Friday, July 29, 2011

How to take advantage of the U.S. debt circus - II

How would you buy, say the DIA spider, in today's markets? It is nearly impossible to predict the current market gyrations although they're probably down in general until, my guess, September when vacations come to an end and the Debt ceiling issue is past us one way or another.

Historically, September is one of the worst months in the stock market year, but the current mood is quite black so don't expect this to be just another September month. One of the possible outcomes of the debt ceiling story may be that it will be raised in a series of steps each of which is linked to a deficit reduction target. This plus the upcoming U.S. election in 2012 would create a lot of investor insecurity and thus poor overall market performance.

So, we're not in a hurry. Say we have $5000 to invest. With a discount brokerage fee of $10 per transaction, even splitting this money up into 10 investments of $500 would result in a commission rate of 2% which is less than that of a full service broker not counting minimum commissions. I suggest to use slightly larger chunks of $1000 and thus a commission rate of 1%.  Start buying your first tranche coming Tuesday and the next one the following Friday. This should be at the most intense level of fracas. Then slow down your pace and make your next investment say in early September (1st week), the fourth at the end of September and the last $1000 in the 2nd half of October.

Usually, stock markets pick-up in October and this year that may be the case as well. Markets climb around 4 to 5% typically between the lows of September and year-end (see figure below). Funny, you remember the expression "Sell in May and go away"? Yeah right look at the graph.

An important warning though, seasonal trends and this year's performance do not necessarily agree. The figure below shows that clearly. But over the long term, you will profit as shown on this blog over and over again.

Maybe this is a good time to re-iterate what we have learned from our various stock market simulations. First of all, ‘buy and hold combined with dividend reinvestment’ provides the best returns for most retail investors (you and me). If you move in and out of the market with your entire portfolio, even when timing your highs and lows well, you still underperform over the long term. If you used a market timing strategy as discussed in an earlier post starting in 1973 until today, you would have been out of the market entirely during 73 of the 460 months; you would have been fully invested for 54 months and for 330 months you would have been only partially invested. During the times that you were out of the market or only partially in the market you would not have made as much dividends as when you were fully invested for the entire period. Those are dividends that you could have reinvested and that caused the underperformance. (Buy and hold works but you’ll need nerves of steel)

Secondly, if you make a one-time purchase during a market lows, say at a 20% discount of the average market valuation (P/E), your annual return is 12.1% using an earlier 30 year stock market simulation based on U.S. stocks versus 10.3% if you bought at a market peak. So it matters somewhat whether you buy at a market peak or low but a regular contribution plus reinvestment of dividends and no selling is your best long term approach.

It is hard to admit that most of us do not outperform the markets. Many professional mutual fund managers with every piece of desirable data at their fingertips including teams of analysts do not help you to outperform the market especially when you have to pay for their management expenses (MER and commissions). So, do not think that you are any different in that regard

Overall, you will not become rich or stinking filthy wealthy from just saving and putting money in the market. You will do fine and you will become financially comfortable, but to reach the stinking filthy level you need special breaks such as the ones described earlier in the year. But how do you recognize those breaks? You see, that is where your investment knowledge and acumen comes in. You not only need breaks; you also need to recognize them!

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