BUY, SELL, OR HOLD: MANAGE YOUR PORTFOLIO FOR MAXIMUM GAIN phần 1 docx

These questions can be broken downinto 10 major areas of study: ques-• Identifying how and why stock prices actually change • Forms of analysis that can help you decide when to buy, sell

Copyright © 2002 by Michael C Thomsett

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Published by John Wiley & Sons, Inc.

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3 The “Practical” Dow Theory 45

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Price Volatility as a Technical Indicator 147

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Creating Your Comprehensive Program

Why does anyone invest money? Why place yourself at risk and expose yourself

to the volatility of the stock market? Why not just leave your capital in aninsured savings account?

Of course, there are logical answers to these questions As an astute investor,you already know that taking risk is an inherent part of investing your capitalanywhere For example, you could opt to place all of your capital in an insuredaccount at your bank; in fact, many highly conservative investors do just that.This option also involves risk, however The yield is so low that you risk losingthe long-term purchasing power of your capital The combination of taxes andinflation can cause the real value of savings to fall over time

So even when you try to mitigate all risks, it’s virtually impossible The fact

is, risk is the flip side of the coin we know as opportunity So, in order to be “inthe game” of the market or to be able to take the opportunities to earn profits,you also need to expose yourself to a corresponding degree of risk

It’s in the nature of investing that opportunity and risk are married in thisway The greater the opportunity, the greater the risk So, every investor has todecide how much risk is appropriate, how much risk he or she can afford, and

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what portion of capital can be placed in higher-risk investments versus a base

of lower-risk or moderate-risk ones Within this body of decisions, many tions arise that demand self-education These questions can be broken downinto 10 major areas of study:

ques-• Identifying how and why stock prices actually change

• Forms of analysis that can help you decide when to buy, sell, or hold

• Applying popular forms of analysis to your portfolio

vari-We are not saying that it is impossible to manage your own portfolio On thecontrary, making your own decisions means that you are in control Investorstend to operate analytically so that facts and figures are appealing and reas-suring to the typical investor Facts and figures by themselves are of little use,

however, unless they are based on true underlying information Among the

information available to you are a lot of useless or baseless conclusions Themarket is characterized by rumor, false assumptions, and decision-makingbased on poor information or even on no real information at all As an investor,you want to be reassured with numerical information You are looking foranswers, and like all investors you would like to find that one solution thatdependably tells you when you buy, when to sell, and when to hold

That single answer does not exist, because no one can know what conditionswill be like tomorrow By gathering a body of knowledge and applying it in asensible manner, however, you can make your decisions based on a logical andreasonable policy You can manage your portfolio to maximize analysis, mini-mize risk, and earn profits You can also take steps to overcome the most com-mon flaw in the way people invest: depending upon unreliable information andmaking decisions without getting the facts beforehand

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This book is designed to explore each of the 10 areas of study that everyinvestor needs to master It is organized to present the popular fallacies thatmany people believe and then offer alternatives These fallacies are widelybelieved, so the majority of investors continue to operate on a false premise inone way or another As you will see in the 10 chapters that follow, however, thealternatives to these fallacies do point the way to market success They demon-strate how you will be able to make intelligent decisions within your portfolio,based on sound information The alternative—proceeding on the basis ofwidely held but false beliefs—will only prevent investors from realizing theirgoals in the market.

The first question faced by you and every other investor is, “When should Ibuy, sell, or hold a particular stock?” The old adage, “Buy low and sell high”should be followed by the equally important “instead of the other way around.”It’s true that many investors apply the adage in reverse As values climb torecord high levels, many investors want to get in on the profits—and, as a con-sequence, they buy at the top of the market Then, when stock values fall,investors fear even larger losses and they sell their shares at the bottom of themarket So, the forces of greed and fear end up having more influence that themore rational forces of optimism and pessimism

Once you are aware of this tendency, you will be able to move away from the

“herd mentality” that characterizes the market The tendency to move with themajority is natural, and it demands courage to keep a cool head when everyone

is making decisions in the opposite direction; however, the key to market cess is to make the important buy and sell and hold decisions based on solidinformation rather than on the basis of what everyone else is doing This book’spurpose is to organize and present the tools you need to achieve that end

