Good companies attract investors. They do so by selling a desirable product that sustains the company’s growth of sales and earnings. The growth of sales is a good measure of market success. Durable companies convert their sales invoices into cash and use the cash wisely. Accounting items such as the free cash flow, sustainable growth rate, quick ratio, and debt-to-equity ratio are easy measures of the company’s health and durability. Growth stocks should be assessed by the quality of the company.
Beth Kobliner, Simon & Schuster, New York, 2017.
about the author
Beth Kobliner is an authority on personal finance for youth as shown by her successful publications of a NY Times best-seller book (Get a Fiancial Life), staff writer for Money Magazine, and contributing author to national newspapers. She served on President Obama’s Advisory Council on Financial Capability for Young Americans.
In this book she offers financial advice for 6 age groups: pre-school, elementary school, middle school, high school, college, and young adult. Much of her advice is based on academic studies. It’s not a textbook for children.
relevant topics for children
Most parents will discuss any topic except money; yet parents are the principal influence on their kids’ financial behavior. Many of a child’s money habits are set by age 7. This book discribes useful ways (called “teachable moments”) for talking about money with children as they grow from age 3 to young adult. Here are the author’s general comments about relevant topics for all ages:
TRUST: Parents need to build the trust of their pre-school children by following through on parental promises.
PATIENCE: Some children are impulsive, others are patient. Patient people tend to save more money! Pre-schoolers can be taught to wait for things.
CHARITY: Raise a generous child. Sharing time and money allows children to feel grateful for what they have. They are ready to show kindness by age 4. Elementary school children begin to understand the needs of others. Teen volunteers can engage in community service for their school and community. Most college students won’t have spare money, but they can donate their time. It allows them to explore the nonprofit world. Parents should honor their child’s charitable work with the same committment as other achievements in life; but, don’t overpraise their charitable efforts.
ALLOWANCE: It doesn’t matter if you give your elementary school child an allowance, but if you do, don’t make household chores a pre-requisite for receiving the allowance, use the allowance to set spending rules, and give them control of their spending decisions.
WORK: Children need to do unpaid chores and do well in school. Advanced chores such as raking leaves and doing laundry are essential to raising a self-reliant child. Elementary school children want to earn money, in which case the parent decides whether or not to pay the child for special chores. Middle school children are able to earn money. Limit the high school student’s work week to 15 hours; school is more important.
DEBT: Start teaching the basic concepts of debt to pre-school children. Middle school children need to understand the minimum monthly payments of credit card debt and protect themselves from identity theft. High schoolers are interested in car loans and credit cards; prepare them for wise use of credit cards. Parents, don’t buy your child a car or cosign for a car loan! After college, adult children are likely to have student-loan debt, car debt, or credit card debt. Parents should neither dip into their own retirement savings nor cosign for a loan as ways of helping young adults manage debt!
SHOPPING: Children want to buy stuff without limits, so parents need to start setting spending limits on pre-school children and teach the concept of ‘living within your means’. Elementary school children how to avoid being victimized by advertising and peer pressure. Tweens should spend their own money, not their parents’. If a teen prefers to spend for personal items rather than save money, they should learn from mistaken purchases. The ‘money culture’ among college students with different incomes can produce embarassment, resentment, and other strong feelings. Emphasize that college-related expenses are essential and everything else is extra.
SAVING: Parents should not raid their child’s savings. Middle school children should have a supersafe account (e.g., savings account, money market account, or CD). High school students should save for college, it will boost their motivation. Young adults should have an emergency fund and make maximal 401K deposits.
INSURANCE: Insurance is necessary for financial protection against devastating expenses. Most bankruptcies result from unpaid medical bills. Teens should pay for their car insurance and minimize their insurance rate with a good driving record. College students must have health insurance for the rest of their lives.
INVESTING: Don’t postpone the habit of investing in stocks; it’s a good way to protect against inflation. Children should learn the fundamentals and start saving small amounts at a young age. When they are old enough to understand numbers and show an interest in how money ‘grows,’ provide them with numeric examples of compound interest. High schoolers should open a Roth IRA to begin growing money.
