Should you sell your declining stock?

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How many times have you asked yourself in the past, “Should I sell my declining stock?” This is one of the toughest questions investors have faced since stocks existed. If you could know that your declining stock will recover soon enough, you would have the potential of becoming rich from stock investments. Not only would you not sell the stock, you would want to buy a lot more of it. The deeper the decline, the more you would want to buy.

Unfortunately, any particular company could declare bankruptcy, resulting in up to 100% loss of your investment. There is no perfect recipe for deciding whether to sell a declining stock, making individual stocks speculative investments.

What if you could own thousands of stocks in many countries all over the world? When this portfolio declines, can you assume it will recover? You can own such a portfolio using index or asset class mutual funds. In the history of this portfolio, this globally diversified portfolio fully recovered from all declines within several years, as measured since the beginning of the decline.

These statistics are very comforting, but history, no matter how long, may not always repeat itself. Let’s try to think about what it takes for a decline to be irreversible. In order to do that, we need to understand what stock investments are and what makes them grow.

The history of companies. Many years ago, individuals and families grew their own food, sewed their own clothes and built their own houses. There were no companies, and people took care of their needs on their own. Over the years, people found out that they could specialize doing different tasks, and do them much more efficiently. Using machinery, it was easier to produce large quantities of goods.

With advanced transportation and communication, people were able to serve large numbers of people. This led to people grouping together to form companies that serve whole countries, continents and even the whole world.

As a company became large, it was usually impossible for a single person to provide money to operate it. The need to raise large amounts of money led to the formation of large groups of people who owned the company. In order to split the company ownership, they divided the company to many small parts – what we call “stocks”, and sold different amounts of them to individuals.

By dividing the company into small enough parts, any individual can buy today a part of a company for as little as a few dollars.

Why do companies go up in value? Companies buy materials and, using the work of individuals, create products that have a higher value than the materials and human resources used. Whenever a product is created with higher value than its components, it can be sold for a profit. This profit raises the value of the company. This is the natural state of a company that offers a product or service in need, and does it more efficiently than the individual consumer.

Can all companies decline with no recovery? In order for companies around the world to decline irreversibly, the process of specialization and mass production should reverse. More people would have to create products for themselves less efficiently. If you believe that a diversified global portfolio can decline irreversibly, you probably believe in people wanting to work harder for their needs.

What if there is a huge catastrophe? This is a question that often comes up when talking about risks of stocks. Any local catastrophe won’t affect a globally diversified portfolio significantly. The companies in unaffected regions may keep growing.

What about a global catastrophe? A global catastrophe could have an adverse effect on the portfolio. As before, let’s start by looking at history. Humans are amazing at dealing with problems. People dealt with the Great Depression, the World Wars, and extreme oil prices in the 1970’s. How did they do that? No matter how few people survive a catastrophe, they have the same human nature of wanting to provide for their needs as easily as possible. The re-creation of infrastructure with knowledge that already exists should stimulate rapid growth and the portfolio should recover more quickly than average.

To summarize

Humans prefer to get things done as easily and efficiently as possible. This preference should lead to the continuing existence and growth of companies. History measures support this preference.

History shows that people are able to recover from large catastrophes. Not only do they recover – they do so at an accelerated pace maintaining the long-term growth of companies and stocks. It happens with the use of existing knowledge, due to their continued preference to get things done as easily as possible.

Closing notes

This article presents good prospects for positive growth of stocks over the long run, assuming a globally diversified portfolio, with low costs across the board, no stock picking and no market timing. Other strategies could lead to different results. It does not imply guaranteed future returns with any strategy.

Disclosures Including Backtested Performance Data

What is the True Value of Desirable Real Estate?

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We have all heard about people that purchased properties 5 years ago and doubled the value of their homes. Some of you are in this group of lucky people. If you have any money to invest today, you might be asking yourself: should I jump on the bandwagon and double my own money in the next five years? Is this the new face of real estate or is the bubble going to burst?

After getting many requests to write about real estate as an investment (not as your primary place of residence), this article will look at residential real estate, with specific attention to desirable locations. It will start with a historic perspective, and then offer my personal observations.

Data

Growth. Below is the growth of real estate from 1975 to 2004. The first graph presents the US as a whole, California and New York. The second presents 3 locations in California.

2005-03 HPI USA

2005-03 HPI California

Source: Office of Federal Housing Enterprise Oversight (OFHEO)

The average long-term growth and growth in the last year are presented below.

Location USA California New York Riverside-San Bernardino-Ontario, CA San Francisco-San Mateo-Redwood City, CA San Diego-Carlsbad-San Marcos, CA
Annual Growth 1975-2004 5.9% 8.2% 7.5% 7.37% 8.77% 8.42%
2004 Growth 11.2% 23.44% 12.6% 29.58% 13.77% 24.41%

Historically, real estate grew at an annual rate of about 6%-9%, depending on the location measured. In 2004, the growth rate reached 11%-30%.

