almost 300 then above 700

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.

Shopify stock prices from 2018 to 2020 with 9-day and 180-day moving averages. Apple stock price from 2018 to 2020 with 9-day and 180-day moving average lines.

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.

Shopify Price with each day showing high, low, open and close. Days when price went down are in red (about 1/2 of the days), otherwise bars are green. Below price chart is a bar chart showing the daily trading volume.

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).

Apple and Shopify Relative Strength Indices with red line at 70 (sell signal) and green line at 30 (buy signal).

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.

Shopify price chart from Feb 1 2020 to May 11 2020 with EMA 12 and EMA 26.

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

Shopify MACD and 9-day simple moving average of MACD.

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.

Apple MACD with 9-day moving average (sell signal).

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.

Shopify Heishen Ashi candles Apple Heikin Ashi Candles

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.

Apple and Shopify closing prices from Nov 1 2019 to mid-May 2020. Red arrow showing downward trend in Shopify price from mid-Febrary 2020 to late-March 2020. Green line showing upward trend in Shopify price from early April 2020 to mid-May (end of chart)

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.

Apple closing prices from Nov 1, 2019 to mid-May 2020. Circle around prices from late Jan 2020 to end of Feb 2020 where price bounces up and down

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 portfolio 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 portfolio 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 trader or swing trader.

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.

Southwest Airlines closing price from Feb 15 2020 to late May 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.

Southwest Airlines Relative Strength Index chart from Feb 15, 2020 to May 20, 2020.

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, 2nd 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 IRA, 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 IRA, 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).

Should I Buy Stocks Now?

Should I Buy Stocks Now?

Many, if not most, financial advisers recommend accumulating wealth from a diversified set of investments including stocks.  An investor can add stocks to her/his portfolio by purchasing stocks from an individual company or from buying mutual funds.  With the stock market down double digits since the beginning of 2020, some experts say stocks are “on sale” and now is a good time to buy, but just over half of Americans report they own stocks. This is down from 62% prior to the 2007/8 recession and it includes ownership of stocks that are contained within retirement funds and mutual funds, as well as individual stocks.  Common reasons to not buy stocks/mutual funds are (1) stocks are complicated and I don’t know how to get started, and (2) stocks are too risky.  Let’s review both of these drawbacks.

Stocks are Complicated

All too often, some of my friends and family are reluctant to purchase stocks because they do not understand the stock market.   Even some of my most intelligent friends shy away from financial conversations that involve the stock market because they do not want to appear ignorant.

If you did not learn about investing in school or from your parents, how can you figure this out?  How do you convert your dollars into stocks?  How do you learn which stocks are worthwhile?  Should you purchase individual stocks or mutual funds and, by the way, what exactly are mutual funds?

Investment Clubs Help You Buy Stocks

You can learn about many of these topics in a fun way by forming an investment club with like-minded friends and/or family.  Since 2004, I have been a member of Take Stock, a ladies’ investment club.  Our club is one of the 4,000 investment clubs of the National Association of Investors Corp. (NAIC).  The NAIC was formed in 1951 as a 501(c)(3) nonprofit organization with the aim of teaching individuals how to become successful long-term investors.  Originally, the NAIC’s focus was investing in common stocks, but, with the popularity of 401(k)s and other retirement plans, the NAIC has added education about stock and bond mutual funds.

The NAIC (also more recently known as Better Investing) stresses four principles for successful, long-term investing:

  1. Invest regularly, regardless of market conditions;
  2. Reinvest all earnings;
  3. Invest in growth companies (and growth mutual funds); and
  4. Diversify to reduce risk.

What Information Can I Get from NAIC/BI?

NAIC/Better Investing (NAIC/BI) provides many tools and resources to help individuals as well as investment clubs learn about investing.  There is a stock selection guide (SSG) that organizes companies’ performance information to allow you to determine for yourself whether a particular company is a stock you want to purchase and the price is reasonable.  Some of the free resources offered by NAIC/BI include:

  • Over 100 free stock investing videos;
  • An introduction to stock investing that explains the SSG;
  • How to start your own investment club;
  • Investor education articles;
  • Stories from members; and
  • 90-day free membership.

How My Club Works

My club was formed in 1999. It is comprised of nine women who meet monthly in each other’s homes.  Of the nine members, the one with the longest tenure is a charter member and the most recent arrival has been in our club for just over one year.   During our meetings, we review our club’s portfolio (currently stocks of twelve companies), discuss stocks to research for possible future purchase, and vote on any companies that we have already researched. It is not required that you meet in members’ homes—you could choose to meet at your local library, a restaurant, etc.  We typically meet in the evening on the second Tuesday of each month and the hostess for that month provides a light meal.  Every July, we meet at a local park for a summer concert and we bring our families/friends.

