There’s been no better illustration of stock market volatility than the events of fall 2008.
In the week ending Oct. 10, the Dow Jones Industrial Average plummeted 18 percent, leaving it down 40 percent from its high in October 2007. The S&P 500 also lost more than 40 percent of its value from the previous year. Almost every asset class, from international stocks to commodities, felt the pain.
Hand-wringing and teeth-gnashing ensued. Then by election day, the Dow Jones rebounded 14 percent. But the rally was short-lived as the market resumed a seesaw course.
It dawned on many investors that their true tolerance for risk was quite a bit lower than they had assumed. According to TrimTabs Investment Research, investors pulled $43.3 billion out of equity mutual funds the week ending Oct. 8, compared to about $7.2 billion the week before.
Is it a good idea to bail when things get bad? What’s the best way to invest, regardless of market conditions? The jury is still out on the best strategy, but here we present several approaches used by professionals. Some require a little bit of attention upfront, while others require constant work and vigilance.
The current market volatility should serve as a reminder of the magnitude of losses that can be sustained in a short period. It also underscores the importance of having a diversified portfolio and appropriate asset allocation.
Getting your asset allocation mix right for your risk tolerance and time horizon is the first key step, says Scott Donaldson, a senior investment analyst with Vanguard’s Investment Strategy Group. “Then you choose the asset allocation, sub-asset allocation and then finally the individual investments” to make up your portfolio, he says.
A conventionally conservative allocation is split between 60 percent stocks and 40 percent bonds. The next step is to consider how to allocate money to specific asset classes, such as large-cap stocks, small-cap stocks, high yield bonds, inflation-protected securities and so forth. Then finally, the real work begins — choosing investments to populate the asset allocation plan.
Investors can follow one of two basic strategies when choosing their investments. A passive strategy uses index funds or exchange traded funds, known also as ETFs, that mimic a sector of the market or a broad market benchmark such as the Standard & Poor’s 500.
An active strategy requires the investor to choose stocks or actively managed mutual funds in an attempt to beat the returns of the market. To make things even more complicated, investors who use an active strategy can take one of several approaches.
Passive investing has its advantages. For one, it’s almost a set-it-and-forget-it strategy. Almost.
A purely passive strategy would be buying an S&P 500 index fund and then never touching it again.
“I think that a strategy that doesn’t involve any selling whatsoever is more of an act of faith than anything else,” says Alex Green, author of “The Gone Fishin’ Portfolio: Get Wise, Get Wealthy … and Get on with Your Life.”
Green recommends that investors seeking a no-hassle portfolio follow a diversified asset allocation strategy and invest in no-load index funds. Investors need only check-in once a year to rebalance it according to the original plan.
To determine the ideal allocation, investors can follow an expert’s asset allocation plan, visit a fee-only certified financial planner or make up their own.
Green shares this allocation from “The Gone Fishin’ Portfolio,” with the caveat that the book offers much more than just the allocation model.
“In the book I explain the importance of cutting costs, minimizing taxes, rebalancing and sticking with the program — all the things that are important to someone’s financial success,” he says.
Green suggests investors choose Vanguard funds, other no-load index funds or ETFs to populate the portfolio.
Many fund families offer no-load index funds, but be wary. Although some track the same indexes, not all are created equal. When choosing an index fund, investors should take note of fees and expenses as well as how closely the fund tracks the index it follows.
“If, historically, the fund is either plus or minus a percentage point off its benchmark, that’s a fairly high tracking error,” says Vanguard’s Donaldson.
In other words, the best performance does not necessarily indicate the best index fund.
“Your goal is the fund that gives you the purest exposure to the segment that you’re looking for,” Donaldson says.
Some proponents of indexing subscribe to the efficient markets hypothesis, which holds that markets are rational and efficient. Stock prices reflect the true value of companies, affirmed by the consensus of a large, informed investment community.
Those who accept the efficient markets theory as true also believe that investors cannot expect to consistently beat the market — a claim that many dispute and a big reason why actively managed portfolios remain popular.
“The biggest drawback — if that’s what you want to call it (to passive strategies) — would be for someone who has a goal of outperforming the market. Because, really, actively managed strategies are the only way that you can do that,” says Donaldson.
