John: ‘With respect to Abe’s question about the Magic Formula, here’s the approach I’ve taken: When I’ve had one of the stocks for a year and the price is above what I paid, I place a stop limit order to sell the stock just a bit below the current market price. That way, if it continues to go up, I participate in the further gains (and further defer any tax liability). If it slips a bit, and triggers my sell order, I still capture virtually all of the gain.’
☞ A perfectly reasonable strategy. The downside is that the stock – having (let’s say) risen sharply in the first year, as its undervaluation was largely corrected – will indeed continue to rise, but not as quickly as some new, more-deeply-undervalued replacement would have.
George: ‘Abe should read the Magic Formula FAQ.’
Q: If after one year a stock that I originally purchased is still on the current list of top-ranked magic formula stocks, should I keep it or sell it?
A: That decision is up to you.
CASH VERSUS STOCKS
Kirk: ‘I have come to the conclusion that holding cash, CDs, and bonds does little for growing wealth. If stocks have returned 11% long term and bonds and cash now yield only 4.5%, why would anyone want to have much cash or bonds? (Except for some emergency cash.) Why not hold 90% – 95% in conservative value stock funds and a bare minimum in cash? During the 2000-2002 bear market, large U.S. value funds lost very little money. If I had gone 95% stocks when I left college 25 years ago, I would be rich now.‘
☞ Twenty-five years ago was the perfect time to start. Interest rates were at all time highs (Treasuries briefly got up to 15%, triple today’s yield), stocks were in the toilet (the Dow was 777, DOWN 23% from its level 16 years earlier), and America was within just a very few years of winning the Cold War and reaping a peace dividend.
The long drop in interest rates did an awful lot to underpin the long rise in stocks – but I don’t see it being repeated over the next 25 years (unless it were in the manner of the Japanese drop to zero, along with an 80% drop in its stock market). And what if interest rates rose? That generally hurts stocks.
The 11% historical return Kirk cites is, over longer periods, more like 9% (before netting out inflation but after including dividends), which still, unquestionably, leaves savings accounts and bonds in the dust.
Going forward the next few years, the stock market return (including dividends) might be more like 7% (though who knows?), with perhaps wild swings up and down along the way.
Why? Well, for one thing, performance tends to return to the mean. After an abnormally good 25 years, you might expect something less good. (Though, again, who knows?) And – see, for example, Rolling Stone, yesterday – we have an awful lot of problems to dig our way out of.
If you have a long time horizon, then stocks – diversified around the globe, not all here (and probably largely in the form of index funds, for most people) – should definitely be a big part of your asset mix.
But if you are saving for college that starts in two years, or for a house you hope to buy if/when the real estate bargains become irresistible (or have just enough in your emergency fund to handle one big emergency), I’d keep that money someplace safe, accepting a certain 3% or 4% (after tax) rather than risking substantial loss in hope of earning 6% instead.
Jeff: ‘Your advice to George – to keep three years’ worth of spending needs, say, out of the market – would, after a year in which the market went down 40 percent, require him to withdraw an additional $40,000 because three years from then, the market could be down again. And is this not a type of ‘market timing’?’
☞ Well, it would be market timing if, having watched the market drop 40%, you decided maybe not to take that next year’s $40,000 out of the market at depressed prices – let alone selling everything in a panic. (You don’t think people panic? Ah, the short memories.) One of the reasons not to have money you really need in the stock market is that you could lose it. But a second reason is to make it less likely that you – who have a nice fat cash cushion – will panic . . . or even just lose a lot of sleep.