Monthly “dues” are used to invest in stocks and your ownership is based upon what percentage of the total portfolio you have invested through your paid dues.  The monthly dues are in multiples of $25 (i.e., $25, $50, $75 etc.) and there is a monthly minimum of $25.

I highly recommend forming or joining an investment club.  You’ll have the opportunity to learn more about the stock market, to learn more about individual companies that you and your club research, and you’ll get to know your friends and acquaintances better.  The best part is you’ll have fun while investing in your financial well-being and you will all become richer by enhancing your friendship.

One Final Caveat

If you are new to investing you will probably want to invest the portion of your money that you will not need in the near term, such as a down payment on a home you wish to  purchase three or more years from now, your children’s education fund, or your retirement fund.  Your rainy-day fund should be kept in more liquid investments that can be accessed quickly.

So now that you know you can have fun and learn about the stock market, you may still be reluctant to buy stocks due to the risk involved.  Let’s review this objection to increasing your wealth. . .

Stocks Are Too Risky

One of the primary concerns about owning stocks is the risk inherent in these investments.  What if I invest my money in the stock market and the stock market crashes as we have seen since Covid-19 or like we saw in 2008/2009?  While it is true that declines of 15+% in your investment portfolio are not desirable, it is also true that in every case where the stock market has had a large decrease, the stock market more than made up for the declines in the months and years following the drop.

As of this writing (April 30, 2020), since the beginning of 2020, the Dow Jones Industrial Average (Dow) is down about 18% and the S&P 500 is down about 11%.   While not good news, if you were invested in the market during 2019, you would still be ahead because the Dow rose more in 2019 than the current 2020 drop. (Dow added 22% and the S&P 500 added 28% during 2019).

We have likely heard the old adage:  risk is reward. That is, the more reward that is sought, the more risk that must be taken.  If you are desirous of the smallest risk possible, then you would probably choose to park your money in (for example) savings bonds or certificates of deposit which will guarantee you a reward albeit a small one.  If you prefer more reward, then you will likely choose to invest some of your portfolio into the stock market.  Let’s look at an example of how a specific risk tolerance manifests into investment growth.

Risk-Reward Comparison

Five years ago, assume you invested $1,000 with (1) small risk (investing in a certificate of deposit), (2) medium risk (investing in an S&P 500 mutual fund) or (3) high risk (investing in only one individual stock).  Here are the results:

 

CD:  “low” riskS&P 500: “medium” riskAmerican: “high” riskApple:   “high” risk

5/1/15

 $1,000 $1,000 $1,000

 $1,000

12/31/19 $ 1,073 $1,531 $633

 $2,376

4/30/20

 $1,077 $1,395 $298

 $2,209

5-year return

7.7%39.5%-70.2%

120.9%

4.75-year return (through 12/31/19, 0pre-Covid)

7.3%

53.1%-36.7%

137.6%

 

Takeaways from this Exercise

Here are the key takeaways from this table.

  • The lowest-risk investment provides a 7.7% return over five years. This is based on investing $1,000 over a period of five years at current CD rates of 1.5% per year.  Note that while the original investment of $1,000 grows over the five years, it is growing less than the rate of inflation over the five years so you have “lost ground” by investing in a CD.    Over this same five-year period, the Consumer Price Index rose by 8.9%, higher than the 7.7% earned in the CD; thus, your buying power is less since the cost of goods has risen by 8.9% while your investment grew at 7.7%.
  • The medium-risk investment provides a much better return than low risk. You would have earned nearly 40% over the five-year period.
  • The high-risk investment was defined as investing in only one single stock. As you can see, if you chose American Airlines for your one stock, you would have lost 70% of your investment.  However, if you had chosen Apple as your one stock, you would have more than doubled your money and earned a 121% return over five years.

Keep in mind that the results above include the effects of the drop in the stock market from COVID-19.  If we look instead at year end 2019 — before the effects of COVID-19 — we see returns of 7.3% (CD), 53% (S&P 500), -37% (AAL), and 138% (AAPL).

Your Risk Appetite

If your risk appetite is miniscule, then you would probably want to avoid the stock market altogether and put your money into certificates of deposit.   This will not bring wealth to you but it will give you peace of mind.  If you have more tolerance for risk, then investing in the stock market by diversifying your stocks is a much better way to accumulate wealth.   As shown in the example above, it is possible to earn more from investing in high-growth stocks, but it is also virtually impossible to pick which individual stocks will generate above average future growth.  The medium-risk option will usually provide much better returns over the long terms than will the low risk-option.

