Buy on the Rumor, Sell on the News


 There’s an old saying in Wall Street that you should “Buy on the rumor, then sell on the news.”  The meaning is that when you start to hear that something is going on at a company through the rumor mill, you should load up on shares.  When the actual news comes out, however, it is time to sell because the effect of the news is already priced into the price of the shares.  To take advantage of news, you really need to get in before everyone else, which means before the news breaks.
Many novice investors will hear news on a stock and buy or sell shares as a result.  For example, there were likely a lot of people who went out and sold shares of United Airlines the day after the video of the passenger being slammed into the arm rest and then thrown, face bloodied, off of the plane.  I mean, that can’t be good for future sales, right.  The memes that went around the next week with phrases like, “United: Fight or flight, we decide.” and jokes about the United “fight club” don’t build brand loyalty.  Some people probably even sold shares short (which is when you borrow shares and sell them, planning to buy them back later at a lower price and keep the difference).

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The issue is that the news was already out there.  By the time the next morning came around, everyone already knew that United had messed up royally, and the comments by the CEO about the passenger being at fault didn’t help.  So put yourself in the shoes of the other person in the trade – the one who was buying the shares.  Would you have paid the same price you would have the day before, before the incident occurred?  If you wanted to buy the shares at all, you probably would have only been willing if the share price were 10%, 20% or even 30% lower.  You would be expecting a big discount since obviously the next earnings will be a bit lower than they were before.  The shares were not as valuable as they were a day ago.

Let’s use another example not related to the stock market.  Let’s say that you own a car that is worth around $25,000  and you accidentally drive it into a lake.  Let’s say that the fact you drove it into the lake makes the news and everyone knows about it.  Could you expect to then sell that car for $25,000 with everyone knowing that it was driven into a lake and probably fouled the engine and everything else?  The price would drop instantly the moment the news got out.  Someone might offer you a few hundred dollars, either to use the parts or with the plan to fix it up. Just because it was worth $25,000 before the event doesn’t mean you’ll be able to sell it for $25,000 after the news breaks.

                                           

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It is exactly the same thing with stocks.  There is something called “the efficient market theory,” which says everything known about companies is instantly priced into the price of their stocks.  This means it is pointless to try to buy and sell stocks based on the news that comes out because the stock is already priced to take that news into account.  Everybody knows the car has been in the lake.  The best you’ll get is a couple of hundred dollars.  It doesn’t matter how much it was worth the days before or how much you still owe on the car.   It also doesn’t matter how much you need to buy another car.

For this reason this blog will never recommend trying to trade stocks, where you buy one day and then plan to sell a few days, weeks, or months down the road for a profit.  All of the news you hear is already priced into the stock price.  Everyone else has already looked at the same charts you have and sees the same trends.  Everyone else knows that the company is coming out with a new product, or that product A is selling well, or that Baby Boomers are retiring.  The stock is already priced correctly for all of that news and anything you’ll see over a periods of weeks to months is just random noise.  You have a fifty-fifty chance of making money.  Investing is putting your odds way into your favor.

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That said, there is a way that you may be able to take advantage of big news that comes out.  Right after the news breaks, people often overreact, especially if it is bad news.  People don’t really know how big the effect of the debacle will have on United’s share price, so they tend to price it considerably lower until the dust settles.  I mean, if you were buying shares, would you buy if you didn’t think you were getting a screaming deal?  You would want a little insurance.

As a result, if you already owned United shares and were looking to add more, or you were planning to buy before the news and still wanted in, you might be able to buy shares right after the news breaks, a little at first, and then a little more if the shares continue lower, and get a really good price.  Often after the dust settles you’ll see a bit of a bounce back.  This won’t make you rich, but might let you get a little better price than you would have otherwise.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Taking Advantage Of Stock Weakness


Interesting post from Girlvestor below. This shows the issue with trading based on news. I’m sure many people heard about the United Airlines treatment of their customer and reacted by selling the shares. The issue here is that the news is already out there, so the effects of the horrendous United customer service are already priced into the price of the shares before you are able to hit the sell button. Often these things get overdone, however, so you might be able to take advantage as Girlvestor did. Often the shares will trade way down to start and then recover a lot of the loss the next day. I wouldn’t recommend buying and selling this way to make quick profits, but if you’re already setting up a position, it may make sense to take advantage of such events to add a few shares.

        

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How Does Mutual Fund Investing Work


Continuing the series of posts on different aspects of finance to help provide the basic financial background needed to be successful financially in life, today we turn to the subject of mutual funds.  If you have not watched CNBC, read a book on investing, or picked up a copy of Money magazine or The Wall Street Journal, you’ve probably still heard of mutual funds but know little about them.  This is really a shame since mutual funds are an easy way to invest and belong in every household – not just those of the wealthy.  Let’s get into some of the basics and then talk about how you can get started in mutual fund investing.

What is a mutual fund?

