Refining Wall Street Wisdom

Going Beyond Bumper Sticker Logic

All of us small investors have read Investing for Dummies, The Tao Jones Averages and watched MS-NBC. We've heard six concepts referred to time and again. Each one has a germ of truth and each one has been oversimplified. Now, it's time to look deeper and refine the ideas into a more useful form.

Buy and Hold
Dollar Cost Average
Buy on Dips
Prices Fluctuate Daily
Markets Move Up and Down
Circuit Breakers Regulate Price Changes

Buy and Hold

This strategy's value is rooted in two concepts, loss of value due to trading costs and that overall returns are proportional to time in the market.

The first concept does not hold in the case of electronic brokers who only charge fixed $15 order fees (i.e. National Discount Brokers) or in the case of families of mutual funds which do not charge for inter-fund transfers.

The second concept only demands that one remain invested but does not prohibit shifting between investments. Never let buy and hold interfere with rebalancing your portfolio to match your investment objectives.

There is one other implicit concept, that it is impossible to time market trades for reasons ranging from market efficiency to market irrationality. Even if you side with these random walkers instead of the intuitionists, contrarians, fundamentalists, and technicians, you are not at risk. If the market were truly efficient you would not only be kept from out-thinking the market, it would be kept from outthinking you. Hence, switching stocks should cost you nothing. Moral: Trust your intuition; at worst it can breakeven.

Dollar Cost Averaging

Dollar cost average by buying fixed dollar amounts at regular intervals. This is a mathematically proven means of taking advantage of market volatility and acquiring stock below its average price.

However, the magic only works for the purchaser. Since buying and selling is a zero-sum game, the seller loses. Moral: buy in pieces, sell as a lump-sum.

Buy on Dips

Stock prices dip for several reasons, liquidity crises and thought-out reassessments of value, and overly generalized reassessments. Classifying dips into these three categories is straightforward.

Occasionally, the pool of buyers dries up and there are sellers trying to dump "at any price". This true market inefficiency represents a great buying opportunity and is easily recognized by a large spread between the bid and ask prices.

Overly generalized reassessments can be recognized when an entire industry category falls in lockstep because of news that might not affect every member of the group. For example, in the October 1997 crash, Oxford Health greatly disappointed analysts and the entire managed care group fell dramatically. Within a day, several members of the group recovered when rational investors determined that the news did not apply to Oxford's competitors. This type of "class action over-reaction" represents good buying opportunities for those who have taken time to learn about the companies they invest in.

True revaluations reflect economic trends, new rumors, industry specific trends, and company specific analysis. For high volume stocks, these kind of revaluations are somewhat efficient and a dip is difficult to turn into profit.

Portfolio Valuation

The only prices that ever matter are the purchase price and selling price. Anything in between does not matter. Only a tiny fraction of shares outstanding get traded everyday. The bulk of shares are held by people with longer term goals and radically different valuations. Moral: Ignore low volume price changes; they are meaningless.

Market movements

Everyday we come home to learn the percentage that the market moved up or down. This creates the illusion that prices are mathematically continuous functions. The reality is that the market can change instantaneously. A simple example is the value of a car. Someone offers you $10,000 for you car. When you tell them that the transmission is broken, the offer may fall instantly to $7,000. There is no period of going through $8,000 where you could have caught it on the way down. Moral: Corrections can happen so fast that they can't be beat. Don't count on being able to bail out before a market drop gets severe.

Market Circuit breakers

Exchanges have rules which temporarily suspend trading when the indexes change by large percentages. Since prices can change instantaneously, these Circuit breakers cannot stop a fall. No suspension of trading can force a buyer to emerge a particular high price. A potentially negative effect is the fear created by closing an exchange early.

I believe that circuit breakers have value but should be redesigned. Their principal value is in allowing time for information to be disseminated and for overloaded systems to catch up. They can't stop large movements, but can make the movements more orderly.

The circuit breakers should be linked to volume, not prices. The breaks should only slow trading, not suspend it.

Companies with cash sometime stabilize their stock by announcing buybacks. This mechanism could be generalized and a company could preannounce graduated price supporting buyback orders. For instance, if IBM is trading at 135, it could have standing limit orders at 130, 125, and 120 at successively increasing volumes. The result would be increased confidence, guaranteed liquidity, and increased stabilization.

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