How I Built My Wealth

Stocks—primarily mutual funds with a variety of individual stocks—have contributed to my personal wealth accumulation.  I recommend including stocks in your assets and joining or forming an investment club with friends and family can be a fun way to further your wealth.  Good luck!

 

Kay Rahardjo, FCAS, MAAA is an actuary and risk management professional. She retired from The Hartford in 2014 from her role as Senior Vice President and Chief Operational Risk Officer. She developed and taught an operational risk management course at Columbia University.

At What Price Should I Buy a Stock?

At What Price Should I Buy a Stock

Deciding at what price to buy a stock or other security is almost as hard as deciding whether to buy the security at all.  There are many different approaches for deciding at what price to buy a stock.  One of the ones I’ve seen discussed most often is dollar-cost averaging.  Other strategies include (1) buying the position on whatever day you decide to buy it and (2) setting a target price that is below the current trading price, among many others.  In this post, I’ll explain and compare these three strategies.

Dollar-Cost Averaging

Dollar cost-averaging is a strategy for buying stocks that is intended to reduce the risk that you will “buy high.”

How it Works

Here are the key steps for implementing this strategy:

  • Identify the security you want to buy.
  • Determine how much money you have to invest in that security.
  • Divide that amount into equal increments. In the examples below, I have split the amount into four increments.
  • Decide over what time period you want to make your purchases. In the examples below, I have illustrated a purchasing time period of four weeks.
  • Invest one increment at points in time evenly spaced over your selected time period. For example, let’s say you want to invest over four weeks.  You might buy the selected security every Wednesday in four equal pieces.  If you have $1,000 to invest, you would buy $250 of the selected security each Wednesday for four weeks.

The underlying premise of this approach is that you buy more shares of the selected security than if you happened to have bought the security on a day that the price is high.  Specifically, because you are buying the security in equal dollar amounts, you will buy more shares when the price is low and fewer shares when the price is high.  As such, your average purchase price will be low.

Simple Example

Here’s a simple example in which you invest a total of $4,800 in increments of $1,200 a week for four weeks.

WeekStock PriceShares Purchased
1$10.00120
28.00150
312.00100
49.25130

In this example, you buy a total of 500 shares.  If you had bought all of your shares on at $10 (the first week price), you would have 480 shares ($4,800 / $10).  In this scenario, you will have 4% more shares ([500 – 480]/480 – 1) if you use dollar-cost averaging than if you bought all of your shares at the first week’s price.  4% more shares corresponds to 4% more money when you sell the security.  Although 4% may not sound like a large difference, it can add up over time as you buy and sell stocks.

To be clear, though, dollar-cost averaging isn’t always better.  If you had bought all of your shares at the Week 3 price of $8, you would have 600 shares or 20% more than if you used dollar-cost averaging.

Investing Strategies

Here are the three strategies for determining when to buy a security that I’ll use for illustration.

Strategy 1 – Invest Immediately

Invest all of your available money on the day you decide to make the purchase.

Strategy 2 – Dollar-Cost Averaging

Use dollar-cost averaging by buying ¼ of your money available on Wednesday of four consecutive weeks[1]. This strategy is similar to what happens when you buy securities in your employer-sponsored retirement account if you are paid weekly.  Every week, you employer takes some of your wages and invests it in the security you have selected.

Strategy 3 – Wait for Price Drop

Invest all of your available money after the stock price has dropped by 5%. Hold your money in cash while waiting for the price to decrease.

More Examples

I’ve created a few more simple examples to compare the strategies for deciding when to buy a security.  These examples are intentionally simple and therefore unrealistic.  Nonetheless, they are helpful in understanding the different strategies because of their simplicity.  In all of the examples, you have $1,000 to invest.

Smooth Increase

In the first scenario, the stock’s price goes up smoothly by 10% every year.  A graph of its price over two years would look like this.

Line graph with straight line going from $10 stock price on day zero to $12 stock price on day 700

The chart below focuses on the first month of the above chart and includes the purchases for Strategies 1 and 2 as dots.

Graph showing prices when you buy under Strategies 1 and 2

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
810.0224.95
1510.0424.90
2210.0524.88

The total number of shares you buy is 99.73.

Under Strategy 3, you never buy the stock because the price never decreases by 5%.

The table below compares the numbers of share bought under each strategy

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.00$1,210
2Dollar-Cost Averaging99.731,203
3Wait for Price DropN/A1,000

In this scenario, there is very little difference between the first two strategies, though you will buy more shares if you invest immediately. Any time you delay your purchases in this scenario, you are certain to pay a higher price which reduces the number of shares you can buy.  Under Strategy 3, because the price never decreases, you never buy the stock, so end up with the same amount of money with which you started.

