The Investment Scientist

Archive for the ‘Security Selection & Market Timing’ Category

New York Stock Exchange

New York Stock Exchange

The S&P 500 closed the first quarter at a record high. Should that worry investors? The short answer is, No.

When the market was 30% below the high three years ago, I did some research. I categorized all market conditions into:

1. Breaking a new high.

2. Less than 10% below historical high.

3. Between 10% and 20% below historical high.

4. Between 20% and 30% below historical high.

5. Between 30% and 40% below historical high.

6. More than 40% below historical high.

Then I calculated the one year forward returns of the six conditions.

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New York Stock Exchange

New York Stock Exchange

With the market up about 5% in January, a prospective client of mine called to let me know he is not going to invest in stocks at this time – in fact, he is going to pull all of his money out of the market.

This may not be the best course of action for him.

According to research done by Cooper and McConnell, what the market does in January has a strong predictive power for what the market will do for the rest of the year.

Using data since 1940, they found that if the market is up in January, it will rise an additional 14.8% for the rest of the year; if the market is down in January, it will rise only 2.92% for the rest of the year. This gives rise to a spread of almost 12%, a highly statistically significant number.

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New Year's investment resolutions

New Year’s investment resolutions

After working as a financial advisor for six years and after reading tons of research, I have developed a good sense about how the average investor loses money. As the New Year approaches, I think it’s good to share my insight so that readers can determine if they are making these mistakes.

Conflict of interest

I cannot emphasize this enough: Wall Street firms don’t work for you. If you have a Merrill Lynch or Morgan Stanley advisor, expect to give away 2.5% of your money every year – about half of it will be in explicit fees, the other half will be in hidden fees. If you invest through insurance products, expect to give up 3.5 percent of your money.

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Like Odysseus, automatic investments help investors avoid the Siren call of market timing

We call it stupid if someone takes a $55k job, even if he is offered the same job at $100k.

We call it market-timing when the same thing happens in the stock market. The long-term average annual market return is 10%, but the long-term average annual investor return is only about 5.5%. This is documented both by Dalbar’s study titled “Quantitative Analysis of Investor Behavior” and Morningstar’s research on fund returns and investor returns.

How could this possibly happen?

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Last week, the Fed announced another round of quantitative easing (QE3).

This time around, they plan to buy $40 billion worth of mortgage-backed securities with created money until the employment picture improves.  Compared to QE1 and QE2, QE3 is open-ended.

How does this affect your personal finances?

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financial blogging

I was in Denver attending the Financial Blogger Conference (FinCon12), and I was thrilled to meet Allan Roth there.

If you don’t know Allan Roth, for the sake of your financial wellbeing, you should.

Allan is an hourly fee-only financial advisor practicing in Colorado Spring. He also writes an investment column for CBS MoneyWatch. Recently, Jason Zweig invited him to write a column in the Wall Street Journal as well. Read the rest of this entry »

New York Stock Exchange

When talking to prospective clients, I am upfront about what I can and can not do. I can NOT beat the market.

Recently, that straightforwardness caused me to lose a prospective client to a major Wall Street firm. Apparently, the financial advisor from that firm was able to convince him that with their exclusive location, expensive brochure, and nice Armani suits, they could beat the market.

This led me to do a mental exercise.

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Golf ball

Is a round of golf all the value you get from your financial advisor?

Why do you charge me 1% every year regardless how well you do for me? I would rather not pay you anything for the first 5% return and split anything above and beyond that.

This is a question a prospective client of mine asked me. Let me explain why this fee arrangement is not in the client’s best interest.

Historically, the mean return of the market is 10%, and the standard deviation of return is 15%. This means the market is equally likely to go up 25% in one year and go down 5% in another.

Despite what they want you to believe, financial advisors have very little control over the market.

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Facebook Winners’ Curse

Back on April 9, Mark Zuckerberg announced that Facebook had agreed to acquire Instagram for a jaw dropping $1b.

