There are some concepts you must clearly understand in order to learn market timing principles. Many of you can probably just scan this section because it is rather basic. However, please don't skip it altogether because you will miss information that is built upon later in the tutorial.
The Stock Market
The stock market is where shares of stock are traded. A share of stock is an ownership share in a corporation. For example, assume XYZ Inc. has issued 100 shares of stock. If you own one share, you actually own a 1.0% stake in XYZ Inc. Shares of stock issued by large U.S. corporations are publicly traded at stock markets or stock exchanges. The prices of these shares are constantly changing as they are determined solely by supply and demand. Anyone with money can buy shares in these corporations by simply setting up an account with a stock broker and submitting a purchase order. The order is electronically transferred to the stock exchange, where the order is executed.
Stock Market Indexes
A stock market index is a number computed from the prices of a group of stocks. It is computed daily to gauge the movement in the market for that day. Here are some examples:
Dow Jones Industrial Average (DJIA)
The DJIA is computed by adding all the daily stock prices of a group of 30 major U.S. corporations and dividing that total by a number called the divisor; this is called a price-weighed method. This divisor will change whenever one of the 30 companies declares a stock split. A company will split its stock when the price becomes high, making it more affordable. By changing the divisor, the index value is unaffected by stock splits.
The DJIA has two disadvantages as compared to other types of indexes:
- It consists of only 30 stocks
- Higher priced stocks affect the index more than lower priced stocks.
The S&P 500 doesn't have the disadvantages of the DJIA. It is made up of 500 stocks. The total market value of each company is computed and summed. A company's market value is simply the share price times the total shares outstanding. The sum of all 500 companies' market values is then divided by a divisor. The result is that each company influences the index based on its total market value rather than its share price. This type of index is a capitalization- based index.
NASDAQ 100
Like the S&P500, the NASDAQ 100 is capitalization- based. It consists of 100 high tech, financial, and other growth companies that are traded on the NASDAQ Stock Exchange.
Stock Mutual Funds
A stock mutual fund is a portfolio of stocks that has been purchased by a fund manager using money that has been invested by many individual investors. At the end of each trading day, the total value of the portfolio is determined and divided by the total number of outstanding shares, resulting in the current share price. All new investments the fund has received prior to that market close (4:00 p.m. EST) are exchanged for shares in the fund using the share price. The fund manager then invests the new investment capital.
For example, assume that before the market close on Thursday, November 10, 1991, you invest $1000 in a mutual fund called XYZ Fund. At the close on this day the fund has the following portfolio:
At this time the fund has sold 20,000 total shares. This results in a share value of $9.50 per share. Therefore, your $1000 investment will buy 105.263 shares of the fund and there will now be 20,105.263 total shares outstanding. Note that 105.263 new shares were created, but the value of each share is still $9.50 per share ($191,000 / 20,105.263 shares). The next day the fund manager will invest the new $1000 as he so chooses. When you decide to sell your shares, the price per share you will receive is the computed share price at the next market close.
There are some big advantages to investing in mutual funds:
Stock Market Movement
Most stocks move with the market. For example, if the general market is in a downtrend (a bear market), even stocks that are fundamentally excellent values, will trend downward. In fact, aggressive growth mutual funds whose portfolios consist of professionally selected stocks get absolutely devastated in bear markets. Many investors, who are not able to sit by and watch their funds lose 40-50% of their value actually end up selling out at exactly the wrong time. Whether you invest in stocks or funds, it is absolutely necessary to know when to be very conservative about your stock market investments.
Positions
Your position is based on which way you are betting the market will go. We refer to these positions as long, short, and cash.
Long Positions
If you buy stock or mutual fund shares hoping they will increase in value, you have taken a long position.
Short Positions
If you believe the market will fall, you can profit by selling short. This is referred to as a short position. Selling short is selling borrowed shares of stock or shares of a mutual fund, hoping to some day buy them back at a lower price and return them to their owner. For example, assume you borrow 100 shares of XYZ Corp. and sell them for $5 per share. You will receive $500 proceeds from the sale. At some later date, XYZ Corp.'s stock has dropped to $3 per share and you decide to buy the shares and return them to the person you have borrowed them from. This is called short covering. To repurchase the shares you will have to pay $300. Since you received $500 on your short sale, and paid $300 to cover your short, you have gained a $200 profit on the trade. This is a very common transaction. A stockbroker who will charge you a commission handles all of the details.
Cash Positions
If you are not short selling when you believe the market is going to fall, you will simply sell your long position and place the proceeds in an interest bearing account. This is a cash position.
Buying On Margin
If you buy stocks or mutual fund shares from a broker, you can leverage your purchases. That is, you can borrow money from your broker and buy more shares using your cash and the cash you have borrowed. The amount of cash you must provide is governed by the margin requirement that the U.S. Federal Reserve sets. For example, currently the margin requirement is set at 50%. Therefore, whenever you buy stock or funds you can borrow an additional 100% from your broker bringing your maximum invested position to 200% instead of 100%. When you purchase shares on margin, you must pay your broker interest on the borrowed capital.