Smooth Check Mark

The second illustration is stock whose price goes down smoothly for six months and then increases for the next 18 months.  A graph of its price would look like this.

Line graph with line that looks like a check mark.

The chart below focuses on the first six months of the above chart and includes the purchases for all three strategies as dots.

Graph showning prices you pay under 3 strategies if price graph is checkmark

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
89.9825.05
159.9625.10
229.9425.15

The total number of shares you buy is 100.30.

Under Strategy 3, you buy 105.2 shares at $9.50 (5% below the initial price of $10) on day 177.

The table below compares the numbers of share bought under each strategy and the amount of money you will have at the end of two years.

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.0$1,097
2Dollar-Cost Averaging100.31,100
3Wait for Price Drop105.21,154

In this scenario, the best strategy is to wait until the price drops by 5% which happens to be the minimum price over the two-year period.  The results of the other two strategies are very similar, though investing all of your money on the first day is the worst choice, as you buy stock during the period in which the price has fallen under the other two strategies.

Bumpy Increase 1

Next, we will look at two illustrations of what a stock price might actually look like.  Here is a graph of the first illustration.

Prices when they increase on a bumpy path

The chart below focuses on the first month of the above chart and includes the purchases for Strategies 1 and 2 as dots.

Prices at which you buy under strategies 1 and 2

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
89.8325.43
159.8825.30
229.8025.51

The total number of shares you buy is 101.24.

Under Strategy 3, you don’t buy any shares because the price never falls by 5%.

The table below compares the numbers of share bought under each strategy

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.00$1,144
2Dollar-Cost Averaging101.241,158
3Wait for Price Drop0.001,000

In this scenario, the best strategy is to buy your stock using Dollar-Cost Averaging (Strategy 2), but only by a small amount compared to using the Invest Immediately strategy.  You will have 1% more money than if in you invest it all on the first day and 13% more money than if you wait for the price to drop.

Bumpy Increase 2

The second realistic illustration is exactly the same as the first one with the exception that, in the first month, the price bounces around a bit above the initial $10 price rather than just below it.  The chart below focuses on the first month for this illustration and includes the purchases for Strategies 1 and 2 as dots.

Prices at which you buy under strategies 1 and 2

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

DayPriceShares Bought
1$10.0025.00
810.2124.49
159.8825.30
2210.3124.25

The total number of shares you buy is 99.04.

Under Strategy 3, you don’t buy any shares because the price never falls by 5%.

The table below compares the numbers of share bought under each strategy

StrategyNameNumber Shares BoughtValue in Two Years
1Invest Immediately100.01,144
2Dollar-Cost Averaging99.041,133
3Wait for Price Drop01,000

In this scenario, the best strategy is to use the Invest Immediately strategy (Strategy 1), but only by a small amount compared to Dollar-Cost Averaging.  You will have 1% more money than if in you use Dollar-Cost Averaging and 14% more money than if you wait for the price to drop.

More Realistic Examples

Now that you have a better understanding of the three different strategies, I’ll turn to even more realistic scenarios.

  • The first of these scenarios will use the actual returns on the S&P 500 from 1928 through early 2020. This scenario is likely to be relevant when you are considering an investment in an index fund.
  • The second scenario is intended to be similar to an investment in an individual stock. To create the example, I took the S&P 500 times series and doubled the volatility.[2]

The daily stock prices are illustrated in the graph below.

S&P 500 prices from 1928 to 2020

Investment Horizons

To illustrate the impact of the different strategies, I looked at three different time periods over which you might hold the stocks – one year, five years and ten years.  If you are young and hold a stock until you retire, such as I have with some of the stocks I own, you might own the stock for 30 or 40 years.  I didn’t feel there was enough data available in the above time series to look at the impact on owning securities for more than ten years.  So, if you think you will be a very long-term investor, you will want to focus on the ten-year results.  Also, these analyses are not helpful to people who plan to own stocks over very short periods of time, such as some traders who might buy and sell a security in the same day.

Comparison of Realistic Results

The table below compares how much money you would have, on average across all possible starting dates for which data were available, at the end of each of the three time periods if you used each of the three strategies to buy $1,000 of an S&P 500 index fund.

StrategyOne YearFive YearsTen Years
Invest Immediately1,0741,3721,873
Dollar-Cost Averaging1,0741,3731,877
Wait for Price Drop1,0221,1811,485

 

The table below compares how much money you would have, on average, at the end of each of the three time periods if you used each of the three strategies to buy $1,000 of the illustrative stock.

