What's the difference between an investing maxim and an investing myth? The short answer is that the first makes you money and the second loses it. The trouble is, some advice sounds so pithy and convincing that you think it has to be true, especially if it's offered by someone who's made a killing in the market.
Step back to the heady days of 1999, the year the AIM Global Technology Fund topped Canada's mutual fund rankings with a smokin' 219% one-year return for its U.S.-dollar version (when converted back into Canadian dollars). If you'd invested $10,000 when the fund was launched in November, 1996, your investment would have been worth $52,100 at the end of 1999. No worries that stocks held in the fund were trading at a stratospheric average of more than 100 times their earnings per share. "Technology will always offer tremendous opportunities," enthused the fund's manager, Bill Keithler, at the time.
"If you refuse to pay the multiples, you miss huge moves up in the market. The market wants to own these things, and will pay almost any price."
And you know what? Keithler was right. Well, he was right for two months. By the end of February, 2000, that $52,100 would have grown to $68,304. Then the great 1990s tech boom started to crack, and by the end of the year, you would have been down to $36,130. So, should you have hung on for the long term? You still have to wonder how long the long term will be. At the end of last November, the $10,000 invested in the fund at inception would have been worth $15,077.
Are there maxims that actually work? We examined 10 of them and weighed the evidence, pro and con. It appears that almost all of them do pay off-for some of the people, some of the time. And some maxims are better than others. Sometimes.
1. THE TREND IS YOUR FRIEND PRO This buy-high-and-sell-higher approach is a counterintuitive favourite of so-called momentum traders, who try to buy during upswings for a particular stock or the market, and short-sell during downswings. As renowned early-20th-century speculator Jesse Livermore said: "Always sell what shows you a loss and keep what shows you a profit." If a stock is climbing strongly, it's probably doing so for good reasons, and other buyers will want in. Some modern statistical research backs that up. In a study published in The Journal of Finance in October, 2004, academics Thomas George and Chuan-Yang Hwang found that stocks that hit their 52-week high prices subsequently tended to outperform those that hit their 52-week lows. One big reason: Investors are at first skeptical of positive news like a new 52-week high, and it takes a while for a rally to pick up steam.
CON Conservative, long-term value investors are wary of stocks that have surged in value. It's not the trend itself that bothers them; it's the level of the share's price relative to a company's or industry's earnings and to other fundamental indicators. They know they may miss out on some big short-term gains, as revered value investor Warren Buffett did in 1999 and early 2000, when shares in Berkshire Hathaway, his holding company, had plunged by almost half while the tech-heavy Nasdaq Composite Index more than doubled in value. But strong trends can also reverse sharply. The Nasdaq gave up its big gains by the end of 2000, falling back to around 2,500, while Berkshire Hathaway A shares almost doubled, back to about $70,000 (U.S.) apiece. "We have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint," said Buffett. "Try to control your excitement." Seven years later, the Nasdaq is trading around 2,500. As of late December, Berkshire Hathaway A shares were worth $137,980 (U.S.).
The upshot: The trend can be your friend, but maybe not for long.
2. Buy when the blood is running in the streets PRO If you're aiming to buy low and sell high, it would make sense to try to pick the point of maximum pessimism when individual stocks, industries or entire asset classes have fallen out of favour. Take General Electric, which was trading near $40 (U.S.) when CEO Jack Welch retired in 2001, sank to $22.17 (U.S.) in early 2003 as successor Jeffrey Immelt struggled, and has climbed back to around $36 (U.S.) lately. Or how about McDonald's, which hit a low near $12 (U.S.) in early 2003 as anti-fast-food activists ganged up on the company, but soared to all-time highs of more than $60 (U.S.) a share last year? One successful method of picking low-priced stocks is the so-called Dogs of the Dow strategy: You buy the 10 highest-dividend-yielding stocks in the Dow Jones Industrial Average at the end of every year-usually, the yield is high because the share price has declined. You then hold the shares for a year and buy new dogs the next December. From 1928 to 2004, the average annual compounded return for the Dogs of the Dow was 13%. That was almost two percentage points higher than the Dow industrials, and 2.5 percentage points better than the Standard & Poor's 500 Index.
