Economic Recessions and Investing

The recession and the anticipatory fall in stock prices that preceded it has scared a lot of investors away from the market.  This is unfortunate since it is during these times that the stock positions are built that result in the truly great returns.  Just like shopping at the supermarket, the time to stock up is when things is when they are on sale. 

Individuals tend to do just the opposite when it comes to investing, however, buying only after big run-ups and selling after prices have declined.  The result is so pervasive that there are strategies that actually try to follow the inflows and outflows of “the crowd” and do the opposite.  The more bullish the public is, the more stock one sells.  The more bearish, the more one buys.  This strategy has additional merit in that when everyone is bullish it probably means that they have already invested all of the money they have and there is little capital available to drive stocks higher.  (Note that with real estate, once home prices has risen to the point that individuals could not even afford the payments with no money-down, interest only loans, housing prices quickly went from straight up to straight down.)

The difficulty is that individuals tend to equate buying and seeing prices rise with “winning” and buying and seeing prices falling as “losing.”  One needs to get over this mindset to succeed at investing because it will cause one to miss out on great investing opportunities.  If one buys a stock in a falling market and sees the shares decline a bit, one should see it as an opportunity to buy more at lower prices.  If held long enough (and assuming that quality stocks are being purchased) the stock should be much higher than either price paid.  One should take advantage of the fact that a falling market causes all stocks – good and bad – to fall.  The difference is that the good stocks quickly recover while the bad languish.

Unfortunately, the style needed for successful investing runs counter to an individual’s normal psychology.  If a person buys a stock and it goes down, he may initially stay with his convictions and perhaps pick up a few shares (like doubling down in gambling), but if the stock continues to decline he will eventually sell out.  If he does not sell out, he may sell as soon as the price returns to the price paid, feeling that he “got his money back,” only to see the stock soar to new heights.

This can be avoided with a few simple strategies:

1.  When buying a stock, particularly in a down market, build up a larger position by buying only a portion at a time.  For example, build up a 500 share position by buying 100-200 shares at a time on dips.  One should have a targeted number of shares before starting, however, to avoid the other common mistake of averaging down in a losing stock.

2.  Plan to invest for the long-term.  If one is planning to be invested for 10-20 years in a stock, one will have a different perspective on 10-20% declines.

3.  Do not invest money that is needed in the near-term.  If a retirement is looming or college tuition bills are just around the corner, funds needed to pay for these expenses should not be invested in the stock market.  Because downturns can last for five to ten years, one should not have money invested in stocks that will be needed within the next five years or so.  While putting cash into a CD may seem like a waste, the psychological peace it will give will result in smarter investment decisions.

The other question that may be asked is “What types of stocks should one buy during a recession?”  As was previously stated, all stocks tend to go down during downturns in the market.  This means that the shares of the top companies in a sector will tend to fall along with those of the second and third-tier companies. 

Find the companies that are leaders in the industry, which probably had higher PE ratios than the industry average during the good times.  Other good signs are companies that have little if any debt, strong cash flows, and had consistent earnings growth.  These companies will tend to be stronger than their competitors and therefore better able to weather the recession.  They will pick up market share as their competitors fail, emerging from the recession stronger than ever.

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Buy Stocks

Buying stocks is more than simply placing the order with your broker or entering numbers into your online account.  To effectively and efficiently buy stocks, one must understand the mechanics of placing an order and methods that will result in a better price and  reduce the anxiety behind making trades.  In this article I will cover these aspects.  First, the mechanics.

There are two basic types of buy orders –market orders and limit orders.  A market order will buy the stock at whatever the market is asking for the shares at the current time.  A limit order will wait until the asking price drops to the level of the limit before the shares are purchased.  With a market order, therefore, you are accepting whatever price the stock is trading at, while with a limit order you are guaranteed to get the shares for a certain price or less.  With a market order you risk getting a poor price, while with a limit order you risk not getting the shares at all if the stock price climbs and never reaches the level of the limit.

Typically, I will place market orders if the stock is liquid (there are a lot of shares outstanding and a large number of shares change hands every day) and I feel that the price of the shares is reasonably value or cheap.  In this case I am more worried about getting the shares than the price paid (since I’m investing long-term, the difference of a few pennies per share will not matter).  If the stock is illiquid, such that few shares trade and the price may move up several dollars per share during the trade, or if I like a stock but feel it may be a bit expensive, I then place a limit order.