The allure of an active approach is its potential to beat the market. The flipside is that active strategies are risky and expensive because they involve more trading. Because of its relatively higher fees, actively managed funds have a tough time outperforming index funds.
These facts don’t deter some investors. After all, mutual fund managers make a living betting on their investment prowess. Most employ fundamental analysis, though some use technical analysis as a guide to stock picking.
Fundamental analysis involves studying the entire picture of the broad economy, industries within the economy and then individual companies within each industry to assess its financial strength.
It’s a fairly complicated endeavor. Dan Newhall, principal in Vanguard’s Portfolio Review Department, cautions that the average individual investor may be better served by choosing an actively managed mutual fund rather than investing directly in stocks themselves.
With a mutual fund, individual investors get professional money management, diversification of investments, potentially lower costs, plus access to information, technology and teams of financial analysts.
That said, if individuals know what they’re doing, they can invest in individual stocks and keep a diversified portfolio. One general rule of thumb to ensure that too many eggs don’t get stuck in one basket is to devote no more than 3 percent of a portfolio to one individual stock.
Well aware of the risks, the hopeful securities investor bent on traditional fundamental analysis would begin investigating the economy and the various industries within the economy.
“What you want to think about in fundamental analysis basically is the relation of the firm to the macro economy,” says Stephen Penman, George O. May professor of accounting at Columbia Business School and author of “Financial Statement Analysis and Security Valuation.”
By macro, Penman refers to the big economic picture that takes into account lots of different variables, such as inflation, unemployment and industrial output. With the advent of the Internet, finding data on broad economic developments is much easier than in the pre-wired days of yore.
Well-known indicators are tracked, analyzed, dissected and quickly available for public consumption. For example, The White House regularly releases reports on economic indicators.
A few of the more common gauges of economic activity include the Consumer Price Index, the national Gross Domestic Product, short-term interest rates set by the Federal Reserve and housing starts.
Filtering down to the industry level, one would look at how the economy is affecting businesses — for good or bad. For instance, at this point in time, “World financials are very doubtful and they’re in bankruptcy,” says Penman.
“Whereas another company like Procter and Gamble would be more concerned with the effect of the financial situation flowing into the real economy — the consumer economy — and what the effect would be there,” he says.
Lots of other things affect industries as well: consumer sentiment, technology, the weather, politics, government regulation, competition and labor conditions — to name a few.
Shifting down yet another level to companies within a sector or industry, investors should “look where the industry is going and note the firm’s market share of the industry. Because ultimately among the drivers of fundamental value are future sales and future revenues that come in,” Penman says.
To investigate individual companies, investors can turn to the annual or quarterly financial statements, called the 10-K and 10-Q reports, respectively, filed with the Securities Exchange Commission.
The annual 10-K report reveals a company’s accounting as reflected in the balance sheet, income statement and cash flow statement.
It also offers the perspective of senior management, who explain events of the past year and also predict what might happen going forward.
“The management analysis will give you an interpretation of the reason for what’s in the report, what the business is like now, and give you some indication of the future — sometimes they do it too optimistically and sometimes they do it too conservatively because of the fear of litigation and so on,” says Penman.
“It’s always a place to start. You can add to that impression by looking at more general industry and firm-specific information outside the firm,” he says.
To really get a good picture of a company, one should look not just at the last year’s earnings reports, but at a five or 10-year history of the company’s performance.
“Can they grow sales? What’s the profitability of their sales? What earnings do they make from sales? What are their margins? And then it’s a question of how much assets they employ to develop those sales. Obviously more assets mean more investment and lower return on investment,” says Penman.
Whereas an indexing strategy might subscribe to the efficient markets hypothesis, and fundamental analysis involves a close look at a company’s financials in the context of its industry and the overall economy, technical analysis falls more under the theories of behavioral finance, which factors the human element into market behavior.
Technical analysts use charts to study historical stock prices and trading volume data to gauge investor sentiment as a guide to the prospects of a particular security.
“Basically you’re trying to determine the underlying market psychology based on historical price patterns,” says Chip Anderson, founder and president of Stockcharts.com.
“If prices have been going up, you can use various techniques to decide if you think the prices are going to continue to go up, or reverse and go down. The ultimate goal is to find stocks that have a particular price pattern that you feel reflects a market psychology that you can use to predict future movements,” Anderson says.