CON Many bleeding patients don't recover, and some of them die-you know that if you held on to your Bre-X stock certificate. Or shares in Nortel and Ballard Power Systems that you bought, say, back in 2000. The risk of buying a stock solely because the price has declined substantially is that you may be caught in a so-called value trap-the price is low, but still too high relative to the company's earnings, prospects and other fundamentals.
The upshot: Do some triage.
3. Diversify. Diversify. Diversify PRO The mantra belongs to William Sharpe, who shared the Nobel Prize for economics in 1990. Basically, he's telling you not to put all your eggs in one basket. Buying just one stock or bond or property is risky. By spreading your money among a variety of asset classes (stocks, bonds and real estate, or funds that hold them), and among several industries, geographical regions and currencies within those asset classes, you cushion the impact of a downturn in any one.
CON Maybe you could shorten that mantra by at least one "diversify." The counterargument can also be found in the work of William Sharpe. In a 1972 article in the Journal of Financial Analysts, he looked at diversification and what's called non-market risk. In the case of stocks, the market risk inherent in owning any one stock is that most of them fall when the market as a whole declines. Non-market risks affect one company or industry-suppose Frank Stronach decides to develop another wacky sports car and Magna International's share price plunges, or North American auto sales decline and the shares of all parts makers suffer. Sharpe's article showed that non-market risk declines dramatically as you start adding stocks to your portfolio, but when you reach 25 or 30, the benefits of adding more become negligible.
The upshot: Portfolios are like your sock drawer-if it's full, you don't need more space; you need to throw out socks.
4. Follow the U.S. Presidential cycle PRO U.S. presidents and their parties want to get re-elected, so they tend to introduce economic austerity measures during the first two years of their four-year term, then loosen the purse strings in years three and four. U.S. stock markets often follow suit. As measured by the bellwether Dow Jones Industrial Average, many bear markets since the late 1920s have begun or continued during the first year of presidential terms-1929, 1937, 1957, 1969, 1973, 1977, 1981 and 2001. By contrast, the Dow has climbed in most presidential election years. The cycle appears to have a big impact abroad as well. In a 1996 study, University of Western Ontario academics Stephen Foerster and John Schmitz looked at the period from 1957 to 1996, and found that the presidential-cycle pattern held true for 18 major stock markets, including those in Canada, Europe and Japan.
CON One of the most powerful influences on stock and bond markets is interest rates. Increases in interest rates put downward pressure on prices. If you glance at the historic interest rate statistics, dating back to 1954, on the U.S. Federal Reserve Board's website, you'll see that for each of the severe bear markets since then, the Fed increased interest rates that year or the year before. True, the central bankers look at the politicians' fiscal policy as part of the many indicators they consider when setting rates, and presidents certainly try to influence the Fed. But it really is an independent agency, and that has been frustrating for many presidents. As an unnamed Johnson administration official said shortly after leaving office in 1969: "If you can trust the president of the U.S with the atomic bomb, why can't you trust him with money?"
The upshot: Markets usually pay more attention to the Federal Reserve chairman than the president, and you should, too.
5. "Buy land. They ain't making any more of the stuff" PRO Humorist Will Rogers's quip had logic to it, and for homeowners in just about every major city in Canada, it's hard to argue with results. The average price of a house nationwide, as reported by the Canadian Real Estate Association, climbed to $333,544 at the end of last October, almost double the level of $167,807 in January, 2000. Stocks, as measured by the S&P/TSX Composite Index, haven't done as well, climbing only by about three-quarters. Buying a home and paying off a mortgage also seems to force a financial discipline on many families that they might otherwise lack. According to one 1999 study, the median net worth of renters in Canada was just $14,000, compared to $149,000 for homeowners with a mortgage, and $252,000 for those who had paid theirs off.
