Catching a Falling Knife


Wall Street has a lot of sayings developed by traders who learned one lesson or another, usually after losing a great deal of money.  One of the bromides is to “catch a falling knife,” usually used in phrases like “He tried to catch a falling knife with that stock and lost his shirt.”

In stock market parlance, to “catch a falling knife” if to buy a stock that is declining rapidly in price with the hopes of buying the stock at the bottom, thereby getting a good price, from which the stock rebounds sharply, leading to a quick profit.  As would be the case with trying to catch a real falling knife (picture point side down, razor-sharp, rocketing towards your foot) the maneuver is tricky.  If you move too soon, you will be rewarded with a slice in your finger or a point in your palm.  If you move to slowly as the handle whizzes by, you’ll miss the knife entirely.

Buying falling stocks is a form of value investing, in which an investor buys stocks that he believes are undervalued and holds them until he believes they are fairly valued or overvalued.  The general premise is that an undervalued stock will eventually return to its fair value, and that undervalued stocks will do better than overvalued stocks.  Value investing is based on the “buy low, sell high” philosophy.  This strategy has proven itself at various points in the past, although in recent years the momentum investing approach (buy high, sell higher) has actually been more profitable.

 

        

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The trouble with buying declining stocks is that stocks that are falling rapidly in price are usually falling for a reason.  Looking at the current British Petroleum fall, the stock is declining because the clean-up efforts from the oil spill will cost unknown billions of dollars, which in turn will hurt earnings.  There is speculation over whether the dividend will be cut or eliminated, how big the losses will be, and how much will be paid in legal costs and claims resulting from the numerous lawsuits that will no doubt come in the next year or two.  In addition, the actions that the US Government may take and their effect of future profitability are unknown at this point.  Because stock investors hate uncertainty the price will continue to fall. (Even if the news is bad, if you know the numbers you can value a stock.  If there is uncertainty no one knows how to value the stock and therefore are afraid to step in and buy).

The only time to try to catch a falling knife is when the whole market is declining, and then to pick up shares of a stock you have determined to be a good long-term buy and were accumulating anyway.  In this type of situation, good stocks and bad tend to decline, so your great company will fall along with everything else.  When the markets turn around, the great stocks are the first to shoot back up, providing once-in-a-lifetime returns.

To determine if the whole market is declining, rather than just your stock, look at the mid-term charts (maybe 6-month time span) of several stocks.  If they all look about the same, with head and shoulder patterns and then a downward trend, the whole market is falling (the current market is like this).  If only the stock you are interested in is falling, it is best to stay away because there is probably something other know that you don’t (yet).

 

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If you determine that the whole market is falling, the way to catch the knife is to wait for the initial decline to start to slow and flatten out and then buy about 1/3 of the number of shares you will eventually buy.  Then, wait for the rise and hope it is a bear-market, “suckers” rally.  If it is, wait for the stock to decline beyond the previous low and then wait until it begins to flatten again.  Buy the second 1/3 here.  Repeat one more time if the market cooperates and there is a third downturn.  If the stock moves up and crosses the original high (the “head” of the “head and shoulders” pattern) wait for the subsequent low and buy the rest  of the shares because the fall is probably over.

After you are all in, just sit back and wait.  The stock may fall farther, but by buying in stages you lower your cost basis and also are aided psychologically.  As the stock moved to new lows, since you were hoping it would continue to decline, you don’t get the self-doubt that you get when you buy the full position at once and see the price continue to decline.  It is almost impossible to catch the exact bottom, but this way you had three tries.  Eventually the stock should recover and set a new all-time high if you picked the right kind of stock, so whether you got the exact bottom or not won’t really matter.

Happy catching!

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Should You Invest a Lump Sum All at Once?


