Filtering Out the Daily Grind of the Stock Market
Stocks are down one day and up the next. Should you react to headlines?
July 28, 2011— -- Investors have followed the debt ceiling talks in Washington mostly with dismay, selling stocks when the news seemed most gloomy but buying when hints of a deal have surfaced.
The market gyrates constantly on headlines, but you should pay them little heed. Trading on day-to-day news events may be a good strategy for professional investors, but not for individuals whose long-term goal is wealth accumulation. One reason professionals profit from these events is that people listen to bull or bear voices urging them to act – not based on reason, but on the emotions of fear or greed. These voices are noise that individual investors should filter out.
Failing to filter can make you a slave to the news and the talking heads on financial channels—to the detriment of your returns. On July 13, Federal Reserve Chairman Ben Bernanke made remarks taken to mean the government might be planning to pump money into the economy to stimulate growth. The market rose. But when Bernanke indicated the opposite the next day, the market plummeted 1.5 percent. Some of the same people who bought one day sold the next.
It's not just day-to-day events that create market noise. For weeks this year, noise surrounded the fiscal problems of Greece, which was in danger of defaulting on debts. Yet because Greece isn't a major European economic power, the threat its financial instability posed to the U.S. market was greatly overstated, as Greece's European neighbors were preparing to bail the nation out.
If market swings from short-term events cancel each other out, what's the problem? Abundant studies show that frequent trading lowers returns, especially for individual investors. In addition to the actual cost of trades, this churn can lead to buying high and selling low and failing to be in stocks during the precious few and short periods of significant price growth.
Also, frequent trading can play havoc with asset allocations – the percentage of a portfolio dedicated to one type of stock versus another – for example, large cap stocks versus small cap. This allocation should be based on an investor's time horizon and risk tolerance -- not the noise of market voices reacting to today's headlines.
If you're not listening to these voices, whose voice should you be listening to? Your own. Your voice should be business-like because investors should run their portfolios like a business, basing decisions on facts. Because of actor Jack Webb's immortal line -- "just the facts, ma'am"— I call this the Dragnet method.
The facts that investors should be concerned about are those that reliably reflect companies' value. These include:
• Earnings. A company's revenues minus the cost of sales, operating expenses and taxes over a given period. Earnings have a big impact on stock prices.
• Price/earnings ratio (P/E ratio). This indicates how expensive a stock is. A stock's P/E ratio shows how much investors must pay for earnings at any given time.
• Dividends. Quarterly cash payments to shareholder made from earnings. Research shows that stocks that consistently pay dividends usually grow over the long term. These facts cannot be disputed; they are what they are. Chances are, market noise surrounding trivial news events won't affect them. If and when it does, you'll see gradual changes over time. Then you can act on factual trends instead of trading on speculation about the effects of isolated events.
The market is always pricing new information into stocks, but most of this information is meaningless in the long run. What counts are a stock's factual indicators of health.
The opinions expressed here are solely those of Mr. Schwartz.
Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group (http://capstoneinvest.net). He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation to advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.
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