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What is Rebalancing?

Posted on July 8, 2016 by Daniel DollingerJuly 28, 2016

Definition

Rebalancing is simply buying and selling things in a portfolio so a particular asset class is a previously agreed upon percentage of the portfolio.

For Example

A client (with a $100,000 portfolio) told their advisor they want their portfolio to be 50% cash and 50% stocks. So their portfolio is $50,000 of cash and $50,000 of stocks. The value of the stocks rises so the portfolio is now 40% cash and 60% stocks. So their portfolio is $50,000 of cash and $75,000 of stocks. The advisor would sell $12,500 of stock to bring the portfolio back to a 50:50 split. The portfolio would therefore be $62,500 of cash and $62,500 of stocks. There are many different types of asset classes. Some examples are stocks, real estate, precious metals, artwork, bonds, etc.

As I’m writing these to help my readers, I would be very appreciative of any input in regards to what I should write next. If you want me to write about a particular topic, please contact me. If you would like to submit a post to my blog, please contact me.

If anything that I mentioned above interests you, please consider downloading my free e-book. The book contains my thoughts on investment management and some information that I think everyone should know. You can also download it below.

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What is Shorting?

Posted on July 6, 2016 by Daniel DollingerJuly 28, 2016

Definition of Shorting

The usual ways of thinking about stocks or commodities is that you buy them at a given price and then you later sell it. Shorting reverses that process. When you short something you borrow the stock or commodity from your broker (at a given interest rate), you then sell it. Later you buy the stock or commodity on the open market and give it to your broker.

Example of Shorting

The investor borrow 100 shares of stock A from their broker and they agree to pay the broker 1 dollar per day in interest. They sell the borrowed shares for 1 dollar each on the open market. 30 days later the price of the stock is 50 cents per share. The investor buys the shares on the open market for 50 cents per shares and gives them to their broker. They made 50 dollars on the transaction (100 – 50). After you subtract the interest (30 dollars) the investor is left with 20 dollars of profit.

The Risk

Shorting is incredibly risky as your potential loss is infinite. If the stock price had risen to 1000 dollars per share, you still would be required to buy the stock on the open market. When you’re required to buy back the shares (whether you want to or not) depends on your account margin. It is simply the ratio between the value of the shorted stock and the value of your account. If that ratio gets too high the broker will demand the shares back.

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Investment Newsletter for the end of June 2016

Posted on July 4, 2016 by Daniel DollingerJuly 28, 2016

Overview

The market was essentially flat this month. For the quarter, everybody made money.

Brexit and the Stock Market

The market this month gave me an obvious topic for this newsletter. Fear. Or more specifically stark raving panic. The UK voted out of the European Union. Everybody then screamed and the market went down 900 points in two days. Of course, nobody understood what being in the EU meant economically. Also nobody understood what the vote meant. Of course, fear does not care about those things. The market crashed and the future looked black. What happened next is more interesting. The fear ran out. The people who were going to sell did so. Lord bless them because they are the people who always lose money. Because of them, other people make money. In three or four days, the market recovered everything it lost.

Fear Pit

What you just saw is what I am calling a fear pit. The market has two emotions. Greed and fear. When greed goes irrational, it’s called a bubble. There is no established word for irrational fear, so I am going to call it a fear pit.

Advantages and Disadvantages of Brexit

The European Union provides certain benefits and disadvantages to the UK. The main advantage is free trade. The main disadvantage is excessive regulation. Because of the regulation, the UK was losing its independent power. Large movements of refugees into the country was the latest sign of that. The country staged a popular vote to leave the EU. In general, the political elites and the big cities voted to stay in the EU. Everybody else said get out.

What Happens Next

What happens now is that the government will stall and then notify the EU to start a two-year negotiation process to leave. The two-year period can be extended over and over. The prime minister has said he will resign in October. He said the next government would have to notify the EU. That means the two years will not even start until October or November at soonest. The political class does not want to leave. Do you have any doubt that a bureaucrat can stall for a long time? Eventually, they will leave and what will that mean? Most likely, The European Union will carve a category for the UK like they did for Norway. Not part of the EU, but with free trade.

