Monday, October 06, 2008

Quiet reads for the stormy times

So, has the ride been rough in stock markets over last few weeks? No doubt. Time to take the money out? At the risk of repeating myself, answer is No. If you take money out now, you will probably incur great amount of irreversible losses. Stay put if you are already in the market. If you have money and believe that over the long term, market is going to comeback, it is time to buy. Do we know if the market has bottomed? No good answer here. Best strategy is to stick to investing basics.

There are some books which have impressed me quite a bit and made me a believer in investing in broad based well diversified stock holdings. I want to give their names here and also want to remind myself to read them or skim them over. I think they are really good books  to read especially during these difficult times so that we do not take some foolish decision in the moment of panic.

First book is 'Stocks for the long run' by Prof. Jeremy Seigel. Wharton biz school professor. Prof. Seigel has compiled tonnes of data over last century to write a compelling book which has been a best seller for last many years. This is the book to read and be convinced that historical figures are in favor of astute investors who buy diversified portfolios and hold them for a long period. The book analyzes stock returns and compares them to returns on other asset classes such as  precious metal, real estate etc. and shows how stocks beat all other asset classes over a long period of time.

Second book is 'A random walk down wall street' by Prof. Burton Malkiel. A highly respected Princeton professor. In this book Prof. Malkiel makes a strong case for sticking with index funds and shows that nobody can consistently beat market returns. If  well-paid and full time professionals can not do that, why waste time? Better it is to buy a whole bunch of low cost index funds in all sorts of areas and forget the ups and downs.

Both these books are written by academicians with tonnes of research and data for common man. Both books are fast reads and should be available in your library or for purchase for a few dollars. They have been best sellers for so long that you can find used copies for a couple of dollars or even free if you are willing to pay nominal postage. If your believe in the premise of books, then buy new copies. You are not going to regret. You may become a better investor too.

If you are disciplined investor, you are probably familiar with the concept of 'dollar cost averaging.' DCA is a method by which you put in fixed amount of money to buy stocks or mutual funds at a regular intervals of time. It has been found to provide nice returns because by putting in fixed amount of money at regular intervals, you automaticall buy low and sell high. When market is rising, you will buy fewer shares and when market is down, you buy more shares. What if this method can be further improved? That's where Value cost averaging comes in. VCA requires little more work on your part but studies show that VCA has potential return better returns than DCA. VCA requires little more work because you have to adjust how much you want to buy based on market performance. Also, if your expectation is not right, you may end up holding too much cash especially while markets are rising and waiting for markets to come down. One way to ensure that you always buy stocks, but still use VCA, is buy expecting more returns than market can possibly return. Expecting a return of 15% annually is a good expectation. So, if you are buying on monthly basis, it works out approximately 1.25% return month to month. For most accurate results, reverse the compound interest formula for 15% with period set to 12. But, 1.25% is good enough. To start off with VCA, buy some mutual fund the first month for $1000. If the share price is at $100, you will buy 10 shares. When you are ready to buy shares next month, remember that you expect 1.25% return. So, share price should be 101.25. So, by chance, if the share price is 101.25, you do nothing and hold on to your cash. When market has given you the required rate of return, you stay put. But, if stock has dropped to say $95 a share. So, your portfolio value is $950. Ideally it should have been 1000*1.0125 = 1012.5. So, you will buy shares worth 12.5 dollars to bring your portfolio to where it should have been. You will also adjust your reference to $95 a share and expect it to become 95*1.0125 = 96. 1875. Next month you expect your portfolio to be at 1012.5*1.0125 = 1037. 8125. If the value is less than this, you will buy to bring the value to this number or if the value is equal or greater, you will stick with cash or find other opportunities to invest. If you can not find better opportunities to invest, you go ahead and buy as much as you can. By following VCA, you are becoming disciplined at keeping an eye on the returns you expect. Holding cash for sometime is not a bad thing in VCA because next month stocks may fall quite a bit and you may need extra cash to make up for bigger difference between what your portfolio is worth and where it should have been. There are some variations how people do VCA. Some people do not adjust the reference price month to month at all. They make up a model, say with monthly returns of 1.25% on the starting price, and stick with it hell or high water. It is a good approach if stocks prices are stable but when they are quite volatile, what you can spare at the end of the month may not be adequate at all. By adjusting reference price month to month you are making it easier for yourself to buy decent number of shares. If you have a lot of extra cash and your model has aggressive expectations, you can leave the reference point fixed and just keep buying. Just bear in mind that during prolonged bear markets,you may need a lot of money to keep up if your expectations are quite high.

VCA is not very difficult although it may seem so. You can create simple Excel worksheet in no time. There are a lot of web site which describe VCA in better terms than I have done here.

VCA or DCA, disciplined investing must pay back. So, keep investing. Once you have set aside enough cash reserve to last you comfortably for 6-9 months, there is not much you can do about problems which may go longer than those many months. If it makes you feel better and if you can afford, feel free to hold up to 1 year worth of living expenses in liquid cash. But, do not get worried by temporary market swings and pull back all your money and hide it in your mattress.

Cheers to successful investing!

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1 comment:

BLOSSOM said...

Great information. Yes markets are coming down and no stability. a rise and fall after a great fall. Thanks a lot