There was an interesting article in Money magazine this month about dollar cost averaging.  Typically, this is where you would buy investments at regular intervals, for example putting $500 per month into a mutual fund over a period of several years.  The idea is that then you buy shares both when prices are high and low, buying more shares when they are low (since you’re putting in a fixed amount of money each month).  Buying more shares when prices are lower means that you’ll get a cost basis lower than the average stock price for the period over which you were buying, so even in a flat market you’ll make a small profit.  Dollar cost averaging is a great idea since it 1) does get you a good price and 2) gets you putting away money regularly, which is the secret to becoming financially independent.

What the article was really talking about, however, was whether it was better to invest a lump sum all at once, or invest a portion of the money each period over several periods.  For example, if you got a $1M inheritance or a big lump sum payout from a pension fund, should you invest it all at once or maybe put in $50,000 per month for a couple of  years.  Their conclusion was that it is better to just drop it all in at once.  I’m not sure I agree.

        

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They cited a study by Vanguard that showed that you’d be better off 2/3rds of the time just investing all at once than spreading it out over several periods.  This makes sense since the market goes up about 2/3rds of the time.  Their reasoning for doing so despite what happens the other 1/3rd of the time – when the market declines after you invest – is that if you plan to put 60% in stocks and 40% in bonds, for example, you’re already investing to manage risk.  It therefore makes little sense to hold back cash and go against your investing plan.

The problem I have with this plan is psychology.  It would be devastating for most people to invest the $1 M they’ve gathered up all of their lives in their pension plan and see a 40% loss as we saw in 2008.  It would be even worse to see another event like the market crash of 1929 where 90% of the value was wiped out and it was more than 15 years before people were back to even.  Many people would simply cash out and go into T-bills and bank CDs after suffering through such an event.  As we saw in 2009 and 2010, this is often exactly the wrong thing to do since markets have almost always recovered fully from such events within a year or two (1929 being the exception).  If someone invested just $100,000 of a $1 M lump sum right before the drop, hopefully they would see it as an opportunity and continue to invest in regular increments.  Even in 1929 they would have made out like bandits this way because it is right after large drops that the market is on sale.

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So yes, statistically it is better to invest all at once, but psychologically it is better to wade in slowly. The consequences of dropping a large sum into the market right before a major event are also so severe that a 66% probability of doing better just really isn’t worth the consequences of being wrong.

Even when building up  position in a stock I tend to wade in, rather than taking the plunge all at once.   For example, if I wanted to build up a 1000 share position in BJ’s Restaurants International (a company I usually have a big position in and which I have on now), I wouldn’t typically just put $40,000 into it to buy 1000 shares at $40 even if I had the cash sitting around.  Instead, I might buy 200-300 shares, gather up more cash over the next month or two, then buy another 200-300 shares.  If the stock drops in price, I might use the opportunity to buy more shares at once.  Doing so actually makes drops in share price a good thing that I look forward.

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What’s Wrong with the Healthcare Market?


I was thinking the other day about the American healthcare system and why it doesn’t seem to function like the other markets.  I mean, there is really no issue with getting food – it is cheap and plentiful.  Sure, people who make a lot of money are able to buy better quality food, or at least food that costs a lot of money in fancy restaurants, but anyone who is willing to work a little can get enough to feed their families, even if it is very little steak and a lot of ground beef and chicken.  Clothing is also not an issue – you can pay $5,000 for a dress, but anyone who works can get can cloth themselves and their family.

The healthcare markets, however, are different.  The cost of things can be very high, such that even someone who makes a good, middle class income can be bankrupted by a hospital stay.  There are some ways to save money, but in general the premium price is almost always charged, particularly when things are urgent.  Why is it the free enterprise works great for food and clothing – necessities of life – but not healthcare?

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Then I started thinking about it a bit and realized that healthcare is not operating under the free enterprise system like food, clothing, shelter, and virtually everything else.  Healthcare is different for these reasons:

  1.  Most people pay for buffet plans, then use as much as they want without concern for costs.
  2. Most services are provided without the consumer or the provider knowing what the price will be.
  3. The final price is decided after the product is consumed, and often the consumer and the person/entity that pays is different.
  4. Many people receive services and pay nothing.