The vote was non-binding. I repeat. It was advisory only. In short, the vote means absolutely nothing. Economic trade between the US and the UK will be unchanged. Trade between the EU and US, unchanged. I doubt there will be any change to the world economy.

More Effects of the Fear Pit

Fear does not think logically like what I just said. I received several emergency contacts to sell. Fear pretends to have a logically face, however. “Because international trade will collapse, we will go into a recession” is one of several things I heard. It is a fake logic. It is an excuse so that you can do what your stomach is already telling you to do. Every news report and talking head said “disaster.” I must really be stupid not to listen. I managed to stop these clients from selling out. You’re welcome by the way.

My Plan

My game is played by following a long term plan. It is about discipline. The emotional swings either up or down are destructive. The talking heads are destructive. They amplify the emotions so that they can be relevant. Boring does not sell newspapers. The emotion leads you to rush into and out of the market. Always too late and always with lots of commissions. Follow the long term plan instead. I did rebalance, however. If the world is going to heck, it is a good time to pick up a bargain.

Sure, I was frightened. It felt like my entire future was at stake. What if I was wrong? I felt that, but knew that I was not wrong. My future was unchanged. Yours was unchanged also.

Always face into the wind my friends.

Sincerely,

Dan

Daniel Dollinger CPA CFP®

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What is a Derivative?

Posted on July 1, 2016 by Daniel DollingerJuly 28, 2016

General Definition

A derivative is any contract that concerns the buying and selling of securities or commodities at a future date. For example: you’re a restaurant owner and you meet a great apple supplier. You currently have plenty of apples but you know you will need them in the future. So you agree to buy 1000 apples from the supplier in one month at a particular price.

Futures Contract

The above example is a derivative called a futures contact. The buyer and the seller have an obligation to satisfy that deal in a month; no matter what the market price is at that time.

Option

The other main type of derivative is called an option. Unlike a futures contract, an option doesn’t have to be satisfied. The holder of the option has the choice or the option to cancel. For example: the restaurant owner tells the apple supplier they will pay the supplier 1 dollar per apple in a month. If the supplier agrees, then even if the market price rises to 100 dollars per apple, the restaurant owner can still buy apples at 1 dollar a piece. If the market price drops to 20 cents apiece, the restaurant owner can cancel the contract and buy it at the lower market price. The reason the supplier is willing to offer that option is that the restaurant owner pays the supplier a premium as a way to compensate the supplier for the market price risk. So the restaurant owner might buy the option contract from the supplier for 50 dollars. There are two types of options; calls and puts.

Calls

When you buy a call, you are buying the right to buy a stock at a certain price no matter how much the market price rises. The above example is a call option; the restaurant owner with a call option can buy an apple for a dollar no matter what the market price.

Puts

When you buy a put, you buying the right to sell a stock at a certain price no matter how much the market price drops. For example: Imagine that restaurant owner is really desperate to buy those apples in two months but the supplier doesn’t want to sell to him. The restaurant owner tells the supplier that he’ll pay in two months the market price or the price specified in the option (strike price); he’ll pay whatever price is higher. The supplier takes the deal because now, even if the market price goes down (a common risk in sales), the supplier can always sell their apples at a high price.

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Is Day Trading a Good Strategy?

Posted on June 29, 2016 by Daniel DollingerJuly 28, 2016

Short Answer

As an investment strategy, day trading is theoretically junk.

Random Walk Theory

Stock movements for short periods of time are completely random. The drunk staggering left and right from a light pole. There is no pattern. The “random walk theory” has been repeatedly proven.

It’s Luck

If the market is going up in general, day trading will win. It will not win by as much as the market goes up. When the market goes down, day trading will lose. It will lose more than the market. There will be individual stock exceptions – lucky you. Do not, under any circumstance, think it is skill.

