Money Management and the Economy

Monday, February 18, 2008

The recession is coming! The recession is coming!

You aren't smarter than the market. It really is that simple.

So you think we are headed for a recession and the market is going in the tank. You aren't alone. There are plenty of other investors out there with the same idea. And your opinions are already reflected in the current market price of stocks. While you could turn out to be right, it is equally or more likely you are wrong. Guessing what will happen next in the stock market is not an investment strategy, its a gambling strategy. The only advantage it has over Vegas is that the investment analysts and financiers usually take a smaller amount off the top than the casinos do.

So what should you do? The answer depends on whether you are a buyer or a seller. And that has nothing to do with what you think the market is going to do. It is a question of where you are in the investment cycle. If you are adding to your investments then you are a buyer. If you are at a point where you are moving money out of the stock market, you are a seller.

While most people are buyers, there are circumstances where you might be seller. One is that, as you get closer to retirement or other use of your investments, you want to shift your investment mix from heavily in stock to a less risky mix with less stock and more bonds. There are two ways to do this. One is to add new money to your bond investments. The other is to sell some of your stock and put the proceeds into bonds. A second reason you might be selling is that your stock did better than your bonds the past year and you need to sell some stock and move it into bonds to rebalance to your targeted investment mix. The third reason would be that you are retired and are selling stock to pay living expenses or you need to cash out your investment for some other purpose.

If you are a buyer, the answer of what to do now is straight-forward. Buy stock. Use dollar cost-averaging to avoid getting caught spending all your money now when you might be able to buy more shares at a lower prices later in the year. By averaging out costs over the year you will protect yourself from buying high in what is a volatile market.

If you are a seller, you actually have an apparently more complicated decision to make. But because we simple minded investors don't like complicated answers, there is a simple one. Or rather two simple ones.

If you want to change to a less risky investment mix because you are getting closer to retirement, or other use of the money, you should do it over time. Just as you cost average purchases, you should cost average sales. That means figuring out how much you will need to sell to achieve your new investment mix. Then divide that amount into 12 equal installments. Then sell stock worth that much on a monthly schedule. By cost-averaging you will guarantee that you aren't selling all that stock at rock-bottom prices. You will sell at roughly the average price for the year.

Correction: On reflection, this is not correct. In fact cost averaging your stock sales means that you will sell more shares when the price is down and fewer shares when the price is up to generate the same amount of money. This will actually result in your getting less than the average price for your shares. You should decide how many shares you will need to sell. Then divide the shares into equal installments. Whatever disparities the different selling prices create will get fixed when you do your annual rebalance.

If, on the other hand, you are selling in order to rebalance your investment mix, you should continue to do this all at once on an annual basis. The point of rebalancing is to sell high. You are selling because the class of assets you are selling did better than the other classes of assets in your portfolio. Think about it as taking your profits (or cutting your losses if all your assets went down).

The one thing you should not do is change your investment mix because you are nervous about where you think the market will go. Managing risk based on your expectations about the market is the same as any other attempt to time the market in stock. Its likely that you will end up with that more conservative investment mix just about the time the market decides to take off. You will have sold low and now be faced with buying high to restore the mix you initially had. Your investment mix should be based on your long term goals, not your current nervousness. You are not smarter than the market. So don't try to be.

Tuesday, February 5, 2008

Media Investment Advice

CNN's Walter Upgreave today made clear why taking investment advice from the media is a bad idea. In his column today he takes a contrary view of "dollar cost averaging". The dead giveaway is this line:

"But while dollar-cost averaging has risen to the level of accepted truth in many circles, it isn’t the magic bullet it’s made out to be. Indeed, some of the claims are simply an illusion."

Put another way, his job is to provide something interesting for us to read and repeating conventional wisdom won't get you many readers. But there is a reason why dollar cost averaging is conventional wisdom and Upgreave is doing a huge disservice by encouraging people to ignore it. Sometimes conventional wisdom is wrong, but, if you really understand the role of investment mix or dollar cost averaging in risk management, you realize that Upgreave's argument has no merit. Here is the nut of his argument:

"Over the course of the year, you would have actually been investing much more conservatively than you intended when you chose a 60-40 mix. The reason is that you’re holding on to so much cash, you’re virtually guaranteeing you won’t be at your 60-40 target mix for most of the year. By moving your money a little at a time, you’re actually undermining your investing strategy."

There are several reasons this is flat out wrong. The first, is that by investing all your money in a lump sum you are increasing your risk well beyond what you intended by a 60-40 investment mix. This is because you are taking on the risk of daily/weekly/monthly fluctuations in the market compared to a similar investment dollar-cost averaged. In essence, he is encouraging you to make a short term investment in the stock market.

One way to look at this is to take your lump sum and divide into four installments. That is what you do with dollar cost averaging. The next question is what should you do with the money in the mean time until you need it? Upgreave is, in essence, suggesting you invest it in stock and bonds using the same 60-40 mix that you had settled on for your long term investment strategy. But the 60-40 mix that is appropriate for money you will not need for at least 10 years, is not appropriate for money you will spend on stock three month from now.

To get an idea of how this works take a couple scenarios this year:

Lets assume you got a tax refund of $1200 on June 1st, 2007 and invested it in Vanguard's Balanced Index fund which gives you that 60-40 mix. The fund's shares were at 22.54 that day so you would have purchased 53.24 shares. Three months later, on September 4th that same $1200 would have bought 54.15 shares. By December 4th is would buy 53.98 shares.

At the end of 2007 those 53.24 shares were worth $1172. The 54.15 shares were worth $1192. and the 53.98 shares were worth $1188. By February 4th, 2008 that $1200 would buy 56 shares. Those same shares would have cost $1262 in June.

Having saved your money in a conservative cash account, you would be buying low. Having spent all your money in June - you would still own just 53.24 shares.

But why stop now? What happens when shares have reached $40 per share? That investment from June is worth 2121, if the investment was made in September it is worth 2166. The December investment is worth 2159. The February investment is worth 2240. If you invested the money in four installments, you made $50 more than you would have if you had invested int all in May and those net losses will continue to grow right along with the price of your shares.

Of course, the opposite could have happened. The market might have gone up. On average, that is more likely to happen. But if you don't cost average, you aren't playing the averages. You are timing the market whether deliberately or not. You may happen to get lucky and buy when the market is low. If you are very unlucky, and buy when the market is high. But avoiding that kind of high risk, is exactly the reason for having a relatively conservative 60-40 mix of stocks and bonds to begin with.

There is no doubt that leaving your money in cash is more conservative than investing it in the market. Bonds are more conservative than stocks. That is a the reason why investment horizon is important in determining your mix of cash, stocks and bonds. In the long run, stocks, on average, will give you the best returns. But, as the saying goes, in the long run we are all dead.