COLLEGE: Attending college is the best pathway to earning higher wages compared to entering the workforce with a high school diploma. Middle school is the time to start talking about college and high school is the time to prepare for the college admissions process. High schoolers are advised to save for college; their chores should give way to college prep and testing. Avoid large student loans by chosing a good, inexpensive college and doing a better search for grants and scholarships. There are 3 ways to save for college:
- 529 Savings Plan. the earnings are tax-free for educational purposes and there is no income cap for donations. If your child rejects the plan’s participating schools, then rollover the savings to another education account, change the beneficiary to another child, or withdraw the savings with penalties.
- Coverdell Account. the earnings are tax-free for educational purposes, but the annual contribution is limited to $2,000 when a married couple earns less than $220,000 annually. The savings can be used for elementary school and high school educational purposes.
- Custodial accounts are available at banks and mutual funds. If the child’s earnings exceed $1,050, they are taxed at the child’s tax rate for the next $1,050, then at the parent’s tax rate for higher amounts until age 19 (age 24 for full time students). Colleges count the account balance as the child’s asset and expect 20% of the balance to go toward college expenses. That means less aid for the family.
The college student’s priorities are studies, a paying job [working students feel more invested in their education!], and employment after college. Does your college graduate want to start a career or go to grad school? Parents, don’t jeopardize your financial security to pay for their grad school.
the author’s curriculum and activities for pre-school children
EXPLAIN PATIENCE. Patience, trust, and generosity are personal traits that facilitate financial success; pre-school training should help develop those traits. Impulse buying reduces funds for tomorrow’s purchase! Always consider tomorrow’s purchases before buying on impulse.
Teach your children to perservere. Explain that you can’t always get what you want! Advise them to be patient (‘self control’) and wait for something.
EXPLAIN WORK. Instill a work ethic; chores are a part of life. Explain how you work to earn money Convey the idea that a job is a source of pride and dignity
EXPLAIN SHOPPING. Explain that you have to pay for things in cash (money, check) or card (debit, credit); the credit card is one way to pay (at the risk of incurring debt!). Teach them to distrust advertising! Explain how ads are produced with actors, scripts, colors, etc. Explain the risks of materialism
DISCUSS CHARITY. Be respectful of families with different levels of household income by explaining that “some people have plenty and others not enough”. Help bring your child closer to people of need by avoiding the terms “poor” and “rich” when discussing family wealth.
Worthy causes? Maybe your child needs guidance. What would they like to change in the world? Who would they like to help?
DESCRIBE THE HISTORY OF INSURANCE. Ancient shipowners created a fund to pay for losses from shipwrecks. Their bookkeeper became the insurance company.
INTRODUCE INVESTING. The basic concept of investing is to spend time and effort to produce something good (e.g., turning flour into bread).
PRACTICE PATIENCE. Encourage them against skipping to the head of the line. Discuss a communal effort (e.g., family savings pot) to save for a family reward (pizza, water park, etc.)
LEARN ABOUT WORK. Perform household chores. Discuss the jobs of people you know.
DISCUSS CHARITY. Consider these charities: heifer.org , nokidhungry.org , kaboom.org , nature.org , pencilsofpromise.org , donorschoose.org.
general goals after pre-school
ELEMENTARY SCHOOL. Continue the development of personal traits by adding an adult perspective on respect for other people. School children need to start managing their money and protecting it. They are vulnerable to harmful attack from many directions, including identity theft from their online accounts. Give parental guidance.
MIDDLE SCHOOL. Tweens are vulnerable to marketing campaigns, overspending, and credit card debt. Give parental guidance.
HIGH SCHOOL. Reduce the time spent on household chores. The teen’s main job is graduating from high school with a good education. Teen’s also need to prepare for higher education or entering the workforce. Give parental guidance.
Kobliner’s book contains credible advice for the homeshooling of children in financial matters. There is much more information in her book than I’ve been able to summarize in this article. Be sure to visit her web site, “Money as You Grow”, for additional help and perspective (https://www.consumerfinance.gov/consumer-tools/money-as-you-grow/.