Think about what it would be like if you went into a restaurant that had the same policies.  You can already see what happens when you pay a fixed amount for unlimited food since there are buffet restaurants.  People eat a lot more than they would if they were paying per item, and also tend to concentrate on the more expensive items.  Very quickly the buffet restaurants learn how much they need to charge and earn a profit, and that tends to be a reasonable amount since there is only so much people can eat.  But in the medical system prescriptions, devices, and services can be really pricey, so if people just keep consuming a little bit more it drives up costs, which is why premiums seem to rise every year.

 

                 

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Think now what the effects of the second and third items – having services provided without knowing the cost and not even deciding on the final price until the product was consumed  – would be in the restaurant industry.  What if you walked into a restaurant and sat down and there were no prices on the menu.  You ask the waiter about the price of a steak and he says that he’s not sure since it would depend on your insurance.  You tell him you don’t have restaurant insurance and ask him what you would pay.  He says he’s not sure since everyone pays with insurance.  He might be able to tell you the list price was $500, but says you’d probably pay a lot less.  You then go ahead and order meals for you and your family, sweating the whole time because you’re not sure what the meal was going to cost you.

At the end of the meal, the waiter comes out with the check – $3,455.  You look through the bill and see that rolls were $30 each!  You know you could have bought a whole pack of rolls across the street for $5.  You say that there must be some sort of mistake.  The waiter refers you to a manager who says that they could work out a payment plan.  He also says that he’d be willing to cut $1,500  off of the bill.  You’ve already consumed the food, so you can’t just say “No thanks!” and walk out the door.

Would you go to a restaurant like this?  Maybe you would if you had a meal plan where you paid a fixed amount for food at the restaurant, but what if the price of that meal plan just went up every year until you were paying $5,000 per year for the plan?  Would you be tempted to go to the restaurant more often?  Would you get more food than you really needed, and insist on only the best food while you were there?


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And what if while you were at the restaurant, you saw the family next to you just walk out without paying a bill?  They got the same food and the same service, but paid nothing.   You ask the manager why they didn’t pay and he explains that they didn’t have any money to pay, so they just eat for free as part of the restaurant’s benevolence.  Of course, you realize that the restaurant doesn’t have any source of money except for people like you who eat there and pay their bills, so you’re really paying for the bill of the family that eats free.  Going to the lot you notice that they are stepping into a brand new Cadillac.  You are getting into an old Honda because you want to save up some of your money to pay for things like food and can’t do that with a big car payment.

Obviously this is not the way that restaurants work.  The prices are clearly printed on the menu in almost every restaurant and there is no negotiation.  While you do not pay until after you’ve eaten, you have a good idea of what your bill will be and you choose restaurants based on what is in your wallet since you know that you’ll need to pay the bill after the meal or they’ll call the police.  No one eats without paying, so the price fo your food is only based on what you eat.  You’re not paying for other people.  As a result, prices are reasonable and there is a wide variety in choices of restaurants.  If eating at fancy places is your thing, you can put your money towards that and cut in other areas.  If it is not, you don’t need to pay the same price as others who like fancy places when you do go out since you can pick a cheaper place.  With medical care, especially when it is an emergency, there is little choice.  Plus if you’re on insurance because you’re worried about a big bill, you end up paying premium prices whether you use your medical care often or not.

 


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So how do we fix the healthcare system in the US?  Well, we start having people save up money for medical costs so people can pay for their own care for one.  We make prices transparent for another and have consumers pay the bill and get reimbursed by insurance rather than having fifty different deals cut with insurance companies and having the consumer have no idea what things costs.  We also get medical costs out there where people can see them rather than have everything so hidden.  Maybe there is a tech entrepreneur out there who can take that last idea and run with it.  Think about an app that tells you what the price of procedures are across your city and what that would do to medical care prices.

So what do you think?   Please join the conversation and leave a comment.  Contact me at VTSIoriginal@yahoo.com.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.