J.K. Lasser's buy, sell, or hold : manage your portfolio for maximum gain

261 Pages·2002·1.097 MB·English

by  Michael C Thomsett, J.K. Lasser Institute

™
J.K. LASSER’S
B U Y, S E L L , O R H O L D :
M A N A G E Y O U R
P O R T F O L I O F O R
M A X I M U M G A I N
Michael C. Thomsett
Copyright © 2002 by Michael C. Thomsett.
All rights reserved.
Published by John Wiley & Sons, Inc.
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Contents
Preface ix
1. The Pricing of Stocks 1
Recent Price History and Patterns 2
Current Prices per Share 5
Beliefs about Future Price Movement 9
Reckless Optimism 12
Fundamentals and Stock Prices 16
Notes 22
2. Fundamental and Technical Analysis 23
Fundamentals—A Look Back 24
Problems of Financial Reporting 26
Relation between Fundamentals and Pricing 30
Technical Analysis: A Look Forward 33
Problems of Technical Analysis 34
The PE Ratio 37
The Reliability Problem of the PE Ratio 41
Solutions for the PE Puzzle 42
Notes 44
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3. The “Practical” Dow Theory 45
Origins of the Dow Theory 46
Basics of the Dow Theory 47
Problems with the Dow Averages 50
Overcoming the Problem 53
Timing Your Market Decisions 54
Applying the Dow Theory 56
The Intrinsic Flaw of Indexing 63
Notes 66
4. Identifying Investment Risk 67
Risk and Opportunity 68
Market Risk 71
Economic Factors and Risk 74
Inflation and Tax Risks 77
Short-Term Risk versus Long-Term Risk 80
Opportunity Management Aspects of Risk 83
The Need for Risk Management 86
Risk and Diversification 88
Risk Tolerance Levels 90
Notes 92
5. The Egg and Basket Idea 93
Diversification: A Misunderstood Concept 94
Broad Forms of Diversification 97
Fundamental Diversification 99
Mutual Funds as the Vehicle 102
Diversification by Market Risk 106
Diversification by Markets 109
Notes 111
6. Liquidity in the Market 112
Portfolio Liquidity: The Profit-Taking Problem 114
Alternatives to Selling at a Loss 117
Liquidity and Fundamental Attributes 120
Emergency Fund: The Traditional Approach 125
Coordinated Portfolio Management 128
Tax Planning and Liquidity 130
Liquidity and Timing 133
Notes 136
7. Volatility and Its Many Meanings 137
One Aspect of Price History 138
Translating the Raw Material 142
Interpreting the Patterns 145
CONTENTS ix
Price Volatility as a Technical Indicator 147
Volatility in Earnings 150
Differences between Price and Earnings 155
Conclusions Based on Fundamental Volatility 158
8. Using Other Peoples’ Money 161
The Inaccuracy of Leverage Examples 162
Leverage and the Regulatory Environment 164
Leverage at the Corporate Level 167
The Risks of Leverage 168
The Realities of Leverage 172
Another Form of Leverage 177
Note 181
9. Rates of Return 182
The Problem of Comparability 183
Comparability in Corporate Rates of Return 185
Investment Return: Calculation Methods 191
Compound Returns: How It Works 195
The Self-Deception Problem 199
Returns Reported in the Financial Press 202
Price Comparisons as the Basis for Decisions 204
Internal Rate of Return (IRR) 207
Return Calculations for Option Buyers 210
Mutual Fund Returns 215
Notes 218
10. Professional Advice for Investors 219
Market Analysts 221
Brokers 224
Financial Advisors 229
Commonly Held Beliefs 232
Other Professional Help 234
A Question of Need 236
Notes 238
11. Developing Your Comprehensive Program 239
Three Market Rules of Thumb 239
Theory and Practice 241
Index 245
Preface
Creating Your Comprehensive Program
Why does anyone invest money? Why place yourself at risk and expose yourself
to the volatility of the stock market? Why not just leave your capital in an
insured savings account?
Of course, there are logical answers to these questions. As an astute investor,
you already know that taking risk is an inherent part of investing your capital
anywhere. For example, you could opt to place all of your capital in an insured
account at your bank; in fact, many highly conservative investors do just that.
This option also involves risk, however. The yield is so low that you risk losing
the long-term purchasing power of your capital. The combination of taxes and
inflation can cause the real value of savings to fall over time.
So even when you try to mitigate all risks, it’s virtually impossible. The fact
is, risk is the flip side of the coin we know as opportunity. So, in order to be “in
the game” of the market or to be able to take the opportunities to earn profits,
you also need to expose yourself to a corresponding degree of risk.
It’s in the nature of investing that opportunity and risk are married in this
way. The greater the opportunity, the greater the risk. So, every investor has to
decide how much risk is appropriate, how much risk he or she can afford, and
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what portion of capital can be placed in higher-risk investments versus a base