The stock market lists several thousand stocks which have a variety of prices in relation to company profits. Company managers decide how they will use the profits to either pay dividends to shareholders or retain the earnings to build shareholders’ equity (ref. 1). The retained earnings may be used in ways that ultimately raise or lower the market price of the stock. Consequently, bankers and brokers pay attention to quarterly reports of the company profits measured as earnings per share (EPS).
Investors want to know whether the stock is priced too high (“overvalued”) or too low (“undervalued”) compared to the EPS. Professional analysts assist investors by preparing the PE, PEG, and PEGY valuation ratios.
- PE standardizes the market value of a stock for ease of comparison with other stocks.
- PEG refines the valuation of stocks by adjusting PE to the growth rate of company earnings. PE is in equilibrium with the growth of earnings at PEG = 1.
- PEGY adjusts PEG to stocks with high yields of dividends.
PE is the ratio of stock price (P) to company earnings (E). Formula 1 is used to calculate the PE (ref. 1,2):
PE = P / E, formula 1
P is the price per share and E is the EPS accumulated over a 12-month period. For more information, please see notes at the end of this article.
example: if one share of stock is priced at $50 and the company’s annual EPS is $5, then 50/5 equals 10/1. The PE is 10.
The timing of company earnings determines whether the PE is labeled as “trailing” or “forward”.
Trailing PE is the current price per share divided by the EPS accumulated from the past 12 months or past 4 quarters. Trailing PE is based on known quantities. Forward PE is the current price divided by the accumulated EPS expected for the next 12 months or next 4 quarters. Forward PE is an uncertain forecast of future market value based on the management’s or analyst’s expectation the EPS for the next 12 months.
PE represents the market value of all shareholders’ claims to $1 of annual EPS, past or future. The market value is judged to be high (“overvalued”) or low (“undervalued”) compared to an arbitrary estimation of fair value. There are several ways of determining a fair value.
- Compare the stock’s PE to an average PE of the industry, market, or historical record (ref. 3).
- Normalize the PE to the company’s rate of earnings growth, which generates the PEG ratio. By convention, the PE is fairly valued when PEG = 1 (ref 5,6).
- The least practical method is a comparison to some theoretical PE that is not readily available to most investors (ref 1,4).
PEG is the ratio of PE to G (ref. 1,7,8; formula 2):
PEG = PE / G, formula 2
G is the compound annual growth rate of EPS over a time period of 3-5 years, perhaps even longer in special cases. For more information, please see endnotes.
example: if one share of stock is priced at $50 with an annual EPS of $5 and a 10% compound annual growth rate of EPS, then 50/5/10 equals 1.00. The PEG is 1.00.
PEG measures the market value of a stock relative to the company’s rate of earnings growth (ref. 7,8). The theoretical equilibrium between market value and the rate of EPS growth occurs at PEG = 1.0. PEGs below 1.0 suggest undervaluation and those above 1.0 suggest overvaluation (ref. 9).
Trailing- and Forward PEGs represent the stock’s market value relative to past and future eras (ref. 7,8). Trailing PEG is a factual measurement of market value provided that the EPS was measured during the past year and the EPS growth rate occurred during the past several years. Forward PEG is an uncertain prediction of market value based on the company’s expected earnings for next year and an analyst’s forecast of earnings growth for the next several years.
examples: when the forward PEG is above 1.0, the market expectation of growth exceeds consensus estimates and the stock is overvalued (ref. 8). If PEG is below 1.0, the stock is undervalued (ref. 2,7).
Limitations of PEG (ref. 3,8):
- The EPS growth forecast may be invalid.
- Another variable besides PEG could add or subtract value to the investment. For example, PEG ignores the value of a cash-rich company.
- An overvalued company, for example one with a PEG of 3.0, might still be a stable investment despite its low rate of earnings growth.
- PEG is best suited for stocks that don’t pay dividends; otherwise, calculate the PEGY.