CON The dour, perennial worrywarts at The Economist magazine-who fret over an awful lot of statistics we don't have room to list here-warned in December, 2005, that "the air is slowly leaking from the global housing bubble." One big red flag: The ratio of house prices to residential rents in several countries was much higher than usual. Australia's real estate market had already been hit hard in 2004, and the "hissing sound" from the U.S. got much louder last year. So far, Canada has been spared, but for how long? Even leaving aside potential gains or losses in price, buying a house, a condo or a piece of land is an illiquid investment for most individuals-if you need cash immediately, it's much easier to sell some stocks, bonds or mutual funds.
The upshot: Buying a home is a good thing, but try to make sure you won't have to unload it to alleviate a temporary financial crisis.
6. Don't sell stocks on Friday PRO Stock traders-who often are not the same thing as stock investors-love spotting patterns in markets, and many of them factor those patterns into their trading strategies. Often there appear to be sound fundamental reasons for the patterns. The 2008 edition of Yale and Jeffrey Hirsch's Stock Trader's Almanac, a respected industry bible, notes that from 1989 to May, 2007, the Dow Jones Industrial Average posted a whopping cumulative gain of 9,338 points on Mondays and Tuesdays, and a cumulative loss of 1,367 points on Thursdays and Fridays. The reason? Short-term traders apparently don't like the uncertainty of keeping positions open over the weekend, so they tend to sell toward the end of the week, even if they take a small loss. The following Monday, they're often reluctant to jump back in too quickly, which means stocks rally over the next day or two.
CON Like many patterns, this one does not hold every week. Nor is there any fundamental reason why it should. Think about it: Would companies only release good financial news on Mondays and Tuesdays? Would positive economic developments happen only on those days of the week? Those things tend to help push up share prices, regardless of traders' emotions or their weekend plans. In fact, the Hirsches' own statistical summary shows that from 1953 to 1989, Monday was the most cumulatively negative day of the week for the Dow.
The upshot: Your first question about any apparent market pattern should be: coincidence or what? And do you want to make investment decisions based on happenstance?
7. You can't time the market PRO There are reams of academic research showing that most investors-even professional money managers-don't beat the market indexes over the long term. One classic study that explains why is Princeton professor Burton Malkiel's book A Random Walk Down Wall Street, first published in 1973. Malkiel believes in the "efficient markets theory": All information about individual stocks is reflected in their prices, and pretty well all traders and investors know what those prices are, so it's unlikely anyone can consistently beat the market. Individual deviations from market averages are random.
CON This is a toughie, but let's start with two self-effacing gents with glasses: Berkshire Hathaway's Warren Buffett and Bill Miller, manager of the Legg Mason Value Trust. Although Berkshire Hathaway's A shares have sagged occasionally over the past four decades, the average annual total return since 1965 has been roughly double that of the Standard & Poor's 500 Index. As for Miller, as Globe Investor magazine noted last fall, he beat the S&P for 15 years straight, from 1991 to 2006. The odds of that are roughly one in 2.3 million. How do they do it? Classic, disciplined value investing, which can't be summed up in one or two simple rules. On the other hand, it may not be rocket science. In a lively 2003 book titled Yes, You Can Time the Market!, Ben Stein, a U.S. economist, lawyer, financial writer and game-show host, and Phil DeMuth, a psychologist and investment adviser, looked at stock market data going back to 1902 and determined that you could have beaten the market by using index funds and applying several classic value ratios, including the market's aggregate price-to-earnings ratio and the average dividend yield. You buy when the ratios indicate that the markets are undervalued and sell when they appear to be overvalued.
The upshot: If you stick to a sound discipline, you may not beat the market, but you probably won't do much worse.