In placing a limit order, one must understand the mechanics of the trade.  When limit orders are entered, the person who placed the order first at a given price will have his order filled before people who come after him.  (This is true of market orders as well, but in a liquid stock there are normally plenty of shares available for sale such that the price will not move much even if there are several orders in line in front of you.)  For this reason, I tend to avoid placing orders at round numbers (like $40 per share).  Instead, I would place it at $40.03 per share or some similar number.  That way, as the price drops I would get the shares before the price dropped all of the way to $40 where a lot of people probably have orders entered before me.

The second aspect of purchasing a stock is the psychology — the battles with that voice inside our heads that judges our actions and causes anxiety, leading perhaps to foolish trading behavior.  Psychology is the reason that people tend to buy stocks when they are high near market tops and sell them when they are  low near market bottoms.  One trick I’ve learned is to not buy the full position from the start.  Instead, if you are looking to buy 500 shares (if you are serious about investing, you should be looking to buy 500-1000 shares of your top picks). you should put in an order for 200 shares.  Then, hope that the stock goes down a bit, then buy another 200 shares.  Wait a bit, hoping the stock falls further, then complete the building of the position buy purchasing the last 100 shares.  In this way, rather than feeling self-doubt when the price falls after the purchase, you will feel good because you are now able to pick up more shares at a lower price.

If the price of the stock does not fall after the original purchase but instead rises, I would wait for the first dip to add the next 200 shares, and then wait for the one after that to fill out the rest of the position.  One must be careful to resist the temptation to get worried and start paying whatever price for the shares, because right when you do this the stock will fall.  

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Buy Stocks in a Falling Market – How to Catch a Falling Knife

Wall Street has a lot of sayings developed by traders who learned one lesson or another, usually after losing a great deal of money.  One of the bromides is to “catch a falling knife,” usually used in phrases like “He tried to catch a falling knife with that stock and lost his shirt.”

In stock market parlance, to “catch a falling knife” if to buy a stock that is declining rapidly in price with the hopes of buying the stock at the bottom, thereby getting a good price, from which the stock rebounds sharply, leading to a quick profit.  As would be the case with trying to catch a real falling knife (picture point side down, razor-sharp, rocketing towards your foot) the maneuver is tricky.  If you move too soon, you will be rewarded with a slice in your finger or a point in your palm.  If you move to slowly as the handle whizzes by, you’ll miss the knife entirely. 

 Buying falling stocks is a form of value investing, in which an investor buys stocks that he believes are undervalued and holds them until he believes they are fairly valued or overvalued.  The general premise is that an undervalued stock will eventually return to its fair value, and that undervalued stocks will do better than overvalued stocks.  Value investing is based on the “buy low, sell high” philosophy.  This strategy has proven itself at various points in the past, although in recent years the momentum investing approach (buy high, sell higher) has actually been more profitable.

The trouble with buying declining stocks is that stocks that are falling rapidly in price are usually falling for a reason.  Looking at the current British Petroleum fall, the stock is declining because the clean-up efforts from the oil spill will cost unknown billions of dollars, which in turn will hurt earnings.  There is speculation over whether the dividend will be cut or eliminated, how big the losses will be, and how much will be paid in legal costs and claims resulting from the numerous lawsuits that will no doubt come in the next year or two.  In addition, the actions that the US Government may take and their effect of future profitability are unknown at this point.  Because stock investors hate uncertainty the price will continue to fall. (Even if the news is bad, if you know the numbers you can value a stock.  If there is uncertainty no one knows how to value the stock and therefore are afraid to step in and buy).

The only time to try to catch a falling knife is when the whole market is declining, and then to pick up shares of a stock you have determined to be a good long-term buy and were accumulating anyway.  In this type of situation, good stocks and bad tend to decline, so your great company will fall along with everything else.  When the markets turn around, the great stocks are the first to shoot back up, providing once-in-a-lifetime returns.

To determine if the whole market is declining, rather than just your stock, look at the mid-term charts (maybe 6-month time span) of several stocks.  If they all look about the same, with head and shoulder patterns and then a downward trend, the whole market is falling (the current market is like this).  If only the stock you are interested in is falling, it is best to stay away because there is probably something other know that you don’t (yet).

If you determine that the whole market is falling, the way to catch the knife is to wait for the initial decline to start to slow and flatten out and then buy about 1/3 of the number of shares you will eventually buy.  Then, wait for the rise and hope it is a bear-market, “suckers” rally.  If it is, wait for the stock to decline beyond the previous low and then wait until it begins to flatten again.  Buy the second 1/3 here.  Repeat one more time if the market cooperates and there is a third downturn.  If the stock moves up and crosses the original high (the “head” of the “head and shoulders” pattern) wait for the subsequent low and buy the rest  of the shares because the fall is probably over.