Some investors prefer high-yield ‘value’ stocks rather than low-yield ‘growth’ stocks. High yield stocks typically pay higher dividends at lower EPS growth rates (e.g., the stocks of utility companies). PEGY includes dividends in its valuation ratio for high-yield stocks (ref. 8; formula 3).
PEGY = PE / (G+Y), formula 3
Y is the stock’s dividend yield. Dividend yield is the ratio of the annual dividend per share to the price per share.
example: if one share of stock is priced at $50, the annual EPS is $5, the compound annual growth rate of EPS is 8%, and the dividend yield is 5%, then what are PEG and PEGY?
PEG = 50/5/8 = 1.25. PE is overvalued if the high dividend is excluded.
PEGY = 50/5/(8+5) = 0.77. PE is undervalued if the high dividend is included.
Besides measuring market value, the PE and PEG also predict the stock’s payback period. A payback period is the amount of time needed for the accumulation of company earnings to match the original amount of investment. If all accumulated earnings were paid to investors, which is unlikely, the payout would provide a 100% return. Longer payback periods represent riskier investments, especially when the company is still establishing its market position or competing with innovative companies (ref. 9,10,11).
The PE ratio also represents a payback period measured in years.
example: if a stock is priced at $50 per share and the EPS is $5 per share every year, then $50/share divided by $5/share/year equals the payback period of 10 years. The same units of $/share cancel each other in the numerator and denominator.
The PE payback period is the time needed for an accumulated EPS to equal the original share price, assuming the EPS remains constant during the accumulation period. Most companies don’t repeat the same EPS every year.
The PEG payback period accounts for the desired phenomenon of EPS growth. The PEG payback period is the number of years that the growth of earnings accumulates enough value to match the original investment (ref. 9,10).
example: if a stock is priced at $50 per share, the EPS is $5 per share, and the EPS growth rate is 10%, it would take 7 years for the EPS to accumulate a value of the original stock price of $50. The PEG payback (7 years) is earlier than the PE payback (10 years) due to the 10% rate of earnings growth.
Company earnings are a strong determinant of stock value. PE, PEG, and PEGY ratios represent the stock market’s valuation of company earnings. Don’t rely solely on company earnings to judge the investment value of stocks. Also assess the business performance and company value (ref. 2,6).
Formula 1: PE = P / E
- P is the current auction price for a share of common stock listed in the stock market. The auction price fluctuates often depending on when a trading order is filled at an agreeable price between buyer and seller. Analysts typically use the closing price of the latest trading day to calculate the PE.
- E is one year’s accumulation of the company’s earnings per share of common stock [EPS]. EPS represents the company’s net income divided by its outstanding shares and fluctuates at quarterly intervals. Any guaranteed payments of dividends to shares of preferred stock automatically reduce the EPS before calculation of the PE. EPS depends on the analyst’s choice between GAAP- and non-GAAP earnings and choice between basic and diluted outstanding shares.
Formula 2: PEG = PE / G
- PEG fluctuates with frequent changes of PE and infrequent changes of G.
- G is the EPS growth rate, which is the compound annual growth rate of EPS for a time period of at least several years. Although G is measured as a percentage change of EPS per year, the common practice is to ignore the units of measurement when calculating PEG.
- Trailing PEG is the trailing PE divided by the G for past earnings.
- Forward PEG is the forward PE divided by the G for future earnings.
1. How to Find P/E and PEG Ratios, by Thomas Smith, Investopedia LLC. http://www.investopedia.com/articles/fundamental-analysis/09/price-to-earnings-and-growth-ratios.asp?lgl=v-table
2. How to use the PE Ratio and PEG to tell a stock’s future, by the Investopedia Staff, updated March 17, 2016. http://www.investopedia.com/articles/00/092200.asp
3. What is the PEG Ratio? https://www.fool.com/knowledge-center/peg-ratio.aspx
4. Aswath Damodaran, Intrinsic Valuation in a Relative Value World. http://people.stern.nyu.edu/adamodar/pdfiles/country/relvalFMA.pdf .