StrategyOne YearFive YearsTen Years
Invest Immediately1,0871,3761,875
Dollar-Cost Averaging1,0871,3791,880
Wait for Price Drop1,0771,3301,772

 

Dollar-Cost Averaging vs. Invest Immediately

For both the S&P 500 and the illustrative stock, there are only very small differences (less than 0.3% for the one-year investment horizon and less than 1.3% for the longer investment horizons) in the average amount of money at the end of each of one, five and ten year between the Dollar-Cost Averaging and Invest Immediately strategies.

Wait for Price Drop

On the other hand, there is a larger difference between the average amount of money at the end of the three time periods if you use the Wait for Price Drop strategy and the average amount using either of the other two strategies.  For the S&P 500, you will have between 5% and 20% less money, on average, if you use the Wait for Price Drop strategy than if you use the Invest Immediately strategy, depending on your investment horizon.

For the more volatile illustrative stock, you will have between 1% and 5% less money, on average, if you use the Wait for Price strategy than if you use the Invest Immediately strategy.  With the higher volatility of the illustrative stock, it is more likely to have a 5% price drop.  There are therefore fewer scenarios in which you don’t get any investment return than there are using the S&P 500 prices.  As such, there is a smaller difference between the results of the Wait for Price Drop strategy and the other strategies for a more volatile security than for a more stable one.

Key Takeaways

As can be seen, the best strategy depends on the pattern and volatility of the security’s price.  Briefly:

  • For securities that have fairly smooth trends, there isn’t a lot of difference between the Invest Immediately and Dollar-Cost Averaging strategies.
  • For securities with more volatile prices, such as the two Bumpy Increase scenarios, the choice between the Dollar-Cost Averaging and Invest Immediately strategies can be a bit larger. However, there isn’t one that is better in all situations – Dollar-Cost Averaging was better in Bumpy Increase 1 while Invest Immediately was better in Bumpy Increase 2.  Because you can’t know whether your security’s price will follow a pattern closer to Bumpy Increase 1 or Bumpy Increase 2, neither strategy is preferred.
  • If you think that the price of the stock might trend down somewhat significantly or has a lot of volatility allowing the price to be significantly lower than the current price, waiting for a 5% (or other value you select) price decrease (Strategy 3) could be the best strategy. The drawback of this strategy is that there are a lot of scenarios in which you will never buy the security and then will get no return.

What Do I Do?

With all this information, you might wonder what I do.  I first need to provide a little background about my current investing situation, as it is likely to be different from yours.

I am retired, so am starting to spend my investments.  As such, I have a shorter investment horizon than I did when I was younger and in the saving mode.  I have a number of stocks and a few mutual funds that I have owned for many, many years and do very little trading of those positions.

Another portion of my money is in sector funds (index funds that focus on one segment of the economy, such as industrial companies, healthcare or technology) and a few large companies.  I tend to hold those securities for six months to two years.  The securities I am trading are closer in nature to the S&P 500 time series than even the hypothetical company with twice the volatility as the S&P 500.  As such, the Wait for Price Drop strategy doesn’t work for me.

With the very small differences between the Dollar-Cost Averaging and Invest Immediately strategies, I choose the Invest Immediately strategy because it is easier.  I have to place only one buy order instead of several orders.

Limit and Market Orders

As discussed in my post on stocks, there are different types of orders you can place when you want to buy a stock.  I always place limit orders.  A limit order allows me to buy a stock from the first person who wants to sell it to me at the price I have stated in the order.

The other type of order is a market order.  If you place a market order, you don’t get to set the price.  You buy the stock at whatever price it is trading at the moment you place the order.

There are risks to both types of orders.  If you place a market order and the price jumps up, you will buy the stock at the higher price.  If you place a limit order for a price below the current market price, you might never buy it similar to the Wait for Price Drop strategy.

A Compromise

To avoid the risk that I might buy a stock at a significantly higher price than I intend, I place a limit order with a limit that is about half way between the closing price and the low price from the previous day.  (I almost always place my orders over the weekend, so don’t have “up-to-the-minute” prices.)  This difference is often between 0.5% and 1% of the price.  By taking this strategy, I get a very small boost to my return by setting my limit below the market price but with very little risk that I won’t buy the stock because I have chosen the limit amount to be within a single day’s trading range.  The additional 0.5% to 1% doesn’t sound like a lot, but if I am able to increase my total return by that amount every year or two, it compounds quickly.