Technical analysis consists of three basic components: trends, levels of support and levels of resistance.
Support level: Support is a price level which a security has trouble breaking through. As the price goes down it is more likely to rebound when it gets in the support range.
Resistance level: Resistance is the opposite of support. As the price goes up, it may encounter a level of resistance that it has trouble breaking through. As the price rises it is more likely to retreat when it gets in the resistance range.
Trend lines: Trend lines are rising or falling levels of support or resistance. They are drawn between at least two lows or highs and then extended onward to represent the expected resistance, in the case of a downward trend, or support, in the case of a rising trend, the price will encounter.
Head and shoulders: The head and shoulders pattern is one among many patterns that investors who use technical analysis can use. This pattern typically signals a reversal, in this case that the price will go down after an upward trend.
Flags and pennants: Pennants are another pattern technical analysts find in their stock charts. They represent a continuation of a previous trend and identify a pause in the action. When investors see a triangular pennant or their rectangular counterparts, a flag, it means that the preceding trend may continue.
Support and resistance are each points where stock prices repeatedly reverse course.
“You’re not giving the numbers on the chart any magical power. What you’re trying to think about is: Are the people that make up the market going to give any credence to a particular number — for instance Dow (at) 10,000 or any stock hitting $100?” says Anderson.
“Those are numbers that often will cause people to pause, maybe just for half a second, or they may generate news articles around the world,” he says.
Trends are movements across a chart that reflect prices going up, going down and staying flat.
“Trend is very similar to support and resistance, except it is an angled version of a support or resistance line,” says Anderson.
If investors believe a stock will continue going up at a particular rate, there is a moving line that the price will not cross on the upside and the downside — and the same for the reverse, if the trend is moving down.
The patterns formed on the charts can give investors information about what may happen in the future. A pattern is a recognizable picture formed by the price points plotted on the chart that may indicate future price movements.
For instance, some basic pattern formations are the head and shoulders pattern, and flags and pennants.
“The key though is indicators as well as chart patterns are only useful if you remember the context of the stock and you focus on what is this telling you about the psychology of the people who are in this market,” says Anderson.
“Are they greedy? Are they fearful? Are they changing from greed to fear?” he says.
The investors who sold out their equity positions during the recent market troubles were practicing market timing, perhaps unwittingly. In time, their timing will prove to be bad, since they have locked in their losses at the worst possible time. History shows that markets do rebound — eventually.
And while they sit on the sidelines waiting for the volatility to subside, investors often miss the opportunity to get back in the market in time to experience its positive moves.
But even professional traders often use either technical or fundamental analysis to time the market. In addition to studying price and volume data on charts or studying financial statements and the economy, they focus on something called the moving average.
A moving average calculation simply takes the daily closing price of an index or security over a certain period of time –100 days, 150 days and 200 days are all frequently used measurements — and averages them.
From a market timing perspective, one technique for buying and selling stocks involves acting when a particular stock price crosses the threshold of its moving average.
“All you do is ask: Is the price above the moving average? If it is; you buy. If it is below, then you sell,” says Dennis Tilley, director of alternative research at Merriman Berkman Next.
It results in a lot of trading because the price can bounce back and forth, Tilley says.
Frequent trading leads to higher costs for investors, in transaction fees as well as taxes, if you trade in a taxable account.
Though fundamental and technical analyses as well as market timing can pay off for hyper-disciplined investors with the time and commitment to watch the market, fans of index funds are quick to point out that after taxes and expenses, no-load index funds beat active strategies most of the time.
“There’s a chance to look like a genius if you’re one who invested in Google’s IPO or such — mutual funds aren’t going to do that for you,” says Newhall. “But no one hears about the stock that went nowhere — or to zero.”
“There are so many stories of individuals who get in and think they know what they’re doing and ultimately they are only buying a handful of stocks and maybe they are all in the same sector. So really there is insufficient diversification,” he adds.
In the end, investing is about managing risk while getting the best return possible. There are innumerable ways to go about it, from the deceptively simple to the mind-bogglingly complicated.
No matter which way you go about it, as long as it doesn’t involve a dartboard and a blindfold, settle on plan you can live with and stick to it.