5. PEG Ratio; From Wikipedia, the free encyclopedia. pages 6-7. https://en.wikipedia.org/wiki/PEG_ratio
6. How useful is the PEG Ratio? Joseph Khattab, April 6, 2006. The Motley Fool. https://www.fool.com/investing/value/2006/04/06/how-useful-is-the-peg-ratio.aspx
7. Price/Earnings to Growth- PEG Ratio. Investopedia LLC. http://www.investopedia.com/terms/p/pegratio.asp
8. PEG Ratios Nail Down Value Stocks, by Ryan Barnes, 11/24/2015. Investopedia LLC. http://www.investopedia.com/articles/analyst/043002.asp?lgl=v-table
9. Double your dollars. Selena Maranjian, September 7, 2010. The Motley Fool. https://www.fool.com/investing/value/2010/09/07/double-your-dollars.aspx
10. Payback period = double your money. Course 304: PEG and Payback Periods. Morningstar, 2015. http://news.morningstar.com/classroom2/course.asp?docId=3066&page=2&CN=C
11. The longer the payback period, the greater the risk. Course 304: PEG and Payback Periods. Morningstar, 2015. http://news.morningstar.com/classroom2/course.asp?docId=3066&page=3&CN=C
Copyright © 2017 Douglas R. Knight
Physics needs math, so does Finance. Then no wonder some curious physicists began to create math models of financial markets in the 19th Century, only to find the task more difficult than imagined. Advances during the 20th Century ulitmately generated great wealth among a group of saavy traders known as the “Quants”. Their sophisticated trading models worked for a while until widespread use by firms in ‘Wall Street’ caused the global financial system to collapse in 2008. New models continue to evolve today. This book pays tribute to scientists who tackled the problem of modeling financial markets.
The evolution of market models
- Bechelier made the first price-distribution model of stock markets. His normal distribution only worked in the Paris Bourse where there was little variation of prices.
- Osborne postulated that returns, not prices, are normally distributed. His model of the ‘random walk hypothesis’ expanded the understanding of price variation.
- Mandelbrot claimed that distributions of financial markets are more variable than previously thought.
- Thorp, Black, and Scholes converted price-distribution models to algorithms for daily trading. Their options pricing model was adapted from Osborne. Black later described the shortcomings in his paper “The holes in Black-Scholes”.
- The Prediction Company of Farmer, Packard, and McGill used black box models to improve the Black-Scholes model. They capitalized on short-term inefficiencies in the market.
- Didier Sornette predicted market catastrophes.
Today’s market models are still imperfect!
Early Probability Theory, 16th-17th centuries
1526: Cardono wrote an unpublished book on the theory of probability based on the odds of dice games. For example, what is the chance of rolling 2 dice for a sum of 10?
- mathematical odds: 3 outcomes in 36 tries, or 1 in 12.
- betting odds: 33 to 3, or 11 to 1. Bet $1 and either lose it or win $11 plus the refunded $1.
1654: Pascal and Fermot established the modern theory of probability based on various gambling games. They realized that probability is a chance, not a certainty. In the 20th century, it was realized that the a probability becomes a certainty when taking an infinite number of chances [Law of Large Numbers].
Random behavior of market prices, 19th-20th centuries
Bacheleier invented mathematical finance in the late 19th century. His graduate thesis applied probability theory to market speculation. In his ‘efficient market’ theory, Bechelier assumed that future prices take a ‘random walk’ within limits that describe the graph of a bell-shaped curve. In other words, stock prices have a normal distribution with a stable average. Bechelier’s ‘random walk’ model spawned 2 books in the 20th century.
- 1947: Samuelson published “Foundations of Economic Analysis”.
- 1964: Paul Cootner published Bechelier’s thesis in “The Random Character of Stock Market Prices”.
1959: An astronomer named Maury Osborne wrote “Brownian motion in the stock market”. Osborne dismissed the idea that stock prices have a normal distribution. Instead, the rate of return was normally distributed. His plot of stock prices was not bell-shaped, but lump-shaped with a long tail to one side. Osborne was first to show the importance of the log-normal distribution of prices to markets.
