Sunday, June 17, 2012

When are stocks most likely to go up?

Momentum investors says: “When they are already going up.” Value investors say: “After the crash, when you can buy a company at a discount of its net asset value.” Growth investors say, “When you buy a company whose earnings grow fast.”  They are all right of course,  but there is always a ‘but’ with these approaches and in the ‘but’s lies the risk.

So when do we incur the highest risk?  When the economy is hot; then we then pay almost any price for earnings and earnings growth. When we pay a premium for the company’s net assets and when prices seem to go up forever. So why were you buying stocks in the hot 2007 stock market when risks were highest?
When do we incur the lowest risk?  When everyone is afraid, when stocks are on sale; when momentum has changed from downward to pointing up; when earnings are recovering; when we no longer run the risk of ‘catching a falling knife’.

Is that today’s market? So why are you not buying? Why are you hording cash on the sidelines? I tell you why! You’re afraid of losing you hard saved and hard earned investment loonies, especially after 2008-2009. You’re scared by the headlines; but headlines are to sell newspapers. The real news you will have to eke out from articles which are more often emphasizing the bad than the good. You will have to look for reasons why things are going to get better amongst herds of doom & gloomers, amongst herds of fear mongers and chickenlittles.
Today, we’re climbing a real ‘Wall of Worry’ and it is not easy to put your money out there. But then, things could indeed turn worse again. If investors hate one thing rather than losing money slowly over time than it is to lose money overnight! The answer of how to deal with this is two-fold:

1.       You need to know that you buy truly a valuable, viable investment

2.       If things don’t work out, you should not lose all your investment marbles. In other words, don’t put all your eggs in one basket - diversify.

We’ve discussed how to recognize a viable investment in real estate and we will do the same for stockmarket investments. But first let’s look at point 2 – diversification.
There are many ways to diversify including the classic portfolio rebalancing strategy. But in its simplest form, diversification is to not put all your money in a single investment strategy. Put some in real estate; put some in value stocks; put some in Hi-Tech. Trade a bit in options, buy bonds, and so on and on; or as the old Romans used to say: "et cetera!"

Of course, at the top of the line should be the need to have sufficient cash for you to live through a down turn without have to ration your food and lifestyle beyond what you may consider ‘common sense’. Investment money, in theory, should be money you can afford to lose. Now between you and me, I do not want to lose any money whether I can afford it or not. However, the idea is that you should be able to continue living the way you want even if you lost the money.
This is an important concept. Many things in life show you that if you hold on to it too tightly, you will likely strangle and lose it.  You should allow your children enough freedom so that they will be with you until the day you die or, when you’re an undauntable optimist, forever. That is also true for your financial children - your investments. You should be willing to lose some investment money with the expectation of getting better overall returns.
That is the idea, behind: ‘Nibble, Nibble, Nibble'. You buy the investment that is down, but only in small amounts , not more than you can ‘afford’ to lose and no more than a small portion of your total portfolio.
Recognizing a ‘viable stock market investment’ is not easy. In fact, I have created spreadsheet analogues to the APOD. Now we’re calling them 'financial statements' and just like the APOD there are revenues, expenses, operating income and the costs of financings that lead to net income and cash flow. I am using very simple financials and some macro-economic parameters to come up with easy to understand scenarios from which one can make conclusions that blew my socks off.
If you understand these simplified financials, you will understand why you don’t want to participate in initial public stock offerings or IPOs; you will understand how to increase the value of a company and develop criteria that help you identify the more promising and viable stock market investments.
 In the end, as stated in earlier posts, it is about generating cash flow that allows you to live, to re-invest and to sit out the downturns. So if you just stick with that, you’ll do fine over the long term. Over the short term, it are the market emotions that determine your returns – it is not much better than a casino. Over the long term it is humanity's drive for improved well-being that makes investing worthwhile. This is statistically shown in earlier published data on this blog (Some Ken Fisher vitamins for long term investors  ). Here is a reminder:
(Click on image to magnify)

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