Cycles. In the limited history available we can see 2 real estate cycles, averaging 15 years.

The recent recession in the 1990’s lasted up to 10 years from decline to recovery.

Mortgages. As home prices go up, more people are using adjustable rate mortgages, in order to afford buying a home. Some mortgages allow for payments that are much lower than the accruing interest rate for the first few years. After the fixed period, the loan amount is bigger and the payments increase rapidly.

With mortgage rates near long-term lows, and the federal rate increasing, mortgage rates should go up and increase the cost of borrowing. This, in effect, raises the price of the houses and makes them less affordable.

Investor activity. Investor activity had grown in the residential housing market, as noted in the December 14, 2004 meeting minutes of the Federal Open Market Committee: “speculative demands were becoming apparent in the markets for single-family homes and condominiums”. In March 1, 2005, The National Association of Realtors reported that investment home sales increased by 14.4 percent in 2004 compared to 2003.

Affordability. In recent years home prices grew much faster than income, making homes less affordable.

Supply vs. demand. According to data released on February 28th by the U.S. Department of Commerce, the supply of homes increased by 20.5% from January 2004 to January 2005. Sales in the US as a whole and in the North East declined, while they kept increasing in the West.

Change from January 2004 to January 2005
Region USA West North East
Sales -4.2% 16.6% -33.7%
Supply1 20.5% Data Not Available

1 Ratio of houses for sale to houses sold.

Observations

The US as a whole. In the past year, US home prices appreciated by 11.2%, nearly double the historic pace of 5.9%. There are several possible explanations for the accelerated growth in recent years. In 2000 to 2002 the stock market crashed, positioning real estate as a stable and secure alternative investment. In the meantime, interest rates reached 40 year lows, significantly reducing the cost of houses. As demand increased, house prices went up. This gave lenders the opportunity to come up with more sophisticated loans, letting people pay very little today and more in the future. These loans let people keep buying homes despite the high prices.

As the stock market is recovering, interest rates are going up, and the affordability is going down, real estate is becoming less attainable to many people. More of the buyers are investors and speculators who are hoping for continuing rapid growth, based on projections from recent history.

Based on 2004 supply vs. demand data and the other factors mentioned above, it shouldn’t be surprising to see the US real estate market resume its long-term pace, or even a slower pace for a few years.

High growth areas. In high growth areas, the recent trend is much more emphasized. The 2004 growth was up to nearly 30%, quadruple historic averages of about 7.5%. Many claim that it is due to physical boundaries that limit supply in some of these areas. They say that the US market as a whole may go back to historic averages, but not places with limited supply. Good examples are the San Francisco Bay Area and the coasts.

At first, this sounds convincing, but it implies a very unique future. The price difference between the coasts and the rest of the US will keep growing. Assume half of last year’s growth moving forward, or 15% compared to 6% throughout the US. With this difference in growth, the price difference will grow 3,500 times bigger in 100 years. If today a $100,000 house in Nebraska can cost $500,000 near the coast of California, the same house would have to cost $1,750,000,000 in 100 years compared to $100,000 (all in today’s terms). That would give the coastal homes the same value as 17,500 homes in Nebraska, and California would be full of billionaires.

My conclusion is that locations with limited supply that become popular can appreciate faster than other places, but this faster appreciation cannot be sustained forever.

Historically, US real estate as a whole did not decline for any calendar year since 1970. The high growth areas did decline during recessions. This goes along with the behavior of investments in general: in order to achieve high returns, you have to accept high risks. Unless history is changing, a slow down in the US as a whole, could bring a bigger slow down (or even a decline) in locations that appreciated more recently.

I am not predicting anything specific, but I do claim that sustaining the recent growth has to be based on fundamental increases in home values. Below are a few recommendations that are true for real estate as well as other types of investments:

  1. Invest in undervalued properties – not overvalued ones. As an investor, your goal is to make money. Don’t buy a property for more than you believe it’s worth. Make sure you have good reasons to expect future appreciation.
  2. Do not project the future based on the past few years, especially if they are out of line with long-term historic behavior. If you think recent history is expected to continue, make sure you have a clear idea why.
  3. Make sure you can afford to hold the property for a period longer than past declines. In high growth areas, the recent decline to recovery period was 10 years. In addition, there are very large transactions costs for buying and selling properties. If you can’t hold the property for 15 years or more, you could end up loosing purchasing power if you buy at a peak.

Note that this article refers to residential real estate investments. Specifically, buying a home as a primary residence has many additional economic and non-economic benefits, entailing different considerations.