1960s: Benoit Mandelbrot discovered fractal geometry and adapted the consequences to understanding markets. Mandelbrot’s method described extreme market events.
1965: The issue was whether to analyze stock prices with Osborne’s or Mandelbrot’s method of analysis. Today’s consensus is that rates of return are fat-tailed with an unstable average.
1973: Burton Malkiel adopted Osborne’s work in a book called “A Random Walk Down Wall Street”.
Bachelor, Osborne, and Mandelbrot neither traded nor earned profits; they were academics.
1961: Edward O. Thorp beat the game of Roulette with a successful strategy. He later showed that math models could earn profits from financial markets by operating a hedge fund. Thorp believed that the stock market is the world’s biggest casino. Buying stock is betting that the price will rise and Selling stock is betting that the price will fall. The true price of a stock is where the odds of winning and losing are equal. He devised the ‘delta hedging’ strategy of picking the right mix of warrants and stocks to consistently earn a 20% annual return. The idea was to simultaneously short-sell warrants and buy underlying stocks. The stocks would soften the impact of a bad bet and augment the impact of a good bet.
1967: Thorp co-authored the book, Beat the Market. Jay Regan, a stock broker, partnered with Thorp to create the Princeton-Newport Partners hedge fund.
1969: Fischer Black derived a relationship destined to become the Black-Scholes-Merten model for the pricing of options. Black made quantitative finance an essential part of investment banking.
1991: Physicists James Dayne Farmer and Norman Packard studied nonlinear forecasting. Given a chaotic process such as the financial market, their goal was to predict the next movement of prices.
1991: Farmer, Packard, and McGill formed The Prediction Company with the goal of profiting from Wall Street. They developed black box models of algorithmic trading which often worked for unknown reasons but also suffered unpredictable failures. It is still a mystery how market patterns are corrected.
1997: Didier Sornette, a geophysicist, studied the patterns of complex systems to predict critical events in the physical and social sciences. He filed a patent notice in 9/17/1997 that predicted a market crash the following month. Then he bought far-out-of-the-money Put Options to earn a 400% profit from his prediction.
2008: The economic collapse of 2008 presented an opportunity to change how economists think about the world.
2009: Smolin, Weinstein, and others convened a conference of intellectuals to develop new models of economics. They failed to agree on the problems and solutions.
All of the physicists’ models had successes and failures, but their works represent steps in the evolution of understanding markets. Financial modeling is an evolutionary process in which excellent assumptions can be destroyed by a change in market conditions. The realistic goal is to develop a model that provides a good answer at the moment. Why? One reason is that markets are evolving in response to economic growth, regulations, and innovation. Models ultimately fail!
The life cycle of a successful company progresses through periods of rapid growth, slow growth, no growth, decline, and demise. An adaptable company may endure with successive cycles of renewal, rebirth, and resurgence. This book describes a pathway to success. Finance is a sub-theme; other themes are accounting and management.
A general ledger of all transactions is used to prepare all financial reports and assess the company’s performance. Companies that issue publically traded stock are required to publish 3 financial statements every quarter of the fiscal year. They are:
- Balance sheet
- Income statement
- Cash flow
The Balance sheet is a snapshot of the company’s financial condition at the end of the fiscal period. Items are reported under headings that conform to this equation: Assets = Liabilities + Equity. Assets and Liabilities are subdivided into Current and Long-term transactions. Current transactions are expected to be completed in the next 12 months and indicate the company’s liquidity. Long-term transactions indicate the company’s leverage, plus more. Equity is the company’s net worth. Within this framework, the author explains and discusses items of special relevance to business management.
The Income statment describes business operations during the time period between 2 balance sheet dates. According to rules for accrual accounting, every transaction has an order date and delivery date. Subtotal transactions are grouped under revenues, production, operations, other transactions, and net income. Net income (i.e., company profit) is the bottom line of accrual accounting in the Income statement. Readers of this chapter learn how to evaluate the business and its managers.
