Monday, March 16, 2009

A thought on Stocks & Bonds

I've had a few requests to write a piece on the equity and debt markets (i.e. stocks and bonds in particular). I thought I should invite my sister-in-law to write as she just made $600 in one day of trading last week during a 3-day market upswing. But then she has no formal training in stock analysis and was effectively playing coin slots with the market.

Well you can fill a tome with the topic of investments. I'll pare it down. Right off the bat, bonds - whether discount, premium, municipal, zero coupon, or whatever other type of bond you find in the market is structured to pay you your principal after a certain maturity date (or if called early by the Corporation issuing the bond) plus steady interest payments (normally semi-annual). Since I do not deal with usury I won't discuss bond valuations and yields.

Then we've narrowed it down to stocks. The stock market has seen a massive exodus of funds. Where did they all go? Either to treasury bills, or commodities like gold that are deemed safer during risky times, or to the bond market which is yielding far better than the stock market right now. However, anyone familiar with Ibbotson's yearbooks knows that $1 invested in 1925 grew to an astounding $13,706 by 2005 if the money was invested in small-company stocks. Large company stocks by comparison grew to $2,657 and bonds grew to $71. As a baseline, inflation grew during this time to $10.98. (By the way, these numbers were holding period returns, not geometric or arithmetic average returns). So why doesn't every Tom, Dick and Harry invest in stocks? The reason is volatility and lack of investor discipline. You're either in the stock market to take advantage of daily up and down swings (day traders) or you're in it for the long haul (holders). The long haulers have always come off better. The day traders who understand macroeconomic conditions and are savvy with the impact of pending government policy announcements, earning reports, potential litigation are way better off. But day trading has tremendous risks and tremendous rewards.

So what am I getting at? First a little bit of technical details, then I'll simplify what it means. In any portfolio of securities (carrying one stock, two, three or 20 for example), there is a portfolio risk which is essentially the market risk or systematic risk. No matter what you do with your portfolio mix, the market risk is a constant and you can do nothing about it. The second element is the portfolio risk also known as idiosyncratic risk. This is a risk that is specific to the firms that compose your portfolio and the risks can be diversified away. How? By placing unrelated firms into your portfolio such that your correlation coefficient is as close to -1 as possible. In a portfolio of 2 securities (or 2 stocks), your correlation coeffecient is the covariance of the returns of the 2 securities divided by the product of their standard deviations which should be a number between -1 and +1. The closer you are to -1, the less risk your portfolio has.

Now the simplification. If you have two stocks, one in Gap, and one in Ross, is your correlation coeffecient likely to be closer to -1? Probably not, because both stocks are in the same industry and the same macroeconomic conditions can cause both stocks to rise and fall in tandem. If you have one stock in Gap, and the other in Walmart, you're more diversified. Leaving aside the formulae which makes economists and quants scream with glee, one can intuitively 'see' a diversified portfolio versus a non-diversified one. Why would you want to invest in the stock market now when everyone is running away from it like the plague? Because stocks are available at cut rates now much like your local Iraqi rug bazaar store that has been going out of business for 5 years (seriously I've seen a sign like that).

If you do invest in stocks, make sure you diversify and if you're risk averse, be in it for the long haul. If you're a brash risk-taker like me, trade like a bull and after you've paid off your mansion, car and private jet, send some royalty checks to me. PayPal accepted.

For specific stock tips, you can e-mail me.

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