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My thanks to Bruce Boyle for investment insights and for giving me a differentpoint of view and to Virginia Gerhart for the years of encouragement Specialthanks also go to George C Huff, who gave me the chance to learn so much in amarketing environment, in which the practical always buries the mere theory.Also, thanks to Dave Pugh, editor at John Wiley & Sons, for the feedback andexpertise and for supporting this project

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CHAPTER 1

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The Pricing of Stocks

In the stock market, decisions often are made not on the basis of the facts, but

on what ideas have captured investors’ imaginations This statement is truebecause investors seek answers to their questions, and one of the primaryquestions is “What makes stock prices go up or down?”

This basic and seemingly simple question actually is quite profound Theanswer, too, might be complex and elusive Investors seek certainty in anuncertain world Their desire for certainty has produced a body of news, infor-mation, and analysis that contains the appearance of certainty, however Eachperson has to decide how much of this news and information is reliable If youplan to commit money to the decision to buy, sell, or hold a stock, then you alsoneed to decide what information should form the basis for those decisions.The most common deciding factors used in the market to attempt to antici-pate future stock pricing are recent price history and patterns, current pricerelative to past price levels or other stocks, beliefs about future price move-ment (usually short-term), and a fourth area that can be described generally

as “reckless optimism.” While these three criteria form the basis of most ket decisions by individual investors, none are reliable for making your mostcritical market decisions

mar-Recent Price History and Patterns

The desire for certainty—even in the uncertainty of the stock market—leads

to a search for dependable information So, a stockholder is likely to look to astock’s price history to judge how price movement will occur in the future Youcan study the past in an attempt to understand what will occur in the future,but all you will arrive at will be an estimate, a reasonable understanding oflikely outcomes You will not be able to guess reliably at future price move-ments, however There is, of course, an apparent rhythm to short-term pricemovements For example, one stock might tend to move up and down within aconfined range of price (the trading range) Another might be far morevolatile, moving many points in either direction based on rumor or inconsistentearnings reports In either case, does recent price movement give you themeans for deciding which direction the price is likely to move in the future?

If you believe that recent price changes do predict the future, are you ing to commit investment capital to back up that belief? Price movement, stud-ied visually, will create a pattern that can be studied But what does thatpattern reveal? Remember that the factors that influenced past price trendswill not necessarily be repeated in the near future If a stock’s recent pricetrends show a narrow trading range, that does not set down a law that the pat-tern will be repeated In fact, depending on such information can be quite mis-leading It is easy to study pricing patterns and convince yourself that these aresomehow dependable for the purpose of timing future buy, sell, or hold deci-sions The truth is, however, that price movement is rarely so efficient that his-tory can be used to time your decisions

will-This statement brings us to the first big fallacy of market investing

Fallacy: The pricing of stocks is efficient and fair.

The truth is that price changes tend to occur not in a reasonable manner but

in overreaction to the underlying news In other words, prices tend to swing toofar above or below a logical value, based on good news or bad news This situa-tion is true for many popular stocks To further complicate the matter, some

stocks exhibit the opposite behavior: reacting below a reasonable level or

swinging too little above or below a “fair” price level While you can identifystocks falling into one classification or another, you also need to realize that aparticular company’s stock might overreact at times and underreact at others.The pricing of stocks is neither efficient nor fair If you study the price trends

of a stock over the past year, you are likely to find many instances of price ment that make little sense in the short-term In other words, while funda-mentals such as earnings reports and dividend payments certainly have animmediate effect on a stock’s pricing, many other factors also come into play.They include rumor and speculation and activity among institutional investors,such as mutual funds

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When a fund makes a decision to buy or sell a large block of a particularstock, it is inescapable that the decision will have an effect on pricing When alarge block is taken off the market (bought) or thrust upon the market (sold),the price reacts to the change in supply and demand The decision by a mutualfund to invest in a company, however, or to divest itself of a company, could bemade for reasons other than fundamental changes in the company’s makeup.