 

[1] There is nothing special about once a week for four weeks.  I did some testing of once a day for five days and found that there wasn’t a lot of difference in the number of shares bought, on average across a wide range of scenarios, from what the number using once a week for four weeks.  I also did some testing of what happens when you buy shares once a month for a year.  Across a wide range of realistic scenarios, you own fewer shares on average if you spread your purchases over a year as you purchase securities that you think will increase in price.  If the price of the security increases over the year, you will buy some of your shares at the higher price and own fewer shares.

 

 

[2] This note explains the nitty gritty details of how I adjusted the S&P 500 time series to create the second scenario.  I calculated the 200-day moving average of the daily closing prices of the S&P 500 from 1928 to early 2020.  The deviation is the actual closing price minus the moving average.  I doubled this deviation and added it back to the moving average to simulate prices for the hypothetical stock.

Mutual Funds and ETFs

Mutual Funds and Exchange-Traded Funds

Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or busy investors to participate in financial markets. This post will help you learn about the different types of funds, their pros and cons and other considerations of owning mutual funds and ETFs.

What is a Mutual Fund?

A mutual fund is pool of money collected from the investors in the fund. The investors own shares in the mutual fund itself, but not in the individual securities owned by the fund. However, other than closed-end funds discussed below, an investor’s return is his or her share of the returns of the aggregation of the returns of the individual securities owned by the mutual fund. That is, if, on average, the securities in the mutual fund issue dividends of 3% and appreciate by 2%, fund owners will receive a dividend distribution equal to 3% of the value of their share of the pool plus the value of their ownership share will increase by 2%.

Most mutual funds also issue capital gain distributions once or twice a year. If the mutual fund had a gain on the aggregate amount of securities sold in the year, it will often distribute the amount of the gain to investors as a capital gain distribution in proportion to their ownership shares in the pool.

Mutual funds can be purchased directly from the fund manager or through a broker. Most mutual funds are not traded on exchanges. Purchases and sales of mutual funds occur once a day, with all buyers and sellers receiving the same price which is equal to the net asset value of the underlying assets. (See below for more information and exceptions.)

What is an ETF?

Exchange-traded funds or ETFs have several characteristics in common with mutual funds:

  • They are pools of money collected from their investors.
  • Investors share in the returns of the aggregation of the individual securities.
  • ETFs can hold a wide range of securities, including stocks, bonds and commodities.

These are a few of the ways in which ETFs differ from mutual funds:

  • They are exchange-traded securities (as implied by their name), so they can be bought and sold any time the exchange is open. As such, the price you pay or receive when you buy or sell an ETF can vary over the course of a day.
  • While many mutual funds have a minimum investment requirement, most ETFs do not.

Types of Mutual Funds and ETFs

There are many features of mutual funds and ETFs that are important in determining the best funds for your portfolio. Almost all of these features apply to both mutual funds and ETFs.

Active vs. Passive Management

An actively managed fund has a fund manager who is responsible for selecting the securities that will be owned by the fund. The manager decides when to buy and sell each security.  By comparison, the securities owned by a passively managed fund are determined so that the performance of the fund tracks a certain basket of assets.

Index funds are a common type of passively managed funds.   An index fund is a mutual fund or ETF that has a goal of matching the performance of an index, such as the S&P 500, the Dow Jones Industrial Average or the Fidelity US Bond Index.

There are other passively managed funds whose trades are determined so as to produce returns similar to a certain segment of a market, such as a particular industry or region of the world, that may or may not have an index that measures those returns.

Securities Owned

Funds can own a wide variety of securities – everything from stocks and bonds to commodities, among others. As you are looking for a fund, you’ll want to decide what type of security you are seeking.

Geography

Most funds focus on a specific geography. Many mutual funds focus on US investments, while others purchase securities from within a region of the US, the whole world or segments thereof, such as the developed world excluding the US. While I hold most of my North American equity positions in individual companies, I use mutual funds to diversify my portfolio globally.

Market Segment

Just as funds focus on a specific geography, they sometimes invest in one or more market segments.   Some funds focus on a specific industry, such as natural resources or technology or financial companies. If you think a particular industry is going to benefit from trends in the economy, such as healthcare as the population ages, you might want to buy a fund that focuses on the healthcare industry. On the other hand, you might want to avoid healthcare stocks if you think that the healthcare industry might be at risk of significant disruption from changes in the government’s role in healthcare.

Other funds focus on the size of companies.  For example, an S&P 500 Index fund only buys positions in companies in the S&P 500 which, by definition, are large.  Other funds focus on middle-sized companies (middle-sized capitalization of mid-cap) or smaller companies (small-cap).

Another “industry” on which many funds focus is municipal bonds. These funds invest in bonds issued by municipalities. In many cases, interest from municipal bonds and municipal bond funds is not taxed by the Federal government or in the state in which the municipality is located. For example, if you buy a bond issued by the City of Baltimore, it is likely that it will not be taxed at all if you are a Maryland resident.