Mutual Funds can be purchased on margin at most discount brokers such as Jack White & Company.
Beta
Beta is a measure of volatility of a trading vehicle such as a mutual fund. The general market as measured by the S&P 500 is considered to have a beta of 1.0. Stocks or funds that gain more than the general market in bull markets and lose more in bear markets have betas of greater than 1.0. Conservative funds and stocks may also have betas that are less that 1.0. For example, assume you invest your money in an aggressive growth fund that has a beta of 1.5. If the S&P 500 gains 10%, this fund should gain 15% (1.5 X 10%). If the S&P 500 loses 10%, this fund should lose 15%.
Stock and Mutual Fund
Picking Rarely Works. In 1997, most investors believe that the market will always go up with only very minor corrections of less than 10%. This would eliminate the need for timing the market and would make an investors only job deciding which fund or stock will go up the most. Pick up a copy of any high circulation investment magazine. Month after month they have headlines that read, "10 Stocks that will go up..." or "The 5 Best Funds..." The entire investment industry is built on analysis that attempts to reveal the next Microsoft. There are some big problems with this approach:
Time Magazine summed up the dilemma well in their January 15, 1996 issue:
"86% of the most popular mutual funds did worse than the Standard and Poor's 500 index in 1995. This is more proof that the national pastime of picking the winning mutual fund is a wasted effort. Most people would be better off buying the so-called index fund that give them a guaranteed average return."
The only problem with this advice is that an "average return" can be very negative. Bear markets can easily cause SP500 index funds to drop 30-40% in value. Investors cannot emotionally handle riding out losses like these.
Spend Most of Your Time Deciding WHEN to Buy Instead of What to Buy.
Do you really think that the wealthiest and smartest investors in the world are actually buy-and-hold investors? Individuals who have built multi-million dollar fortunes are not big on losing money. Sure, they may ride out losses on venture capital type investments just as a business owner wouldn't sell his business because of temporary losses. But, the majority of their portfolios are protected from bear markets with hedging strategies which is simply market timing.
Your goal should be to incrementally move from a 100% cash position to a margined 200% invested position based on the probability that the market will rise. Until you have a developed a sound strategy for doing this, don't spend time deciding what to invest in. Simply invest in an index fund.
There are some big advantages to investing in mutual funds:
- If you invest in "no-load" funds, there is no commission on your purchase or sales of fund shares. As the fund manager buys and sells shares, the fund is charged commissions, but they are charged at a smaller institutional rate and absorbed by the entire fund.
- Small investments are properly diversified in many different stocks.
- You have a professional manager who is highly skilled at picking individual stocks and managing the fund. In exchange for this management, the fund is charged a fee, usually around 1-2% per year. This is how the mutual fund company makes money.
- You can easily determine how much risk you are taking based on the type of mutual fund you have invested in. For example: aggressive growth funds, will go much higher in rising markets and much lower in falling markets than conservative stock funds.
- With a single phone call, you can transfer money between different types of funds within the Mutual Fund Family. Most families contain aggressive growth stock funds, conservative stock funds, bond funds, money market funds, and many other types of funds.
Stock Market Movement
Most stocks move with the market. For example, if the general market is in a downtrend (a bear market), even stocks that are fundamentally excellent values, will trend downward. In fact, aggressive growth mutual funds whose portfolios consist of professionally selected stocks get absolutely devastated in bear markets. Many investors, who are not able to sit by and watch their funds lose 40-50% of their value actually end up selling out at exactly the wrong time. Whether you invest in stocks or funds, it is absolutely necessary to know when to be very conservative about your stock market investments.
Positions
Your position is based on which way you are betting the market will go. We refer to these positions as long, short, and cash.
Long Positions
If you buy stock or mutual fund shares hoping they will increase in value, you have taken a long position.
Short Positions
If you believe the market will fall, you can profit by selling short. This is referred to as a short position. Selling short is selling borrowed shares of stock or shares of a mutual fund, hoping to some day buy them back at a lower price and return them to their owner. For example, assume you borrow 100 shares of XYZ Corp. and sell them for $5 per share. You will receive $500 proceeds from the sale. At some later date, XYZ Corp.'s stock has dropped to $3 per share and you decide to buy the shares and return them to the person you have borrowed them from. This is called short covering. To repurchase the shares you will have to pay $300. Since you received $500 on your short sale, and paid $300 to cover your short, you have gained a $200 profit on the trade. This is a very common transaction. A stockbroker who will charge you a commission handles all of the details.
Cash Positions
If you are not short selling when you believe the market is going to fall, you will simply sell your long position and place the proceeds in an interest bearing account. This is a cash position.