More businesses fail due to the lack of cash than the lack of profit. Consequently, it’s important that the Cash Flow statement reports a net cash balance from the net cash flows of operations (CFO), investing (CFI), and finance (CFF). The CFO is derived from Net Income (in the Income statement) by excluding non-cash transactions listed in the Income statement such as depreciation, receivables, pre-paid expenses, inventory, and payables.
Finance and Management
The remaining chapters are devoted to these topics:
- Key performance indicators (KPIs) for evaluating financial statements.
- Cost accounting, the analysis of manufacturing productivity.
- Finance of new projects by previewing the return on investment (ROI), weighted cost of capital (WACC), and internal rate of return (IRR). Never invest in a project that has a negative IRR.
- Breakeven point, to determine such things as the price of a product’s launch and risk assessment.
- Creating a business plan to guide business operations and attract financial resources.
- Annual budget, part of the business plan.
- Financing the company by getting a loan (debt) or selling shares (equity).
The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:
- Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
- Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
- Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.
The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.
ways of setting the stop
The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:
- Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
- Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares. Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].
The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.
Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.
add a limit price (“limit”) for extra protection
A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.
who should worry about an extreme loss?
Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.
Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.
Copyright © 2017 Douglas R. Knight
Selling all or part of a profitable investment is a tough choice to make. On one hand, holding the investment allows time to accumulate a high return, but at the risk of losing profit in the market’s next big decline. On the other hand, selling portions of the investment to ensure a profit today will diminish the future return.
Both choices are easy to illustrate by imagining a stock investment that pays no dividends. Assume there is a consistent growth of stock price and that no additional shares are purchased after the original purchase. The profit is skimmed by selling part of the investment when its market value grows to twice the original purchase. Repeat the process every time the market value doubles until the investment is closed. Chart 1 illustrates the skimming of a $1,000 investment.
After 5 years, the investor could claim a profit of $1,000 on the original $1,000 investment. Then the choices would be to close the investment at $2,000, withdraw only the $1,000 profit and wait for more (green circles), or withdraw nothing and wait for a bigger profit (black squares). The largest profit is made by waiting 20 years.
Chart 2 illustrates the accumulated cash balances of the HOLD and SELL strategies.
After closing the investment in 20 years, the accumulated cash balance would be $16,367 from the HOLD strategy and $5,045 from the SELL strategy.
The accumulated cash balance will vary according to the annual rate of return (appended chart 3), the amount skimmed (appended chart 4), and the payment of dividends (appended chart 5). In every condition, the total profit of the HOLD strategy exceeds the total profit of the SELL strategy.
On the question of whether or not to skim profits, skim if you need cash in the next 5-10 years. Otherwise, don’t sell without reassessing the investment or using a risk management scheme. The question of selling for a loss was excluded from this discussion; that’s a different topic.
Appendix: Tables of cash balances
Charts 3-5 are tables of cash balances that represent profits from an imaginary investment of $1,000. The choices for taking a profit were to HOLD the investment for 20 years before liquidating the account or to SELL profitable portions of the investment. Assume there were no trading fees.
Chart 3 shows that a 15% annual rate of return earned a bigger profit than a 7% annual rate of return. Furthermore, the HOLD strategy earned a larger profit than the SELL strategy at both rates of return.
Chart 4 illustrates the effect of skimming 50%, 100%, or 150% increments of market value.
The HOLD strategy outperformed the SELL strategy. With the SELL strategy, waiting longer to skim bigger profits accumulated a larger cash balance after 20 years. Why? The bigger profits were less frequent, which had the effect of preserving the investment’s principal for longer time periods.
Chart 5 reveals a surprising effect for skimming profits from reinvested dividends.
There were no surprises in the HOLD strategy. Reinvested dividends accumulated the largest cash balance over 20 years. However, reinvested dividends accumulated the lowest cash balances in the SELL strategy. Why? Slightly more shares were sold every 5 years from ‘reinvested dividends’ compared to ‘no dividends’. Yet the same number of shares were sold from ‘cash dividends’ compared to ‘no dividends’. The cash dividends directly augmented the cash balances.
