[...] continue on from Part 1 of Stock Market Beliefs, Ed Rempel explains some of Ken Fishers reasonings behind the common stock market [...]

[...] In a two-part series, Ed Rempel, a guest writer at Million Dollar Journey, debunks some common stock market adages, which include “High P/E markets are riskier than low P/E markets“, “rising interest rates are bad for stocks. Falling rates are good”, and “America has way too much debt”. [...]

Before I hook horns with you about this interesting article, I must admit first that in addition to my humble profession of financial advising I also dabble in other interests, mostly in the humanities. It is there where I find a traditional technic I would wormly recommend in relation to all of this “wisdom.”
I mean to say that a bit of “source criticism” would be well applied here and there.
The issue I have with this line of thinking is, as you say: “What is wrong with stop losses? The fact is that stock prices are not serially correlated. This means that a stock that has just fallen 20%, for example, has the same chance of rising or falling than a stock that has not fallen 20%. For some reason, our illogical minds believe that the stock that just fell 20% is a worse investment than whatever we will buy next.” This may very well be so.
The problem is the somewhat blunt application of the principle.
There is really not much solace in selling after having lost 20%. But if the investor is aware of the nature of his investment and its propensity for fluctuation, then a reasonable “mental treshold” may very well be helpful. If the stock, or fund is habitually fluctuating 2-5 percent, but suddenly produces a 10% drop, you may justifiably ask whether it would be reasonable to sell, preserve the gains attained thus far, and ride out the period of losses, before buying the same back at a reduced price.
As for the “dubious value” of dollar cost averaging, it really is better to invest large sums here and there, then painstakingly contribute periodically. But who amongst us has the luxury to make that choice? I presume, it is a small minority. For the rest of us it is still better to engage in dollar cost averaging then anything else. So the comparison is only favourable in seldom seen circumstances. And by the way the combination of the two is possibly the best.

Sandor

Since you and several others mentioned stop losses, here is Ken Fisher’s analysis of this myth.

The belief that stop losses protect you and help your returns is based on a strange error in logic. It sounds so good to be able to limit your donwside to 5% or 20%, while still having your full upside. But Ken Fisher calls stop losses “stop gains”.

The brokerage industry promotes them, since they results in more transactions and the strategy is easy to sell. Every time you hit the stop loss, the brokerage firm gets 2 commissions (including when you reinvest.)

Ken Fisher tested different stop losses from 1% to 50% on the S&P500 and found that all of them resulted in lower returns than just buying and holding the S&P!

What is wrong with stop losses? The fact is that stock prices are not serially correlated. This means that a stock that has just fallen 20%, for example, has the same chance of rising or falling than a stock that has not fallen 20%. For some reason, our illogical minds believe that the stock that just fell 20% is a worse investment than whatever we will buy next.

Stock traders will be able to point to a time that the stop losses protected them from a larger loss, but they don’t compare their strategy to just buying and holding. How often does a stop drop by 20% and then shoot up?

Therefore, a stop loss at 20% results in a transaction and transaction costs based on a coin flip. Will the next stock you buy have any better prospects than the one you just sold? What if the replacement stock also falls? You can keep buying 20% losers all the way down to zero.

Here is his example. Amy buys a stcok at $50 and it rises to $100. Sue then buys the same stock after which it falls to $80. Should they both sell or keep holding? Should Amy hold because she is up, but Sue sell because it has hit her stop loss?

The only sure result of a stop loss at any level is more transaction fees. This is why using stop losses – for traders or long term investors – results in lower returns than a buy and hold strategy.

Ed

P.S. In the same chapter, Ken Fisher shows that Dollar Cost Averaging reduces returns (compared to a lump sum investment), and selling covered calls also reduce returns (since a covered call strategy is identical to selling a naked put).

By popular demand, here is why America’s debt it NOT too high.

I have always been somewhat puzzled that the stock market has generally performed better when the Liberals or the Democrats are in power than when the Conservatives or Republicans are in power. As an accountant, I’ve always been dismayed by the waste in government. The more “tax and spend” governments tended to have better stock markets.

Ken Fisher shows that in the 9 years of peak US government deficits, the average stock market gain the following year was 21.8%, while the 9 years with the highest surpluses were followed by an average S&P500 gain of only 0.8%. 7 of the 9 high deficits were followed by gains greater than 10%, compared to only 3 of the 9 years of high surpluses.

I always figured that this must be a delayed reaction to tax cuts and then a delayed reaction to the higher government debt. Ken Fisher calls the government “poli-tic” (poli = many and tic = blood suckers).

I also have found it embarrassing to me to think that my generation – the Baby Boomers – will be known in history as the most irresponsible generation – the one that ran up nearly all our government debt to finance our comfortable lifestyles and that we will leave it to our kids that we have spoiled to pay for our retirement and all the debt we have run up.

This is why I found Ken Fisher’s conclusion so shocking! There is an optimumm debt level. For a company, if they can earn a 15% return by investing in their business and can borrow at 6%, they should of course borrow more – right? If a company can make its shareholders an 8% return by buying back shares, it should issue bonds at 6% to buy back shares – right?

This leads to the surprising question – what is the optimum level of debt for a government? The optimal debt level is where the marginal cost of borrowing no longer is lower than the marginal return on assets. This is basic economics.

Ken Fisher shows the total of all personal, corporate and government debt as $50 trillion vs. $111 trillion in assets. The net is equity of $61 trillion. This is a debt:equity ratio of 85%. Total GDP is $13 trillion, so the return on assets is about 12%. Since the average after tax cost of borrowing is about 4%, this is far less than the return on assets!

How can this be? Economics shows that the average dollar is spent 6 times per year. So, when the government wastes money on some program to generate votes, those same dollars are spent 5 more times – probably all smart spending. For example, the government wastes money paying for advertising, but then the advertising firm hires and pays employees who buy groceries, and then the grocery store pays its employees who spend the money at restaurents, etc.

So the money is wasted once and then spent well 5 times. All 6 spendings are taxable and all of this activity is good for the stock market.

(Incidentally, this optimal debt level applies to individuals as well.)

Let’s be clear – I’m still opposed to more government debt, since our kids will have to pay the interest at the same time they are paying for our higher health care and pensions. We Baby Boomers will vote for more and more money for health care for all of the next 50 years and expect our kids to pay the higher and higher income tax.

However, Ken Fisher’s point explains my earlier question – more government spending is clearly linked to a stronger stock market. This is because both Canada and the US are well below their optimal debt levels – our return on assets is much higher than our cost of borrowing.

Ed

For examples:

* High P/E is riskier than low P/E if all other parameters are constant.

* Cheaper stocks do better than less cheap stocks most of the time if both they all have identical fundamentals.

DAvid

# A huge terrorist attack (such as destroying a U.S. city) will be very bad for the stock market.
# Stop losses will improve your returns.

What is his reasoning for those being false?