Appreciation vs. Dividends

Some funds focus on high-dividend investments, while others focus on appreciation in the value of the securities they own. You can learn the focus of a fund by looking at its details either in a summary or its prospectus. Funds that focus on high-dividend yields often have “high-dividend” in their name, but not always. The type of return targeted by funds you purchase will impact the specific securities owned by the fund. In addition, the type of return impacts the taxes you will pay (discussed below).

Growth vs. Value

Companies are often categorized between growth and value, reflecting the two primary reasons that stock prices increase. The stock price of a growth company is expected to increase because the company will increase its profits. By comparison, the stock price of value company is expected to grow because its valuation, often measured by the price-to-earnings or P/E ratio, is considered low and likely to return to normal.

Closed-end vs. Open-end Funds

Most funds are open-end funds. The price you pay for these funds is equal to the market value of the securities owned by the fund divided by the number of shares outstanding.   This price is known as the Net Asset Value. You can buy shares from and sell shares back to the fund owner at any time at the net asset value.

A closed-end fund differs in that the number of shares available is fixed when the fund is first created. When you buy and sell shares in a closed-end fund, the other party to the transaction is another investor, not the fund owner.  In fact, closed-end fund shares trade in the same manner as if the fund were a company. As such, the price is not the net asset value, but rather has a market value that reflects not only the net asset value but also investors views of the future performance of the fund.

I found Investopedia to have some great information about open-end funds and closed-end funds.

Advantages and Disadvantages of Mutual Funds and ETFs

The biggest advantage of mutual funds and ETFs is the ease with which you can diversify your portfolio, especially in asset classes or market segments with which you are unfamiliar. I think index-based ETFs are a terrific way for new investors to participate in markets. As I mentioned above, I use mutual funds for international stocks, as I don’t know enough about economies and market conditions outside the US, much less about individual companies, to make informed buying decisions.

A drawback to actively-managed funds is that they tend to underperform the market. That is, there are not many money managers who can consistently produce returns that exceed their target benchmarks. This difference is even greater when returns are reduced for fees paid by investors (discussed later in this post).

There are many sources for statistics about mutual fund returns. CNBC states that, in every one of the nine years from 2010 through 2018, more than half of actively managed large-cap funds produced returns less than the S&P 500. The same article also indicates that 85% of those funds underperformed the S&P 500 over a ten-year period and 92% underperformed over a 15-year period. As such, care should be taken when investing in actively managed funds. If you are looking for funds that will produce returns similar to broad market indices, such as the S&P 500, an index fund might be a better choice.

Income Taxes

There are four types of returns that are taxed when you own mutual funds or ETFs that hold stocks or bonds held in taxable accounts. Funds held in tax-deferred or tax-free accounts will have different tax treatment. The taxable returns on other types of funds will depend on the types of returns generated by the underlying assets.

Capital Gains

When you sell your ownership position in a fund, the difference between the amount you paid when you bought it and the amount you received when you sell it is a capital gain.   The taxation of short-term capital gains (related to securities owned for less than one year) is somewhat complicated in the US. Long-term capital gains are taxed in the same manner as dividends in the US, at 15% for most people. In Canada, capital gains are taxed at 50% of the rate that applies to your wages.

Interest

When you own a bond fund, interest paid by the issuers of the bonds owned by the fund is taxable in the year the interest payment was made. In the US and Canada, interest held in taxable accounts is taxed at the same rate as wages, except for certain municipal and government bonds which may be exempt from state or Federal taxes.

Dividends

Dividends paid by companies owned by a fund are taxable in the year the dividends payments are made. For most people in the US, there is a 15% Federal tax on dividends from investments held in a taxable account plus any state taxes. In Canada, dividends are taxed at the same rate as wages.

Capital Gain Distributions

Over the course of a year, a mutual fund may sell some of its assets. The capital gains earned from those assets are distributed to owners as capital gain distributions. Capital gain distributions are taxed in the same manner as capital gains.

Fees

There are generally three types of fees that can affect your returns on ETFs and mutual funds: front-end loads, operating expenses and commissions. Schwab identifies two other hidden costs that are a bit more obscure, so I’ll refer you to its post on this topic if you want more information.

Front-End Loads

Some mutual funds require you to pay a fee when you make a purchase. The fee is usually a percentage of your investment. For example, you would pay $10 for every $1,000 you invest in a fund with a 1% front-end load. If you purchased this fund, its total return on the underlying investments would need to be 1% higher over the entire period over which you owned it than the same fund with no front-end load for you to make an equivalent profit.

