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More Investment Strategies and Concepts: The Not-So-Basics
Timing the Market
Of all investing clichés, perhaps the most overused is "buy low, sell high." While that is, of course, the key to successful equities investing, it's also too often misinterpreted as an invitation to jump in and out of the market.
No one can reliably call the day-to-day direction of the market. By sheer chance, there will always be a few market timers who successfully predict the crashes that occur from time to time. These peopleand their firms and newslettersthen become the next big thing, with investors following them around like Hamelin rats.
Don't believe it. Expert after expert has proven incapable of consistently predicting the highs and lows of the market. Investors chronically pile on whatever was hot last year. Technology mutual funds, for example, repeatedly reap high inflows just as they've hit their peak, and pay high withdrawals after returns start to sink. That means that those investors stayed in just long enough to lose money.
Another form of market timing is less obvious but equally toxic, and it's a mistake that market newcomers make all the time (yep, I'm guilty, too). Ever thought to yourself: I want to invest, but the market's been rising so much lately? The corollary thought is: The market's really been tanking lately, maybe I should get out.
These thoughts are understandable. But they're also the exact kind of sentiments that get young investors into trouble. It's tough to take the plunge when the water suddenly turns chilly and it's tough to stay in the action when the market's overheating. But the notion that the market's too high or too low is just another form of timing that young people ought to avoid.
Think of it this way. Being afraid to buy after a market drop is equivalent to going to a store and being excited about a pair of shoes. Suddenly, the clerk notices that the shoes had been mismarked and lowers the price. But the new, lower price makes you not want them anymore. While a big drop in an individual stock often warrants a closer look (though there, too, panic selling isn't going to help), a dip in the market as a whole should be viewed with a cool head.
Another classic timing mistake is overreacting to news that's already widely available. You'll hear people say stuff like "I just heard on CNBC that Merck is going to release a new drug that's going to make a pile of money so I'm going to buy some shares of Merck." By the time news that will affect a stock price is in the paper or on TV, you can bet that it's already built into the price you'll end up paying. Unless you have some sort of information so inside that it's illegal to act upon, count on being beaten to the punch by people who do nothing but follow the health care industry. They've already acted on the news, which drives the price up, and thousands of other viewers or readers are already on the phone to their brokers, driving the price up further. By the time you get there, the price will have likely gone even higher than is justifiable by the good newsand you'll be left holding the bag when those who bought for the quick lift start selling and the price settles back to where it "should be."
Investors' tendency toward bad timing was recently proven by an exhaustive look at trading records by market analyst and finance professor Terry Odean. Using data from a discount brokerage, Odean found that 10 percent of the traders made more than 50 percent of the trades. But he noticed a disturbing trend: most investors bought at the tail end of a stock's run-up and sold at the bottom of a crater.
More often than not, individuals who buy on good news and sell on bad news shoot themselves in the wallet, getting in at tops and selling at bottoms. Reactive, short-term investing decisions are almost always regretted. Investors will do better to come up with a sensible long-term strategy and stick to it. If you're in a stock for the long haul, you'll enjoy the benefits from those who pile in every time there's good news. So do your best to analyze companies based on your expectations of their long-term performance. By all means, be prepared to make a change if whatever attracted you to the stock is no longer valid. But take the daily news events with a big dose of saltover the long term, those zigs and zags will likely be smoothed.
Misconception: One example from recent stock market history demonstrates how timing the market can be more dangerous than buying and holding. The strong market of 1982-87 lasted 1,276 trading days and returned an average of 26 percent a year. An investor in the S&P 500 who missed just the top ten days during those five years would have had an annual return of just 18 percent. Missing the top twenty days would have meant a 13 percent annual return, while missing the best forty days would have produced a 4 percent return.
Dollar-cost averaging means investing an equal chunk of money at regular intervals, usually monthly. The point is that when the price of whatever you're buying is low, your fixed amount automatically buys more shares up, and when it's high, you get fewer sharesall without having to follow the ups and downs or trying to time your investment decisions.
Here's how it works. Say you've got $20,000 that you want to invest in the stock market. You've picked a stock mutual fund and on January 1 you put your first $5,000 in. If the fund is selling at a net asset value (NAV) of $50 per share, you end up getting one hundred shares. On February 1, the NAV has fallen to 40 so your next five grand buys 125 shares. On March 1, the NAV of 64 equals 781/8 shares and on April 1, the NAV has returned to 50, meaning another one hundred shares.
All told, your $20,000 has bought 403.125 shares. So even though the average price of the fund during your four months of investing was $51 (50 + 40 + 64 + 50 = 204; 204
• 4 = 51), you only paid an average of $49.61 (20,000
• 403.125 = 49.61). I call that a bargain.
Beyond the nifty little price break produced by dollar-cost averaging, there's the moderating effect it has on your portfolio. Even though the fund began and ended at the same place, there was a lot of volatility in between. The investor in this example, however, didn't have to worry about tracking the fund in the paper or worrying about when to dive in: she was guaranteed not to overbuy at the high price and to pile on at the low.
The strategy works the same way with other types of mutual funds and with individual stocks (perhaps even more effectively as an evening force because of the greater volatility of a single stock compared with mutual funds). This example presumes a large chunk of uninvested cash, say from an inheritance or lottery windfall. A more common form of dollar-cost averaging occurs when people have automatic payroll deduction into retirement plans.
