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Thursday, August 09, 2007

 

Investing - Part 5

To close out this series, I'll respond to questions received from readers about the System, and questions I anticipate readers my have, even though they were not received.

Q. Let's get right down to cases - the system's criteria for choosing transactions is pretty elementary. It seems too simple to be very successful for very long. Shouldn't you work harder to find bargains and determine "tops" for selling points?

A. Success is a function of what your goals are. If you define success by an ability to buy at or near the bottom and sell at or near the top, it's true the system does not consistently achieve that. In fact it rarely achieves it. However, I don't know anyone who does. There are people with a knack for gambling, who seem to win at poker, at the races, and maybe at stocks. These people are fearless, confident, decisive, and respectful of the game. They are very rare. And probably, in their honest moments, they will tell you that they are not as far ahead as you think they are.

Most people are not that way, and they don't have all those strengths. I don't. There are things I am good at, I enjoy reading about companies, and I think I have a feel for companies with good strategic ideas, nurturing and ethical cultures, and solid management. Those are the companies I want on my buy list. However, I know I am a lousy trader. To me, the market's next move and any given stock's next move is just a guess, a shot in the dark. I can't make money calling tops and bottoms. I know this from my experiences with options trades, and with bad decisions as in the Dell episode. I also know I am really weak on the sell decision.

For the few good gamblers in the world, they may not need the discipline of a system. I do. That way, I never agonize about a trade, either a buy or a sell. I just do it, knowing that I am trading in small increments, and no one decision is make or break. The system is designed to result in a tendency or a bias for buying lower and selling higher. But it is only a tendency. Losing trades are very possible.

Also, my main goals are to preserve capital while achieving a reasonable risk adjusted return. I think the system has done that pretty well so far.

Q. So where does the individual investor's work and decision making enter the picture? Or will everyone using the system obtain approximately the same results?

A. The decisions to agonize about are whether to add or subtract a given company from your buy/hold list. Finding "good" stocks and following them closely enough to determine whether they are still on track is where the individual judgment comes in. It is that which will drive the results, so it is very likely that two investors, both using the system, will obtain very different results.

To put it in the simplest possible terms, if you have stubbornly kept Kodak and companies like it on your buy/hold list for the last ten or twenty years, no system is going to help much.

Q. OK, so are there any scenarios where the system breaks down and doesn't protect your capital?

A. I am afraid there are, and I have been trying to anticipate them and make the appropriate adjustments. Again, if we went into a secular bear market, that lasted a decade or so, as in the great depression, eventually, I've got to lose a lot of money unless I abandon stocks. And they won't ring a bell to let you know when it's safe to go back into the market. Though the 2000-2002 market was pretty awful, and caused me to make a few improvements to the system, it was no real secular bear market. Basically, my view is that we have been in a secular bull market since 1982. Unless you ignored the warning signs, and overplayed tech stocks in 1999-2000 without diversifying, you almost had to make money in the market the last 25 years. You didn't need to be a genius. So I would not argue with someone who said that the system will not be proven until it rides out a longer bear market. It could be getting that test now (though if I had to bet, I would say that we are in the midst of a ten per cent correction caused by the mortgage shakeout).

Q. Ok so there are no guarantees.

A. Nope, though someone using a system will trade with more discipline, and that will help most people.

Q You seem to be holding a lot of cash. Aren't you too young to hold that much cash? Especially since 50 is the new 40, etc.

A. Well thank you. It used to be that investment accounts held no cash, and advisors simply allocated assets between stocks and bonds. A typical formula was you subtracted the person's age from 100 and that was the percentage you held in stocks, and the person's age was the percentage you held in bonds and cash (but probably only bonds). So as the investor aged, you gradually moved him out of stocks and into bonds. But those were the days when folks assumed that bonds and stocks moved in opposite directions. However, since the late seventies, we have learned that bond and stock moves are more correlated, since interest rates drive P/E ratios, and therefore stocks. Interest rates always move bonds, of course. So cash (or Treasuries) have become a proxy for bonds that provides a better hedge against stocks, since cash does better when rates go up. For a long time, I have avoided investing in individual bonds (too expensive, markets too illiquid). I do have a few preferred stocks (that act like bonds) and a muni bond fund. Neither counts as cash in my system, which makes my allocation even MORE conservative. I do count Treasuries as cash, which I have now started to buy since they are more tax efficient (i.e. not taxed by New York state, an important tax to avoid if you are subject to AMT).

This is a long way of saying that I am comfortable with 20% of my investment portfolio in cash, given our other assets, and I don't think it's too much for my age, but it could be too little, if anything. The last few weeks should have proven that there is nothing wrong with cash. It would have been better to have been 40% in cash, right?

Q. CNRD closed today at 15.70. Do you regret selling it earlier this year as low as 6.10?

A. Nope. And if you have to ask that question, you need to reread Investments Parts 1-4 again (all available on the blogsite). I also don't regret missing the chance to sell my remaining 2500 shares at 17.75, which top the stock made for a few minutes earlier this week. I have no idea where it goes from here, but the system is sure to tell me to sell more shares if it stays where it is for very long (or goes higher). And when it does, I'll do it. But first, I have to get my cash down to 20% again. And if we keep having days like today, that won't be anytime soon.

Q. Should I adopt your system?

A. Who knows? My system was designed to meet my needs, and whether it does or not is a matter of opinion. It was not designed to meet anyone else's needs and it may not be suitable for you. (That sounds suspiciously like my periodic disclaimer, which I will complete by stating that neither redwavemusings nor its author are investment advisors). The point is that designing a system that meets your needs will bring discipline to your transaction decisions.

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On Monday, against all logic, I bought 100 shares of Bryn Mawr Bank (BMTC), where I had my checking account in college (and until I got married). The price was 22.48. Then on Wednesday, I bought 100 shares of SEI Corp (SEIC), the mutual fund company, for 26.30. Somehow, I got mixed up and got my zero buys and value buys out of order. Clearly SEIC was a zero buy, while BMTC was a borderline value buy, that also would have been the zero buy choice. So unless the market skyrockets tomorrow, I will be looking for a value buy for Monday.
There are a few more stocks on my list that now qualify, thank you.

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