8. Stocks always go up in the long run PRO Promotional spooge from brokers often references Wharton professor Jeremy Siegel's bestselling book, Stocks for the Long Run. No wonder. The charts, in particular, are dramatic. Like the line-graph showing that $1 invested in U.S. stocks in 1802 would have grown to $7.47 million by the late 1990s, versus just $10,744 for bonds, $3,679 for government treasury bills, $13.37 if it had merely kept pace with the Consumer Price Index, and just $11.17 for gold. Siegel shows that the experience in the United Kingdom is similar. If you want to invest in the productive power of a growing economy, it's best to do that directly by buying stakes in companies, rather than loaning money to them or the government, or putting it into volatile, poorly performing commodities markets.
CON For most investors, the long run is less than two centuries. A lot of people purchase their first home in their 20s or 30s, and only start saving and investing seriously for retirement in their 40s. Stock markets can suffer through some severe downturns over two decades. The Great Crash of 1929 looks like just a little blip on Siegel's chart, but it took until 1954 for the Dow to return to its pre-Crash levels. The 1970s were another punishing decade. The Dow first closed above 1,000 in 1972 and didn't stick there again until 1982. It also depends which stocks or stock markets you're considering. Japan's bellwether Nikkei 225 index peaked at 38,916 in 1989. Lately, it's traded around 15,000. The other thing to remember is that investors aren't too bright. If you look at, say, the monthly statistics for mutual fund sales issued by the Investment Funds Institute of Canada, you'll see that sales of equity funds often rise when stock markets are high, and redemptions increase when they're low.
The upshot: Start saving and investing for retirement in your 20s to lessen the impact of panic and stupidity-your own and that in the market.
9. Remember: Price chases profit PRO Let's take a shot at summing up a few hundred pages of hard-core textbook finance in a paragraph. In theory, people buy stocks for the dividends they pay each year and the expected capital gain-the rise in price. To calculate the price today, you add up all the dividends expected in future years, plus the expected price gain. You then discount that dividend stream and the expected gain using the guaranteed rate of return you could earn on a safe alternative investment like government bonds. The longer your time horizon, the less the expected capital gain contributes to your total return. Ideally, a company should pay dividends only from its earnings, or profits. So you should buy companies that have a record of strong earnings and are expected to maintain them. Simple, eh?
CON As mentioned before, investors aren't too bright, and they often get caught up in euphoria. How else do you explain why they bid up Nortel Networks' share price from less than $200 a share (prices reflect subsequent splits and a one-for-10 stock consolidation) in 1998 to a peak of more than $1,200 in 2000, even though the company reported losses for those years? (The shares have traded around $16 lately.) On yet another hand, sometimes losses-and big sustained ones-aren't such a bad thing if a CEO is growing a company by borrowing and spending like a maniac, er, visionary. Rogers Communications lost money for 15 out of 16 years from 1982 to 1998, yet its share price climbed from a low of $5.25 to a high of $14 over that time, and has kept going to around $45 recently.
The upshot: Ted Rogers aside, it's usually better to invest in companies that have made money consistently than those that have lost it.
10. Try the Super Bowl Indicator PRO If a team from the American Football Conference wins, the Dow will decline for the year. If the game goes to a National Football Conference team or any of the three current AFC teams that were in the old NFL (the Colts, Steelers and Browns), the Dow will climb. The indicator has been right for 33 out of 41 Super Bowls-about 80% accurate. Is your broker right 80% of the time? Another good thing about betting on the stock market-by buying an index fund or an ETF-rather than the actual game is the chances are virtually zero that you will lose all your money.
CON There is an Astrologers Fund, but no mutual fund that we know of that relies on the outcome of the Super Bowl. If this was even a half-reliable way of investing, don't you think a canny pro would have launched one?
The upshot: If you have some spare cash, take a flyer on the market. However, if the Buffalo Bills are in the final, double up and bet that they will lose the game-a 100% certainty.