Tuesday, April 19, 2005

Betty asked, Should She Ride This Roller Coaster?

The stock market is a roller coaster only in the short-term. We get a different perspective when we see things close or from afar. Did you know that the surface of a pool ball is more irregular than the surface of the earth! We see mountains and valleys on the earth but we see a pool ball as being smooth.

Take a look at page 171 of Jeremy Siegel's latest book, The Future for Investors. It is not in libraries yet but Barnes and Noble and the other big stores have it. In the book you will see that the graph of stocks from 1801 to present looks pretty smooth. The decline in 1929 is very small relative to the moves of the previous or subsequent 20 years. It also shows the huge long-term advantage of stocks over bonds.

It is the job of the portfolio manager to smooth out the bumps. This is done by committing more cash when stocks are down and adding cash when stocks are up, balancing by sector and balancing with fixed income securities. Balancing is nothing more than a sophisticated form of dollar cost averaging.

We must be thankful that we are small relative to the earths mountains and valleys; they are beautiful! The peaks and valleys in the stock market are also beautiful. They give one the opportunity to do tax swaps, to correct mistakes and to make higher than average returns. In addition, the peaks and valleys give us hours and hours of entertainment.

It is easy to do well in the stock market. Benjamin Graham said that folks underestimate how easy it is to do average. He was right. One can invest 80 percent of ones funds in an index fund, the other 20% in a medium term bond fund and rebalance each quarter. Your returns will be better than probably 80 or 90% of all managed accounts; with lower volatility! You would reduce your returns a little and the volatility a little by making the account 70% stocks and 30% bonds. But, you would not have much fun and you would automatically buy new S&P stocks at inflated prices.

It is a mathematically neat trick that the weighted average return of stocks and bonds will be surpassed automatically if one balances the weights on a regular basis. In other words, over long periods of time, stocks might average 11% and bonds 6%. One might surmise that an 80/20 portfolio will produce 8.8 plus 1.2 for a total return of 10%. The good news is that the portfolio will come closer to 11% than to 10%. The balancing action forces more stocks to be bought when they are cheap and to be sold when they are dear.

Ben Graham also said investors underestimate how difficult it is to beat the market. He was right. It takes education, experience, work and luck. Experience can be a very mean teacher as there are many hidden potholes in the market road. Therefore, one should diversify, keep trading costs low and keep the faith in tough times. If you buy more stock when the market is down, you will be rewarded when the market goes up. If you let winners run and cut losers short, you will benefit from tax savings and by avoiding big mistakes.

The bottom line is that you can easily earn and average of 11 to 12% in the stock market over 20 years; if you are willing to hold individual stocks thereby reducing the carrying fees. By taking an educated but aggressive approach, you might do 2 to 4% better or 2 to 4% worse. Those who try too hard are the ones who make the big mistakes and yes the horror stories are true. Aggressive leveraged accounts can take huge losses in a hurry. It is easy to increase trading costs, to panic when an over-invested portfolio gets whacked or to take too much out of the market waiting for the time to enter. Cash is most often a drag on a portfolio. Many of the best in the business stay fully invested at all time. Those who use leverage on stocks had better be prepared to soar like an eagle and dive like a dophin.

There is no need to be overly aggressive. If you earn 11 or 12% over time, you will be pleased with the growth. Twelve percent doubles your money in 6 years. The last doubling is the big one!

Thank you so very much for writing. I hope you will keep in touch. Without using your full name, I will post your question and much of my response. By the way, I trade through BrownCo where the commission to buy stock is $5. I help manage the accounts of a few friends and family members. I do not charge a fee. I would be happy to assist you in any way I can. In any event, please keep reading and let me know if there is a specific topic that I should cover.