Warning! Dollar-cost averaging is easy and effective. But it's not always the magic bullet it's hyped to be and there're some things you should think about before embracing it.
Even though it's touted as a way to avoid "timing the market," dollar-cost averaging is itself a form of market timing. Nobody knows where the market's going from one day to the next. But because the market does have an upward bias, doling out your money in smallish increments is a way of trying to protect yourself from a collapse the day after you plunge headlong. Young investors, who have time and earning power on their side, may be better off diving in all at once. Some studies have indicated that long-term investors face greater risk missing bull markets than they do getting clipped by sudden dips.
Tip: If you decide to employ dollar-cost averaging, whether through lump-sum intervals or payroll deduction, there's an easy and little-known way to tweak the process. Over the past sixty years, stocks have tended to perform significantly better during the first half of the month than the second. Try to arrange your monthly deposits so that your purchases are made about two to three days before the first of the month. The difference won't be jaw-dropping, but every bit helps.
All Around the World: Investing Overseas
Dying to travel but don't have the bread? Well, here's a way to participate in the best part of globe-trottingspending moneywithout leaving your couch. Now that you're convinced that you need to put your investing eggs in as many baskets as possible, it's time for a primer on the ways to send some dollars abroad.
Dozens of strategies exist for Americans to take advantage of international investing. But there are three methods particularly well suited to novice investors, or those not eager to pay for translators and subscriptions to overseas business papers. Here they are, listed from simple to slightly more difficult.
1. U.S.-based multinational corporations. Many well-known American companies derive a substantial portion of their revenue from overseas operations, and those are often the fastest-growing parts of their companies. So your investment dollar stays safe and visible in the U.S. while reaping exposure to foreign markets and overseas opportunities. For example, McDonald's (MCD-NYSE) derives half its profits from the one third of its restaurants outside the U.S.
Other domestic companies, such as Philip Morris (MO-NYSE) or Coca-Cola (KO-NYSE), seek to cash in on emerging markets playing catch-up. The thinking goes that strong American brand names are inevitably desired by those newly able to afford the vices the West advertises so effectively. A billion Chinese mean a lot of 'boros and Sprite. Toilet maker American Standard (ASD-NYSE) is betting that people in the Third World are as eager to pee in porcelain as Yankeesthe company currently gets almost half its sales overseas.
Investing in companies with substantial overseas business gives an investor some diversity through exposure to international economic events while also providing the peace of mind from investing in a big American blue chip.
2. Overseas mutual funds. These are exactly what they sound like: mutual funds that invest in companies headquartered in foreign countries. (There are overseas bond funds, of course, but American investors interested in the safety of bonds can find plenty to choose from at home and needn't look abroad.)
Foreign funds are a terrific way to achieve a double dose of diversity: you get the multiple stocks of a mutual fund and the overseas exposure of foreign markets. And the whole thing's in the hands of a manager such as Helen Young Hayes (Janus fund, 800-525-8983, no load), who has a handle on the companies and economies of wherever she invests.
Because they are investment products, the names of these funds are confusing. International funds invest exclusively in foreign stocks. Global funds typically keep 75 percent of their assets in stocks from the U.S., leaving only a quarter for overseas stocks. There are also regional funds, which specialize in investing in Europe, Latin America or the Pacific Rim. Specific countries also have funds, but these are usually closed-end funds that trade on exchanges like stocks and can be quite volatile. Then there are WEBS, which function like index funds of specific countries and trade on the American Stock Exchange much like closed-end funds.
3. American Depository Receipts. Created to make investing in foreign companies convenient, ADRs are negotiable dollar-denominated shares that trade just like domestic stocks. Investors can hold them in regular brokerage accounts and the dividends are paid in dollars.
Stick with ADRs that are "sponsored." That means companies like Honda Motor Co. (HMC-NYSE) or British Airways (BAB-NYSE) that trade here on a major exchange (New York Stock Exchange, American Stock Exchange or NASDAQ) and comply with American accounting and reporting standards. Plenty of solid foreign companies are unsponsored (Swiss food giant and baby formula pusher Nestlé, for example), so that doesn't imply that sponsored ADRs are more reliable investments. But with about 450 sponsored ADRs listed on the three major exchanges, investors have a pretty good selection and should stick with those until they have a surer handle on the whole concept.
Depository receipts are a great way to dip your toe in foreign waters with the convenience of domestic investing. But because information on foreign companies is harder to come by, view ADRs as long-term investments to be made only with a small portion of a portfolio.
Tip: For a free directory of all available ADRs, contact The Bank of New York, ADR Division, 101 Barclay St., 22nd Floor, West Bldg., New York, NY 10286; 212-815-2175.
Warning! Overseas investing carries with it risks beyond the ups and downs of the security's value. Currency fluctuations can cut into returns (or enhance them); a strengthening dollar (i.e., a dollar buys more yen or marks than it did before) can cripple an otherwise good investment. Furthermore, the more volatile the economy of the country, the more volatile you can expect investments there to be. That means that emerging market funds are likely to produce higher highs and lower lows than a fund that invests in established European companies. During a bull market like the one the U.S. has enjoyed for the last seven years, investors might be tempted not to bother sending money overseas. But because foreign economies often provide a counterweight to the cycles of the American economy, the peak of a domestic bull market at home is often the best time to begin investing abroad.