Friday, 12 February 2010

Investment sayings, investment myths

When talking about the above, don’t expect me to mention Santa Claus Rally or January Effect (or maybe January defect). These are not myths, rather superstitions backed by some statistical significance. I would be very wary of trusting in four examples mentioned below (and I advise you not to believe also in the ones above), a crafty investor should remember about some certain rules.

THE TREND IS YOUR FRIEND (until it ends)
Is a favourite saying among currency traders. Their strategy is to capitalise on a certain trend on a currency pair and to cover a position and take profits possibly quickly, before the trend reverses. Individual investors tend to show some errors of perception in terms of market trends. The biggest mistake I see is a belief (I have not idea how it is justified) that the trend will continue. An average Kowalski firstly sees the stock market brought a return of thirty per cent in a last year and a year before, he concludes a stock exchange is a machine for making money and decides to invest in stocks. Then usually the prices go down. He thinks it’s just a correction and hold his securities, takes a loss of fifty per cent and pays his money out around the moment indices are about to bottom out. Does it ring a bell? The end of bull market in 2007 and bear market in 2008 and early 2009 looked like this.

When watching a trend you should ask yourself when it is going to reverse. When a speculative bubble grows, the more the prices rise, the more people believe they will continue to rise, the most cautious are the last. Mind my reader, this is totally irrational, the longer a trend continues, the more likely it is to reverse. I know it is hard to recognise the turning point. Before setting out to write this post I browsed Polish market commentaries from February 2009 when stocks were in their many years’ lows. And what have I turned up? Almost nobody predicted a rebound (given how bad things looked a year ago it’s now startling). You have to foresee turning points, sometimes you’ll gain, sometimes you’ll lose, but you have to take this risk, unless you want to be a sucker who buys overvalued stocks.

This saying applies to stock market. Every individual investor who plays Warsaw stock market should know it is swayed, not to say rigged by two big players, called ‘big boys’, or in Polish ‘grubasy’. Everyone knows which two investment banks open their positions here, just nobody wants to mention their names. Another fact that can’t be denied is that investment sentiments on Wall Street has a considerable bearing on other stock market all over the world. When America sneezes, the whole world catches a cold. Why? Many investors come from the United States and the other have learnt to follow them. So what can a small speculator do? Anticipate their moves and not try to beat them, they’re too big to pick up a fight.

It is a myth. Almost every “analyst”, or “expert” will tell you this. If you pay your money in equity fund, the investment duration should be at least three years, the recommendable duration is five years. During my first class in basics of economics, in September 2006 I learnt that an economic theory is true not when it can be proved, but when it cannot be disproved. I decided to use the data for blue-chip index of Polish stock exchange – WIG20. Let’s see how high the returns on 5Y investment replicating the WIG20 was. I analysed the investments made on 11 February (date chosen randomly, it was yesterday) 2000, 2001 and each consecutive year until 2005.

Conclusions: in two cases (2000-2005, 2004-2009) yields were negative, in two periods (2002-2007, 2003-2008) the gains were impressing, in one case (2001-2006) they were above interest rates on bank deposits and inflation, in the last the 5Y rate of return turned out to be positive, but in real terms and compared to other, safe investments it would be negative. This simple experiment shows this theory is ‘half-true’.

And a bit of maths: yearly returns, corresponding with five renewable 12M deposits, compound interest rule applies:
2000-2005: -1,63%
2001-2006: 12,57%
2002-2007: 19,89%
2003-2008: 21,51%
2004-2009: -2,78%
2005-2010: 1,02%

Any alternative? Good timing, not investment duration is what matters, you can gain twenty per cent within one month, or within five years. Fancy following financial advisors’ advice to pay money into an equity fund, forget about for five years and then pay them out? Be prepared for a rude awakening (or high yields, depending on the timing).

Why is this theory undermined by many independent experts? The answer is very simple: bull markets tend to last long (three to five years) and stock prices grow in a rather moderate pace of twenty, thirty per cent per year, bear market last shorter (six months to two years), but stock indices plummet and quickly wipe out the previous rallies.

Maybe it’s not a myth, but rather a distortion. The chart to the right is what usually the ‘benighted’ investors are shown by financial advisors or,, let’s give it straight, salespeople. I didn’t take trouble to find it in English, so: oczekiwany zysk = expected profit, poziom ryzyka = risk level, lokaty = [bank] deposits, fundusze pieniężne = money market funds, obligacje, fundusze obligacji = bonds, bond funds, fundusze hybrydowe = hybrid funds, fundusze akcji = equity funds, akcje = stocks, the horizontal line shows the level of risk.

Many times I’ve heard this chart is misleading, and indeed, it focuses on profits and neglects losses. To the right you can see some modifications I made.
Firstly, let’s add another line that would show possible losses, the bigger the risk you undertake is, the bigger loss you may suffer (upper-left). I know my pictures are clumsy, but assume that the angle between green line and dotted line is the same as between red and dotted ones.
Secondly, as I wrote in the previous paragraph, bear markets are more abrupt, so within one year you might lose more than you might gain (upper-right).
Thirdly, the slopes of these funny colourful lines vary in time. In the last phase of bear market, or when the stocks are undervalued (like in 1Q 2009), it looks like bottom-left picture. But when the stocks are overvalued, or in the last phase of bull market (like in 3Q 2007 or who knows if not in January 2010), more appropriate would be the bottom-right chart.

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