So, without understanding why large blocks of stock move in the market, wecannot really understand why a stock’s price changes This statement is mosttrue for companies whose stock is held in large numbers by institutionalinvestors Whether individual investors like it or not, the institutional tradeshave far more to do with short-term price movement than any logical or rea-sonable analysis

We are not saying that a mutual fund’s decision to buy or sell a particularstock is ill-advised It is important to remember, however, that a fund’s man-agement might make a particular decision for many reasons, including thedesire to improve its own portfolio diversification, the need to meet a prede-termined rate of return, or in reaction to economic changes beyond the com-pany’s fundamentals So, tracking a stock’s price and trying to identify what isgoing to happen in the future can be a frustrating exercise The price move-ment in a company held by institutional investors could be artificially distorted

by the decision of fund management (not just in one fund, but perhaps overmany) It is important to remember that when you study price movement, youneed to consider all of the possible reasons why it occurs; and chances are youwill not even know all of those reasons Some are not apparent For example,when prices change due to economic reports, earnings, and other easily iden-tified news about the company, everyone understands how the price changes inresponse Beyond that, price change occurs for any number of reasons—manythat never are easily identified by the investing public

It is the uncertainty of price movement that makes the market so ing None of the certainties are particularly intriguing in comparison In fact,most investors tend to remain interested in the stock market because of theuncertainty, which itself is appealing Investors tend to think of market success

interest-as making a profit against the odds In other words, success is defined in the

market by beating the averages and not by finding certainty

Given the nature of the market as uncertain, you are faced with two dictory theories about the market and the pricing of stocks These are the effi-cient market theory and the random walk hypothesis Which of these is moreaccurate, if either, and which is helpful in trying to understand how and whystock prices change?

contra-A theory, of course, is nothing more than the idea it expresses In otherwords, the theory does not have to be pure in order to be useful Either of thesetheories help to explain an aspect of market pricing that you will find helpful

in the puzzle of price movement

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The efficient market theory states that the current price of all stocks reflectsall of the information known currently to the general public In other words,under this theory, the market is truly efficient because all of the changes inprice movement are a reflection of the ever-changing supply and demand lev-els for that stock The problem with the efficient market theory is that theremight be many factors affecting price beyond what is known to the investingpublic, and these can also affect pricing of the stock; so while the efficient mar-ket theory might explain a lot of otherwise confusing changes in a stock’s price,

it is not a reliable theory for discovering dependable information For example,the significant influence of institutional investors can distort price based on adecision made today, which essentially has nothing to do with the real value ofthe company A mutual fund has to decide not only when to buy or sell shares

of stock, but also how to move that stock within the market without causing adisruption So to a degree, when a large block of stock changes hands, the veryact of buying or selling can itself distort the market value As the supply ofstock changes, the price invariably is going to change as well—at least,momentarily Such small changes are seen in the daily market reports, but theycould have little or nothing to do with an efficient market

The random walk hypothesis is a far more cynical point of view about themarket Under this theory, price changes are entirely random—at least, in theshort term Most investors who believe in long-term holdings for well-managedcompanies will acknowledge that interim price changes do not affect theirportfolio decisions In one respect, this policy reflects a belief in the randomwalk hypothesis If applied to short-term price changes in particular, the ran-

dom walk hypothesis makes some sense and is logical, as well Even

propo-nents of the Dow Theory (see Chapter 3) state that short-term price changescannot be used as a reliable indicator of anything

The random walk hypothesis certainly makes sense when applied to term price changes The absolute belief that all price change is random is notsupportable for long-term price studies, however Obviously, well-managedcompanies that are profitable from year to year are going to rise in marketvalue, and poorly managed companies that report net losses eventually will gobroke and their stock prices will fall In the long term, the fundamentals—sales and earnings—determine stock pricing The market and its enthusiastsare far more interested in tracking short-term price change, however, eventhough virtually everyone agrees that such changes reveal nothing of lastingvalue This scenario is a paradox of the market Everyone knows that short-term price changes cannot be used reliably Yet, most investors watch short-term price changes and make their decisions based upon those changes.The random walk hypothesis is supported by statistical science, a reality thatforms one of the basic tenets of the Dow Theory In other words, no singlechange in price can be used as a signal to buy or sell A change in price has to

short-be confirmed by other signals, as well Furthermore, any change has to short-be

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