What is Instagram? It is an iPhone app that allows people to swap photos with friends. The one and a half year old company has about 16 employees and its revenue is a cool zero.

Most commentators said that Zuck was either trying to pre-empt a potential competitor or to expand in the mobile market where Facebook is weak. There is nothing Instagram does that Facebook cannot replicate, make available to its 900 million users, and instantly kill Instagram. Why pay $1b for something that is essentially worthless?

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New York Stock Exchange

Value investing as an investment discipline was pioneered by Ben Graham and is practiced by Warren Buffett.  It has a long history of data collection and many rigorous studies done in the most prestigious research universities.

The idea of value investing is that undervalued stocks will ultimately outperform overvalued stocks in aggregate.

There are four simple measures one can use to determine if a stock is relatively undervalued or overvalued….

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The Investment Scientist:

I met a CPA yesterday and we have a lively discussion about option writing strategies. He is torn between the benefit and the time needed to execute the strategy. I wrote an article 4 years ago that could reconcile the two.

Originally posted on The Investment Scientist:

I wrote this article in early December 2008. Amazingly, it is one of the least read in my blog. Hadwealth-preservation someone read it and followed it, he would have earned 10% return so far in 2009.

- Michael Zhuang 3/10/2009

At the moment of writing this, SPY, the exchange traded fund (ETF) for the S&P 500 index, is trading at $85.95 and the near at-the-money call option (with strike 86 and only eight days until expiration) is trading at $3.45! (A call option is the right to buy the underlying stock at the strike price. At-the-money means the option strike price is equal to the price of the underlying stock.)

The at-the-money call premium is a full 4% of the underlying index price! Historically, that number has been in the 1% to 2% range.

What does 4% premium imply?

View original 456 more words

My name is Dow. I was born in May 1896 to my father Charles Dow.

In 1900/1/1, I was 66. No, that was not my age, but my level.  People care about my level since the higher it goes, the richer they get.

In the first two decades of the 20th century, I wobbled around: 100% up and 50% down was the norm of the decades. Nevertheless, I ended the two decades at 108.

Dow 1900-1920

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This is an article I wrote in middle of May that was published on Morningstar.

Half way into May, major market indexes have all fallen more than 5% from their peaks reached in late March. The Nasdaq has fallen close to 10%. It looks like the ancient stock market folklore “Sell in May and go away” is quietly unfolding right before our eyes.

To get a better understanding of this phenomenon, I did two things recently: 1) I studied the historical returns between May 1 and Sept. 30 and 2) I pondered a plausible explanation of stock market seasonality and its implication on investment. Today, I will report to you the results of my intellectual exercises.<

Historical returns
Using data retrieved from Yahoo.com, I calculated the average S&P 500 index return between May 1 and Sept. 30 to be -0.3% over the past 20 years. As a comparison, the average index return between Oct 1 and April 30 is 7.2%. Clearly the five months starting in May are unproductive for stock investment, historically.

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Today is the last trading day of 2011. The S&P 500 closed at 1257, exactly the same close as in 2010! So, if your goal is wealth preservation, the market just did it for you.

Or did it?

From January to April, the market staged a four-month rally of 8.5% to peak at 1364 on April 29. For the next six months, it collapsed nearly 20% to bottom at 1098 on Oct. 3. Then, it staged a late rally to close the year at 1257.

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Behavior Gap

Credit: behaviorgap.com

In my previous article, “The perils of chasing hot fund managers,” I showed that the average investor in a mutual fund run by “star” manager Bill Miller would be better off buying and holding an S&P 500 index fund.

There is only one problem. Most index fund investors are not immune to the buy high and sell low tendency, as illustrated by the table below. Between 1991 and 2005, the Vanguard S&P 500 Index Fund (VFINX) returned an annualized 11.51%, but the average VFINX investor only earned a return of 7.96% during the same period.

1991 to 2005 annualized
VFINX fund return 11.51%

VFINX investor return

7.96%

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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