Buying On Margin
If you buy stocks or mutual fund shares from a broker, you can leverage your purchases. That is, you can borrow money from your broker and buy more shares using your cash and the cash you have borrowed. The amount of cash you must provide is governed by the margin requirement that the U.S. Federal Reserve sets. For example, currently the margin requirement is set at 50%. Therefore, whenever you buy stock or funds you can borrow an additional 100% from your broker bringing your maximum invested position to 200% instead of 100%. When you purchase shares on margin, you must pay your broker interest on the borrowed capital.
Mutual Funds can be purchased on margin at most discount brokers such as Jack White & Company.
Beta
Beta is a measure of volatility of a trading vehicle such as a mutual fund. The general market as measured by the S&P 500 is considered to have a beta of 1.0. Stocks or funds that gain more than the general market in bull markets and lose more in bear markets have betas of greater than 1.0. Conservative funds and stocks may also have betas that are less that 1.0. For example, assume you invest your money in an aggressive growth fund that has a beta of 1.5. If the S&P 500 gains 10%, this fund should gain 15% (1.5 X 10%). If the S&P 500 loses 10%, this fund should lose 15%.
Stock and Mutual Fund
Picking Rarely Works. In 1997, most investors believe that the market will always go up with only very minor corrections of less than 10%. This would eliminate the need for timing the market and would make an investors only job deciding which fund or stock will go up the most. Pick up a copy of any high circulation investment magazine. Month after month they have headlines that read, "10 Stocks that will go up..." or "The 5 Best Funds..." The entire investment industry is built on analysis that attempts to reveal the next Microsoft. There are some big problems with this approach:
- Investors are not properly diversified. Based on bad advice, people invest too much capital into certain individual issues hoping for a big score. The bad advice did not include when to sell the issue so temporary profits eventually are closed out as losses.
- Analysts can rarely beat the SP500 with the stocks they pick. Often, throwing darts at the financial pages beats the best stock pickers in America. I'm sure you've seen articles about monkeys, widows, and children that beat the experts. It's a wasted effort. If you want to pick the next Microsoft, your best bet is to find a company in your town that is very profitable, run by outstanding people and has a fabulous potential future. When it goes public, invest a small amount of money and forget about it.
- No matter what you read in advertising material, most investment newsletters under- perform the SP500. Investment newsletters tout all the great stock picks they make. They ignore the bad ones and the total portfolio gain. The Hulbert Financial Digest tracks newsletter writers advice and very few beat the SP500. Many newsletter writers even lie about their Hulbert rankings in their advertising material.
- Growth mutual funds rarely beat the SP500. Picking the best fund is very difficult. As you add stocks to a portfolio, it becomes highly correlated with the SP500. So, a growth fund that invests in SP500 type stocks will basically replicate the SP500 over time. Since mutual funds pay commissions and are charged management fees, almost all end up under performing the SP500.
- Beating the SP500 for short periods of time is easy. So you want to beat the market. Pick a fund that has a beta greater than the market and as long as the market is rising you'll beat the SP500. An aggressive fund that invests in high-tech companies is a great example. Unfortunately, even in bull markets these funds get hit hard when the tech stocks are out of favor.
- Funds that beat the SP500 in rising markets will get hammered in falling markets. High beta funds work both ways. In a falling market high beta funds will lose more than the SP500. This is why it's so hard the beat the SP500 without market timing over longer periods of time.
- Picking funds give investors a false sense of security. The mutual fund industry has successfully convinced investors that they will become wealthy by buying their funds and holding them forever. Every mutual fund advertisement you see touts recent performance as proof. What they don't tell you is what happens to their funds in sustained bear markets. They don't tell you that the buy and hold method is emotionally impossible and that most investors bail out of their funds at exactly the wrong time. They don't tell you that their bottom line depends on the buy and hold investor. Every time someone sells out of a fund, it costs the fund company money. They certainly don't tell you that their phone system cannot handle panic selling. In a crash scenario, you will be unable to sell your funds because you won't be able to get through to a representative.
Time Magazine summed up the dilemma well in their January 15, 1996 issue:
"86% of the most popular mutual funds did worse than the Standard and Poor's 500 index in 1995. This is more proof that the national pastime of picking the winning mutual fund is a wasted effort. Most people would be better off buying the so-called index fund that give them a guaranteed average return."
The only problem with this advice is that an "average return" can be very negative. Bear markets can easily cause SP500 index funds to drop 30-40% in value. Investors cannot emotionally handle riding out losses like these.
Spend Most of Your Time Deciding WHEN to Buy Instead of What to Buy.
Do you really think that the wealthiest and smartest investors in the world are actually buy-and-hold investors? Individuals who have built multi-million dollar fortunes are not big on losing money. Sure, they may ride out losses on venture capital type investments just as a business owner wouldn't sell his business because of temporary losses. But, the majority of their portfolios are protected from bear markets with hedging strategies which is simply market timing.
Your goal should be to incrementally move from a 100% cash position to a margined 200% invested position based on the probability that the market will rise. Until you have a developed a sound strategy for doing this, don't spend time deciding what to invest in. Simply invest in an index fund.
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