A mutual fund is a way to invest where many people pool their money together to invest as a group.  For example, 10,000 people may get together and each put in $5,000 each to invest in a basket of companies.  In doing so, their money can be spread out into several different investments instead of being limited to one or two investments.  The money is invested by a manager who makes the decisions on where and how to invest within the confines of the guidelines for the mutual fund.  In exchange, the manager takes a small fee based on the dollar value of the assets in the mutual fund.  Owners of the mutual fund (those who invested) own a fraction of each investment in proportion to the amount that they invested.  In the example above, since each person put in $5000 and there were 10,000 investors, each person would own 1/10,000th of each of the investments.  Normally everyone puts in different amounts and therefore owns different percentages of the mutual funds assets.

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Why should I own mutual funds?

If you save up money regularly, rather than spend money as you go, you provide security for yourself and your family when things happen like car repairs and medical events.  In addition, you’ll have the money needed for expenses such as putting a new roof on your house, college tuition for your children, and retirement that are predictable, but require a great deal of savings.   If you invest some of the money that is sitting around in your savings, you can use the power of compounding to increase your savings, thereby reducing the amount of money you need to actually work for and put away.  Without compounding, it is practically impossible to put away enough money to pay for things like a long retirement.  In addition, if you have money just in cash (or even in a bank account) for long periods of time, you’ll lose a lot of the value to inflation.  Investing the money in mutual funds instead will protect you from inflation since the value of the assets in the mutual funds will go up as the value of the dollar declines.

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How do I invest in mutual funds?

Several different companies sell mutual funds with each fund investing in different things.  This is called a “family of funds.”  Investing is as simple as setting up an account online (or with a phone call) and sending in a check or using an electronic transfer.  There is normally a minimum amount that can be invested in each fund, ranging from $3,000 to $5,000 or more.  Other than saving up the minimum, there is really no trick to it.

Once you’ve made the initial investment, you can normally add to it in small amounts.  There is often no minimum for future investments in the same fund, or maybe there will be a small $25 to $50 minimum.  Once you have enough invested, you can also sell some of your first fund and then invest in a different fund, or just save up the minimum again and invest in a second fund.  Some fund companies also allow you to start with less if you agree to use automatic deposit to buy additional shares on a regular basis.  This is generally a good idea since it will mean you’ll be making regular investments, which is one secret to doing well and building up your portfolio.

You can also buy mutual funds through a brokerage account or even a bank or credit union.  In general I would not recommend this path since you’ll probably have a limited selection of funds and you’ll probably pay a big fee to the broker or bank.  A better option if you’re using a broker is to buy shares of an Exchange Traded Fund, or ETF, which is basically the same thing as a mutual fund.  There are some differences, but that is for a more advanced discussion.  If you buy an ETF you will pay the broker a commission, so you’ll need to buy in big enough increments to keep costs down, but the ETFs themselves tend to be very low-cost, so you’ll make back the money in savings if you hold the ETF for a long period of time even if you only buy in $1,000 or $2,000 increments.  Some brokers may even offer free ETFs.

How do I select mutual funds to buy?

There are many different funds to select from and it can become difficult to choose.  In general you’ll want to try to 1) minimize your fees and costs, 2) spread your investments out into different parts of the market and 3) choose funds based on the amount of time you’ll stay invested.  Assuming you’re investing for something like five, ten, or more years into the future, your first fund will probably be a large-cap fund like an S&P500 fund, large-cap growth fund, or similar.  For really long investments, like a retirement fund when you’re in your 20’s, a small cap fund like a Russell 2000 fund or small-cap growth fund might be a better pick since small stocks will beat larger ones over really long periods of time.  Really you could start with one of these funds and then add the second once you’ve saved up enough.  

If you’re only investing for about five years, you might want to buy into a short-term bond fund or just leave the money in bank assets like CDs since the fluctuation in stock prices over short periods of time is unpredictable.  You might also want to add a bond fund to a stock portfolio when you start to approach the time when you’ll need the money for things like college, a home purchase, or retirement.  In general a combination of bonds and stocks will fluctuate less in value than stocks or bonds alone, although you’ll reduce your total return over long periods of time by adding bonds.  If you just don’t like market fluctuations, however, add 30-40% bonds (for example, $4,000 in a bond fund and $6,000 split between a small cap and a large cap stock fund) and it will make it easier to sleep at night.  Even during the 2008 crash, bonds were unaffected.  In fact, they actually gained a bit for the year!  An REIT fund, which invests in real estate, is also a consideration as a counterbalance to stock mutual funds.  

You’ll want to find a fund with fees of 0.30% of assets per year or less.  (This means that they’ll charge you $3 per year for every $1,000 you have invested.)   This is easiest to achieve using index funds, which just choose stocks in order to follow a specific part of the stock market rather than having a manager who tries to outperform the market.  Because few fund managers are able to actually beat market returns, you’ll generally be best off just buying index funds and index ETFs.

Where can I learn more about mutual fund investing?

There are many books on investing that include mutual funds.  Below are a sample of books that you could read. I’ve included the SmallIvy Book of Investing because the last couple of chapters are devoted to mutual fund investing, including how to use mutual funds to gather money for your retirement.

              

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.