Resources

1. Office of Federal Housing Enterprise Oversight (OFHEO)

2. New Residential Sales in January 2005, US Department of Commerce, February 28, 2005

3. Second-Home Market Surges, Bigger Than Shown in Earlier Studies, NAR (National Association of Realtors), March 1, 2005

4. Are Home Prices the Next “Bubble”?, Jonathan McCarthy and Richard W. Peach, Federal Reserve Bank

Disclosures Including Backtested Performance Data

Could High Oil Prices be Good?

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Oil prices are rising every day and it is hard to see the end of this trend. The problems in Iraq, Russia and Venezuela combined with the growth in China and India lead to decreased supply and increased demand. It seems like the world is running out of oil, which might bring world economies to a halt. Will it?

The current demand for oil surpasses the supply, but the world is not running out of oil. Oil is a commodity with cyclical behavior. History is full of examples where supply did not keep up with demand, and people believed that the inflated prices would never go down – but they did.

During 1973-1974, oil prices quadrupled in less than 6 months, and reached higher prices than today, when adjusted for inflation. What was the result of the peak in prices?

  • More fuel-efficient cars
  • Better insulation in homes
  • Improved energy efficiency in industrial processes

In the 80’s and 90’s, prices went back to the long-term historical average of around $20 a barrel, measured from 1869 until 2003. What happened to these energy efficiency improvements after the drop in oil prices? They stayed with us and will continue affecting the world throughout the future.

Can you think of possible scenarios resulting from today’s situation? We have gas-guzzling SUVs that will gradually be replaced by hybrid electric cars. In the longer term, hydrogen operated cars will turn one of the most abundant resources in the world into energy. The Environmental Protection Agency (EPA) will establish stricter rules for energy efficiency.

Like any problem that caused stock markets to go down in the past, there is no question of whether there will be a solution to the energy problems in the world – only when it will be. And the bigger the short-term problem, the stronger the long-term solution.

I would like to give special thanks to Jim Williams at WTRG Economics. I could not have compiled this article without his generous help and his detailed article Oil Price History and Analysis. Note that an updated version of his article is expected soon.

Disclosures Including Backtested Performance Data

Diversification at Work!

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US Stock funds with diversified positions lost 2.76% percent in the third quarter, based on preliminary figures from fund-research firm Lipper.

A portfolio of globally diversified stock funds (Long-Term Component by Quality Asset Management – QAM) achieved positive returns of 3.58%. If you are thinking that sophisticated prediction of the quarter was involved, you are giving too much credit to Dimensional Fund Advisors (the mutual fund company) or QAM. These are mutual funds that hold over 6,000 companies throughout the world, representing the different asset classes. Similar to index funds, they include all stocks that fall into set criteria that define the asset class, with no preference to one over the other.

What is the secret, then? Simple global diversification. As you can see in the chart below, different asset classes went up at different times. Specifically, emerging markets showed high returns, while international stocks went slightly higher, all which offset the negative performance of US stocks for the quarter.

2004-10 Q3Graph

Disclosures Including Backtested Performance Data

Is Your Money Invested Responsibly?

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Whether you are trying to pick the right stocks at the right time or buy indexes and hold on to them for many years – you want to invest responsibly.

Whether you are looking for aggressive investments or preserving your money for current income – you want to invest responsibly.

This article presents a few things to consider when reviewing the way your money is invested. Needs may vary for different investors. Please consult an investment advisor and a tax specialist about your individual needs.

  1. Diversification: Are your investments diversified among a large number of stocks of different sizes, industries and countries? Individual stocks can lose all their value if a company shuts down. It is less likely that thousands of stocks all over the world will be wiped out at the same time. Adding stocks with low correlation to your existing holdings can reduce your risks, while increasing the overall returns. This makes it one of the most important investment considerations.

    It is important to diversify globally for any required level of risk or returns. As little as 5% invested in different size companies in international and emerging markets, can improve the long-term returns of your US portfolio, while reducing the overall risk. Beware that the risk will start going up, as the relative portion of the international investments grows compared to the US portion.

    Bonds are important for reducing the risk of your investments, as they have low correlation with stocks, and have lower risks and returns over the long run. Note that bonds are not a risk free investment, and they might underperform inflation or even lose value at certain times. This makes diversification of bonds very important.

