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.

No comments: