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Author: globalist2013 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Using Stocks as Bond Substitutes Date: 2/8/2013 1:49 PM
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What, really, is the difference between ‘the stock game’ and ‘the bond game’ from the point of view of making money? If a stock doesn’t pay a dividend, then your profits can only come from cap-gains. But if a stock pays a dividend, then it can become “bond-like” in the sense that profits can come from both ordinary-income and capital-gains, just as profits from bonds can come from both.

The standard rule of thumb is that stock gains will come from four sources: earnings (and, hence, the multiple investors are willing to pay for what they hope will be future earnings), the premium/discount investors are willing to pay for the difference between the company as an ongoing enterprise and its takeover or breakup price, dividends (if any are paid), and inflation (as the company re-prices its goods/services). Extending that same rule suggests that bond gains come from the coupon as a fraction of the purchase price of the bond, the inflation-premium imbedded in the bond, and (when they occur and when the bond is sold before maturity) improving credit-worthiness for the issuer and/or falling interest-rates. In other words, the stock game and the bond game are cousins, and they offer exactly the same money once the price of the embedded put that a bond is has been discounted. It wasn’t my intention to do so, but I ended up running an experiment that somewhat demonstrates this.

It’s no secret that Apple’s stock price crashed and that a lot of people who bought the stock because they loved the company got hurt. It’s super easy to sit on the sidelines and to laugh at them for their failing to do even the most basic of risk-management, namely, look at a price chart before putting on a position. If a price is failing, with no obvious bottom in sight, then you’re trying to catch a falling knife. Not smart, and it doesn’t matter whether what is falling is a stock, a bond, a commodity, a currency, real estate, or an actual knife. Let it hit bottom before you make your move. There were lengthy discussions in another forum initiated by people who had screwed up on their timing and who ended up being sliced by the knife of falling prices. Rather than having no skin in the game, I put on a position in AAPL and promptly discovered that I, too, had screwed up on my timing.

The day I entered, I was working off a 1-minute chart. I correctly caught a low, and the trade immediately went into the money. However, I had made the most basic of mistakes by not looking at prices in a longer time-frame, and --predictably-- I got cut as prices rolled over again and headed back down toward where a bottom could have/should have been predicted from a longer-term chart. Also, I failed to set both profit-target stops and loss-stops. My excuse that I was using Scottrade’s order-entry platform, not the one I would have used if I had been executing though IB. But that’s a lame excuse. Always, always, always, you should identify before a position is put on where your exit point will be if prices move against you, if not also where your exit point will be if prices move in your favor. I failed to do both, which is really, really, really stupid.

OK. The deed was done. So the next step was to figure out a repair. That could have been done by 'averaging down'. But averaging down is a highly speculative move that is never a sound idea no matter the fact that it occasionally works. If you got your entry wrong, then get out while your losses are still small. Alternatively, decide whether you’re allowing the trade the wiggle room it needs. If you aren’t lying to yourself about how much room the trade needs, then you can sit tight. I was only down a couple of percent. So I decided I’d let it ride. Subsequent days moved me back into the money, and then out again. But from a chart, it was obvious that the back and forth struggles of buyers and sellers were no longer creating lower lows. Instead, a bottom had been put in, and I knew that the worst was past. Then, unexpectedly, in after-hours trading yesterday, APPL’s price jumped hugely, and I knew I had to act. So I set up a tight, trailing stop this morning and got kicked out. Now here’s the point of this exercise.

Roughly speaking, there are 250 market days per year. Roughly speaking, if you make 3 bps per market day from a bond, you’ll make a fairly benchmark, nominal 7.5% per year. If you make 4 bps per market day, you’ll make a fairly benchmark, nominal 10% per year. If you pay taxes on that 10% and subtract a realistic rate of inflation, you’ll see that you’re doing just slightly better than breaking even with respect to preserving your purchasing-power. In other words, you aren’t making any money. But far more importantly, you aren’t losing any of it, either. Reportedly, an average, annual return of 10% can be expected from stocks. However, as the Dalbar longitudinal studies of investor results clearly document, the average equity investor falls short of that by about one-third, and the average fixed-income investor fall short of his/her much lower benchmark by roughly seven-eights. In other words, there’s a huge difference between theory and practice, and most of that difference is due to one simple fact: poor market-timing. The would-be investor might have correctly identified What? to buy, and he/she might have correctly identified Why? to buy it. But he/she screwed up majorly on When? to get in and when to get out.

Getting timing right can be tough. But decent money can be made when it is done even approximately correctly --never mind optimally-- and I’m back on the sidelines with an 8 bps per calendar day gain from betting on Apple, which is fun. Lesson? Stocks or bonds, it don’t make no difference. Risk is risk, whenever it is found, and it’s always going to pay the same, but with this difference. The relationship between ‘risk’ and ‘reward’ is asymmetrical. Accepting the risk doesn’t guarantee the reward. But if you got the reward, you necessarily took the risks, no matter the fact that you might not have identified them.

Charlie
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