of lower-risk or moderate-risk ones. Within this body of decisions, many ques-
tions arise that demand self-education. These questions can be broken down
into 10 major areas of study:
• Identifying how and why stock prices actually change
• Forms of analysis that can help you decide when to buy, sell, or hold
• Applying popular forms of analysis to your portfolio
• Market risk
• Diversification
• Liquidity
• Volatility
• Leverage
• Rate of return
• Professional advice
These 10 areas of study involve a study of facts and sorting through of vari-
ous kinds of information. You need to become a competent investor in order to
work through the maze of things you need to consider in making your own judg-
ments. The alternative is to take advice from others, but sadly, good advice is
difficult to find and experience shows that bad advice is far more abundant. So
the bottom line is that investors really are on their own. In a market charac-
terized by a large body of information, your biggest challenge is deciding which
data are useful in the larger field.
We are not saying that it is impossible to manage your own portfolio. On the
contrary, making your own decisions means that you are in control. Investors
tend to operate analytically so that facts and figures are appealing and reas-
suring to the typical investor. Facts and figures by themselves are of little use,
however, unless they are based on true underlying information. Among the
information available to you are a lot of useless or baseless conclusions. The
market is characterized by rumor, false assumptions, and decision-making
based on poor information or even on no real information at all. As an investor,
you want to be reassured with numerical information. You are looking for
answers, and like all investors you would like to find that one solution that
dependably tells you when you buy, when to sell, and when to hold.
That single answer does not exist, because no one can know what conditions
will be like tomorrow. By gathering a body of knowledge and applying it in a
sensible manner, however, you can make your decisions based on a logical and
reasonable policy. You can manage your portfolio to maximize analysis, mini-
mize risk, and earn profits. You can also take steps to overcome the most com-
mon flaw in the way people invest: depending upon unreliable information and
making decisions without getting the facts beforehand.
PREFACE xiii
This book is designed to explore each of the 10 areas of study that every
investor needs to master. It is organized to present the popular fallacies that
many people believe and then offer alternatives. These fallacies are widely
believed, so the majority of investors continue to operate on a false premise in
one way or another. As you will see in the 10 chapters that follow, however, the
alternatives to these fallacies do point the way to market success. They demon-
strate how you will be able to make intelligent decisions within your portfolio,
based on sound information. The alternative—proceeding on the basis of
widely held but false beliefs—will only prevent investors from realizing their
goals in the market.
The first question faced by you and every other investor is, “When should I
buy, sell, or hold a particular stock?” The old adage, “Buy low and sell high”
should be followed by the equally important “instead of the other way around.”
It’s true that many investors apply the adage in reverse. As values climb to
record high levels, many investors want to get in on the profits—and, as a con-
sequence, they buy at the top of the market. Then, when stock values fall,
investors fear even larger losses and they sell their shares at the bottom of the
market. So, the forces of greed and fear end up having more influence that the
more rational forces of optimism and pessimism.
Once you are aware of this tendency, you will be able to move away from the
“herd mentality” that characterizes the market. The tendency to move with the
majority is natural, and it demands courage to keep a cool head when everyone
is making decisions in the opposite direction; however, the key to market suc-
cess is to make the important buy and sell and hold decisions based on solid
information rather than on the basis of what everyone else is doing. This book’s
purpose is to organize and present the tools you need to achieve that end.
Acknowledgments
My thanks to Bruce Boyle for investment insights and for giving me a different
point of view and to Virginia Gerhart for the years of encouragement. Special
thanks also go to George C. Huff, who gave me the chance to learn so much in a
marketing environment, in which the practical always buries the mere theory.
Also, thanks to Dave Pugh, editor at John Wiley & Sons, for the feedback and
expertise and for supporting this project.
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