  2. Fees: Investments involve paying many types of fees to various people. Some are clear and some are hidden very well. If you are using an investment advisor or a broker for managing your investments, it is your right to get a list of all the fees you are paying, in full detail. Some of the most common fees include:

    • Transaction cost: The fee you pay for every purchase or sale of a stock or a mutual fund. Some brokers charge 20(!) times more than others. This fee also depends on the number of transactions made. Try to calculate your annual fees as a percentage of your account value.
    • Spread: The difference between the buying and selling price of a stock. This is one of the most overlooked costs. The easiest way to reduce this cost is to trade less. Another way is to use mutual funds that can obtain highly discounted prices by trading large amounts. This is most significant in small stocks, were spreads average 3%-4%.
    • Expense Ratio: Percentage of your investments charged by mutual fund companies. This number will usually vary between 0.1% for low cost index funds and over 2% for expensive actively managed mutual funds.
    • Asset Turnover: Percentage of mutual fund holdings that are sold on average every year. This is not a direct fee, but it affects your taxable gains. Lower turnover means more time for compounding of gains before paying the taxes.
    • Account management fees: Yearly fixed amount or percentage of the account value that is charged by your broker.
    • Investment Advisory fees: Percentage of your money charged by investment advisors. Usually varies between 1% and 3%.

  3. Risk: Do your investments reflect the risks you can afford to take? Here are a few guidelines that should apply to any investor:

    • At all times, you should keep enough money to live off for 3-6 months, in case you lose your job or other sources of income, unless you have substantial investments relative to your spending.
    • If you will need your money in the next 3 to 5 years, keep it outside the stock market. For investments that are not highly diversified globally, this period becomes longer.
    • Construct a portfolio that is not likely to go down to levels that will keep you up at night. Worse than the stress it could cause is the risk of selling right after the portfolio went through a long down cycle. Note that one stock may never go up, but a portfolio that is highly diversified globally is more likely to go back up.

  4. Taxes: Taxes can take a large bite out of your gains. The higher your tax bracket, the more important these considerations are for you.

    • Depending on your needs, consider putting the volatile investments that generate high taxable gains in your retirement accounts. You will enjoy deferral of higher taxes, and higher expected returns in your long-term accounts, compounding the effect of tax-deferral.
    • Minimize short-term sales of stocks (within one year). The rate of taxes on gains will drop from your regular tax bracket to the long-term gains taxes (currently 15%).
    • Buy tax-managed mutual funds. These are mutual funds that minimize short-term gains.
    • Compare the yield on municipal bonds with taxable bonds (after considering taxes), and if better, buy some of them for your taxable accounts.

  5. Number of transactions: There are many reasons to minimize the number of transactions. Here are a few:

    • Transactions cost money. You pay twice: transaction cost, and the spread between the buying price and the selling price.
    • Sales of stocks result in capital gains (in taxable accounts). If sold within one year, the taxes can be double or more. If held for many years, the gains compound over and over before being taxed. This can drop your effective annual taxes dramatically.
    • Whenever you sell a stock in order to buy another one, you might think that the other stock is likely to appreciate in value more than the original stock. You are paying a very big price to make this move (transaction costs, price spread & taxes). Statistics show that most money managers are not able to beat the market return (S&P 500). Make sure you are one of those who are able to consistently predict the market faster than others by a wide margin that makes up for all the costs.

  6. Rebalancing: Whenever your portfolio is out of balance by a certain percentage, sell and buy stocks/mutual funds to balance the percentage of each of them back to your target allocation. One option is to choose 25% deviation of any holding from its target, so a 4% allocation of the portfolio growing to 5% or dropping to 3% would call for rebalancing. A good practice would be to check the portfolio once a quarter. It is best to check the need for rebalancing no less than once a year.

    Following is the main reason to rebalance: Certain holdings tend to change in value at a different pace than others. A common phenomenon is that riskier holdings tend to grow more for the long run. This causes more of your portfolio to be invested at high-risk stocks, causing your whole portfolio to become riskier. Whatever asset allocation you chose, you do not want it to become riskier without your explicit control.

    It is important not to rebalance holdings to the original allocation when transaction costs end up being a significant percentage of the sale or purchase amount. Rebalancing requires careful judgment.

  7. Investment Plan: Whether you work on your own, or hire an investment advisor, you should always operate based on a written plan (sometimes called investment policy). This is another one of the most important things to do, for the following reasons:

    • It makes you think things through. You go through your financial situation, time horizon, risk tolerance, and carefully build a portfolio to reflect these factors. You cannot afford to invest your life’s savings without a well thought out plan.
    • The plan serves as a reference document for rebalancing actions. You should not redefine the allocation whenever you rebalance, unless something in your situation changed in a way that should affect the portfolio.
    • A very important reason: it will help you avoid selling a part of a diversified portfolio after the market goes down and buying after it went up. The buy-high sell-low problem is one of the biggest reasons that investors give up so much of the returns that are there for them to take.

    Make sure to update the investment plan whenever any factor in determining the investment portfolio changes.

Disclosures Including Backtested Performance Data