After you are all in, just sit back and wait.  The stock may fall farther, but by buying in stages you lower your cost basis and also are aided psychologically.  As the stock moved to new lows, since you were hoping it would continue to decline, you don’t get the self-doubt that you get when you buy the full position at once and see the price continue to decline.  It is almost impossible to catch the exact bottom, but this way you had three tries.  Eventually the stock should recover and set a new all-time high if you picked the right kind of stock, so whether you got the exact bottom or not won’t really matter. 

Happy catching!

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to invest $100,000 in Stock – Starting from a large Cash Position

OK, so let’s say old Aunt Lizzie has died (the aunt who you don’t remember seeing since you were five, and just remember that she had a lot of cats) and she has left you $100,000.  You aren’t sure why she left you the money, but now you have a bunch of cash and want to try your hand at investing.

Let’s assume further that you already have an emergency fund (cash) of 3-6 months worth of expenses, a retirement account set up that is full of mutual funds and the like, you don’t have credit card debt, you have the house on a fixed 30 year or — even better –15 year loan, and you have the kid’s college account set up and ready to go.  If any of these are not the case, take care of these first – you aren’t ready to start investing in stocks.

So the question is, how do you invest all of this money, starting from a such a large sum?

Well, if you read any of my recent posts, you’ll know that I don’t think the market is particularly attractive right now, and probably will be heading down for a while.  I could be wrong, however, and all of that federal funds money may finally start the lending flowing and we could see 20,000 on the Dow in a year.  What the market will do over the next few years will also not matter a whole lot in 10-20 years.  There is therefore no reason to wait, but there also is no reason to jump in with both feet.

First of all I would determine how much of the $100k I was wanting to preserve and not put substantially at risk, and how much I was wanting to grow more rapidly with a bit off added risk.  Personally, I might decide that I wanted to preserve $40,000-$50,000 of it through diversification.   (Others who are more risk averse might want to put $70,000-$80,000 in mutual funds.  If you really don’t want to mess around with individual stocks, you would be just fine putting it all into mutual funds.)  This I would put in 2-3 index funds.  Here one might see declines of 20-30% on some years, but this will be rare, and with time this money should grow at an average rate of about 10-15% per year, doubling each 5-7 years.  Here I would put some in now, wait a few months, and put in more, taking about 6 months to a year to become fully invested.

With the rest I’m looking to take a bit more risk for the chance at larger returns through investing in individual stocks.  I know that any one stock could collapse, but it could also grow by thousands of percent.  By buying a few carefully picked stocks I’m hoping to get at least one that grows for years and beats the overall market.

Anytime a large sum is to be invested, even if the market doesn’t look so unstable as it does now, it is always wise to wade in slowly.    I would start by picking 2-3 stocks that have good long-term prospects (see the stock picking category of the blog).  Buy a few hundred shares of each of these – about equal dollar  amounts.  Then watch them for a while, hoping that they will drop a bit and you can buy more shares for a bit less.  Add to positions that do.

Once you have the initial positions, set up, wait about three months.  Check on the positions then and see if the companies still have the fundamentals you thought they did.  If they do, invest more in the 1-2 stocks that have lagged the others – buy low.  Continue to do this, adding a few hundred shares every three months, until you have about 500-1000 shares of each.  You may have $30-$80,000 of the money invested by this time, with $10-$30k in each stock.  If this is too much for you to lose, choose six stocks instead, making each position $5-$15k.  If this is still too rich, choose 10.   If you are still too worried, individual stock investing is not for you.  Buy three or four nice ETFs or index mutual funds and sleep easy at night.

At this point, start to look for another good stock in which to invest the remaining funds if money remains.  As the positions grow, sell off some shares if any of the positions become too big for you to lose – bad things happen some times.  Put some of this money in other individual stocks or add to existing position.  Diversify the rest to preserve the capital you’ve gained.  If any of the companies lose the qualities for which you bought them, sell them off and put the money into something else.  Also, see if you can save some money from your occupation and continue to add stocks to your portfolio.

Hopefully Aunt Lizzie’s gift will lead to a large portfolio of stocks and be worth many times the original gift 20 years into the future.  If this happens, maybe take $100,000 and give it to a grandchild.  Put it in an index fund or ETF when they are twenty and you will have paid for their retirement.  Do it when they are two, and you will have created a multi-millionaire.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.