Excessive Trading Fees

Trading costs drag day trading below the market both on the upside and downside. There are three major trading costs, commissions, money market yields on the extra cash, and bid/ask spread. Everybody understands commission costs. They think because cheap broker x charges them little or no commissions that there are no costs of playing the game. False. The big cost is the bid/ask spread. When you sell a stock, you sell at the lower of the spread. When you buy (even at the same instant, the same stock), you buy at the higher of the spread. The broker keeps the difference. This difference can be significant and keeps brokers in business.

Higher Taxes

Tax wise, if you make a profit, it is short term capital gain. This gain is ordinary income and is taxed at maximum rates. If you have a loss, you can only claim a net of $3,000 per year. The extra carries forward. I have a number of tax clients will be deducting $3,000 for the rest of their lives. Long term capital gain (longer than one year holding period) has a much lower tax rate.

Higher Tax Preparation Fee

Each stock trade sale has to be listed on the tax return. It is easier now that I can download and import transactions but is still a pain to reconcile. I once had a tax client with 3,000 transactions. It took so much time, I had to surcharge him an extra fee.

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What are Different Ways of Evaluating Stocks?

Posted on June 27, 2016 by Daniel DollingerJuly 28, 2016

What is Fundamental Analysis?

Fundamental Analysis is a way that people attempt to find how much a company is worth. They then try to buy the stock when the market price is below the actual value of the company. They reason that eventually the market price will rise to meet the actual value of the company. Think of the phrase buy low sell high.

There are many fundamental analysis methods but they all involve analyzing the statistics and financial numbers of the company. Data that could be analyzed are profit, revenue, costs, growth, dividends, etc.

Some great examples of Fundamental Analysts are Warren Buffett and Benjamin Graham.

What is Technical Analysis?

Technical Analysis is a way that people attempt to find how a market price is going to move. They then try to buy the stock when they think the market price will soon go up. Think of the phrase buy high sell higher.

There are many technical analysis methods but they all involve analyzing the past movements and behavior of the market price. They generally are not concerned about the company itself. Data that could be analyzed are volume (number of people buying and selling), price movement (did the price move up or down), etc.

Some great examples of Technical Analysts are Jesse Livermore and Paul Tudor Jones II.

What is the Efficient Market Hypothesis and Random Walk Theory?

The hypothesis states that all publically available information on a company has already been considered and factored into the stock price. It is closely related to the random walk theory, which states that all short term price movement is random.

The Efficient Market Hypothesis is contrary to fundamental analysis. The hypothesis states that are enough rational people out there exploiting inefficiencies that no inefficiency is left for you to exploit. There is no research left that hasn’t already been considered by the millions of people in the stock market. Random Walk Theory is contrary to Technical Analysis for the theory states that all the price movements that technical analysts use are meaningless. Instead of picking stocks, followers of modern portfolio theory (efficient market and random walk adherents) manage risk by rebalancing asset classes.

Some great examples of Modern Portfolio Theorists are Eugene Fama and Burton Malkiel.

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Because of the Decline Due to Brexit, Should I Leave the Stock Market?

Posted on June 24, 2016 by Daniel DollingerJuly 28, 2016

Short Answer:

No, that is not a valid reason to leave the stock market.

Market Timing is Impossible:

You know the stock market has declined, you don’t know what it will do next. You do not know when there will be a massive correction. It may start today. It may not be for a year. Timing the market is impossible. When you attempt to time the market, you have to make two decisions: when to get out and when to get back in. Short term decisions on the market are random walk, meaning the drunk staggering around a light pole. There is no prediction. There is no such thing as momentum.

Don’t Lose Control of Your Emotions, Maintain Your Discipline:

You are making an emotion based decision. Fear and greed are the base emotions of the market. They will cause you to overreact. Focus instead on the objectives you established for the portfolio. Rebalance to honor those objectives. Discipline is how to win.

Stocks are the Best Asset to be Invested In:

If you sell off your stocks, you have to either reinvest the cash into another asset class or leave it in cash. Leaving it in cash is bad because inflation will eat up your buying power. A popular asset class is real estate. Real estate is just another asset class (like stocks) that goes up and down. Choosing when to buy real estate is a timing decision. Right now, real estate is soaring. I have no idea if it will continue to soar. Momentum is a false idea. On average stocks have a higher return than real estate so I would stay invested in stocks.