Funds that don’t have a front-end load are called no-load funds.

Operating Expenses

Mutual funds and ETFs, even those that are passively managed, have operating expenses. The operating expenses are taken out of the pool of money provided by investors. Every fund publishes its annual operating expense load, so you can compare them across funds. Funds with higher expense loads need to have higher returns on the underlying investments than fund with lower expense loads every year for you to make an equivalent return.

ETFs tend to have much lower operating expense loads than mutual funds. Similarly, passive funds tend to have lower operating expense loads than actively managed funds.  Operating expenses can have a significant impact on your long-term total return, as discussed in this post by Accessible Investor.

Commissions

If you purchase a mutual fund or ETF through a broker, you may pay a commission both when you buy the fund and when you sell it. A commission is a fee paid to the broker for the service it provides allowing you to buy and sell securities. Many brokers have recently reduced or eliminated commissions on many ETFs. If you purchase the mutual fund or ETF directly from the fund manager, you will not pay a commission.

Dividend Reinvestment

Many funds allow you to automatically reinvest distributions (i.e., interest, dividends and capital gain distributions). Although it includes all types of distributions, it is often called dividend reinvesting or reinvestment. It is a great way to ensure that all of your returns stay invested, as you don’t have to keep track of the payment dates on any distributions so you can reinvest them.

I have a few cautions about dividend reinvestment.

First, you want to reevaluate your choice of fund periodically. If you blindly reinvest all of your dividends and something changes that makes the fund a poor fit for your portfolio, automatic dividend reinvestment will cause you to have more money invested in something that you don’t want.

Second, you’ll want to be aware of the tax implications of dividend reinvestment – one of which is helpful and one of which requires some care – if you hold the fund in a taxable account.

Increased Cost Basis

As indicated above, when you sell a fund, you pay capital gains tax on the difference between your proceeds on sale and what you paid for the fund. The distributions that you reinvest are considered part of what you paid for the fund. You’ll need to take care to keep track of the amounts you’ve reinvested, as they increase your cost basis (the amount you paid) and decrease your capital gains tax.

Taxes on Distributions

Even if you reinvest your distributions, you need to pay taxes on them in the year in which they were paid. As such, if 100% of your distributions are automatically reinvested, you’ll need to have cash available from another source to pay the income taxes on the distributions.

Selecting Mutual Funds and ETFs

There are thousands of mutual funds and ETFs from which to choose. Here are my thoughts on how you can get started.

Set your Goals

  1. Determine what type of fund you are seeking. Are you trying to focus on a small niche or the broader market?
  2. Narrow down the type of fund that will meet your needs. Do you want an actively managed fund or a passive one? Are you interested in an open end or closed end fund?  Do you want the fund to look for growth companies or those with low valuations?

Identify Some Funds

  1. Once you’ve narrowed down the type of fund you’d like, you can use a screener to help you further narrow down your choices. Most large brokerage firms, as well as many independent entities, have mutual fund and ETF screeners. For example, Morningstar, a global investment-research and investment-services firm, has a free screener (after you sign up at no charge) at this link.
  2. Look at the ratings of the funds that are identified. The entity assigning the ratings usually expects higher rated funds to perform better than lower rated funds.
  3. Look at the historical returns. While past performance is never a guarantee of future performance, funds that have done well in the past and have consistent management and strategy may do well in the future.
  4. Read the details of the fund either on the fund manager’s web site or in the prospectus. Look to see if the objectives of the fund are consistent with your objectives. Make sure the types of securities the manager can purchase are in line with what you would like to buy. The names of some funds can be much narrower than the full range of securities the manager is allowed to buy. Find out if the fund management and objectives have been stable over time. Some funds can change their objectives on fairly short notice, potentially exposing you to risks you may not want to take or lower expected returns that you desire. To learn more about reading a prospectus, check out the article on Page 9 of this on-line magazine.

Compare Fees

  1. Compare the fees among the funds on your list. If the underlying assets are similar and are expected to produce the same returns, funds with lower fees are more likely to provide you with higher returns (after expenses) than funds with higher fees. Don’t forget to look at both front-end loads and annual operating expense ratios.
  2. Select a strategy for buying your mutual funds or ETFs, such as dollar-cost averaging, waiting for a price drop or buying at the market price.

Make a Decision

  1. Buy a position in the fund(s) that best fit your requirements. As indicated above, you can buy most funds either through a broker (which can sometimes add a commission to your expenses) or directly from the fund manager.
  2. Last, but not least, be sure to monitor your positions to make sure that the fund objectives, holdings, management and fees remain consistent with your objectives.