Brexit Will Not Have any Long Term Effects on the Stock Market:

Brexit will cause some bouncing around in the short term. There was a large fear fit today. It was not rational. Nothing is different today than yesterday. In the long term, stick to your investment plan. Look at the market long term, get away from the panic and greed emotions, and show some discipline. Winning the game is about sticking to a plan. There will always be a sensational news item that nobody really understands but must be really bad because everybody says so. It used to be the Greece crisis. Next week it will be something else. Europe will still be there in five years. People will still buy Shell or BP gas, Lipton tea, and Bayer Aspirin. I will still occasionally buy Scotch Whisky. The stock market will be fine.

Have Patience:

Even if the stock market crashes; it doesn’t matter. The stock market crashed in December 2007, continued to crash in 2008 and part of 2009. It lost half of its value. It recovered everything and then some by the end of 2010. In the stock market, patience is very rewarding.

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Can You Predict a Stock Market Crash?

Posted on June 22, 2016 by Daniel DollingerJuly 28, 2016

What is a Stock Market Crash?

The stock market declines or advances on a regular basis. Some of these swings back and forth are large. A market crash refers to major decline in stock prices. It happens every few years. The market will go down in price and continue to go down until equilibrium is reached. The market is a big auction. Occasionally, there will be less buyer excitement than seller excitement. The reason could be anything. Fear and greed are the basic emotions of the market. The prices will continue dropping until the point where there are equal buy orders and sell orders.

Can You Predict When a Market Crash is Going to Occur?

The market can not be predicted. At some point, there will be a market crash. That fact is guaranteed. There is no way, however, to determine whether that crash will be next week, this year, next year, etc. Even as it crashes, you do not know that it is a market crash. It could just be a correction.

The other direction is also impossible to predict. You can not determine the start of a market recovery.

Think of the market as being in a car looking out the rear window. You can see where the car has been but not where it will be.

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Why Buy Bonds When Stocks Have a Higher Expected Return?

Posted on June 20, 2016 by Daniel DollingerJuly 28, 2016

It is true that stocks have a higher expected rate of return over long periods. It is not true for each period. Stocks will sometimes do better and sometimes worse than bonds.

The fluctuation is risk. If bonds are steady (they actually are not but lets assume so for this question), the back and forth of stocks is risk. Finance people measure this roller coaster using standard deviation. How scary do you want your roller coaster to be. Adjusting the ratio of stocks vs bonds changes the total portfolio risk.

Not all risk levels are appropriate for all investors. My 92 year old mother in a retirement home can not wait for a market recovery if there is a down fluctuation. The money is necessary now. I have her portfolio at about 2/3 short term bonds. I am in my late 50’s. I can handle much more fluctuation as I have many more years left. I have my portfolio at about 40% short term bonds and 60% stocks. I would have a young adult at nearly all stocks.

More risk means more profit but not necessarily when you want it to be there.

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Can You Predict Future Stock Prices?

Posted on June 17, 2016 by Daniel DollingerJuly 28, 2016

Predicting future stock prices is theoretically impossible. The market is essentially efficient, meaning that all publicly available information is almost instantly reflected in the stock price. Anything you read or study about the company can not be used to predict.

There are exceptions of course. Inside information (illegal) would give you an edge over the rest of the public. Thinly traded issues might also take a little longer to price adjust since fewer traders are following the news.

In my view, the biggest exception concerns speculative greed bubbles and fear pits. The group will sometimes begin pricing in irrational expectations. People get a herd instinct and overreact. On the greed side, you commonly see this with technology companies, particularly new age stuff. No company profits or even a prospect of one and stock prices keeps going up. On the fear side, people run screaming away. Look at fossil fuels for example.

Just because there are bubbles and pits does not mean you can use them to trade. If you are in the middle of the storm, how do you know if the storm is going to get worse and when it will end? Is the coal industry in a fear pit and will eventually recover? Or is it dead? How brave are you?

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