Copyright © 2017 Douglas R. Knight
They need protection from the ‘streets’, a decent eduction, and financial skills.
My SmallTrades portfolio holds stocks and four classes of exchange-traded index funds (ETFs).
The goal is to outperform a reputable benchmark, the Standard & Poors 500 Total Return Index, on a sustained basis. The ETFs are diversified and rebalanced in order to partially offset the losses of a declining market. A small group of stocks are used to boost the investment returns.
In FY2016 the portfolio’s market value increased by 8.3% due to a 9.1% gain in stock value and 8.1% gain in ETF value. Charts 2 and 3 illustrate the nominal (solid lines) and real (dashed lines) growth in unit value for shares of the portfolio, ETF group, stock group, and benchmark. The number of shares for each entity was the initial market value divided by $1 of U.S. currency. Assume that the initial unit value of $1 was a real value unaffected by inflation.
Chart 2 shows the pattern of unit-value growth for the benchmark (black lines) and portfolio (blue lines) since December 31, 2007.
The unit value of both entities declined in year 2008 and began to recover in year 2009. The benchmark (black lines) recovered in year 2011 while the portfolio (blue lines) is still struggling to recover [notes 1,2]. The effect of inflation was to devalue real growth (broken lines) compared to nominal growth (solid lines). The real unit value signifies the purchasing power of the investment. The investment has greater purchasing power than uninvested money when the real unit value exceeds $1.
Chart 3 shows the result of implementing the current investment goal [note 2] with a small group of stocks (red lines) and large group of ETFs (blue lines). In chart 3, the initial unit value was re-calculated on December 31, 2013.
Since 2013 the stock group clearly outperformed the benchmark (black lines) and ETF group. The success of the Stock group is attributed to investing in ‘good’ companies for the long term [note 3].
Chart 4 shows the market sector and market cap diversity of the stock group defined in chart 1.
Several stock trades were made during FY2016 to improve the chance for success.
- Alibaba Group (BABA), for 10% capital gain, to exit the Chinese market.
- Geely Automobile (GELYF), for 14% capital gain, to exit the Chinese market.
- Corning Inc. (GLW) for no gain.
- iRobot Corp. (IRBT) for 10% capital gain.
- ITC Holdings (ITC) for 14% capital gain, due to the stock’s delisting.
- Stericycle (SRCL) for 34% capital loss, to stop further loss.
- Biogen (BIIB), an innovative biotechnology firm.
- Cal-Maine (CALM), a leading producer of shelled eggs.
- Express Scripts Holdings (ESRX), a large mail order pharmacy
- Royal Bank of Canada (RY), a well-capitalized bank.
Chart 5 shows the distribution of asset classes among the ETFs. All asset classes drifted from an allocation plan of 30% stocks, 30% REITs, 20% bonds, and 20% gold [note 4].
The SmallTrades portfolio’s primary strategy for risk management is holding a large group of diversified ETFs that are rebalanced to correct a significant allocation error. In theory, a significant drift of asset classes occurs when one asset class surpasses a 28% allocation error. At the end of FY2016, the existing allocation errors (blue bars) were within 24% error limits (red dashed lines) as illustrated in Chart 6.
Chart 6 reflects the portfolio’s response to an incline in equity markets compared to decline of the bond and gold markets. History has shown that a decline in equity markets tends to be offset by a rise in the bond and gold markets.
Plan for FY2017
The SmallTades portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. I would like to own fewer large cap stocks in favor of small- and mid-cap stocks issued by good companies with potential growth of earnings.
- On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in the Roth account. During 2007-2010 the mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’. Several mistakes led to a big loss: A) after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of that company’s large debt and lost $45,000 during its decline to bankruptcy. B) substantial long term profits from good companies were lost by selling holdings for short term profits. I was trying to earn a quick 30% annual rate of return and immediately re-invest in the next set of winners. It was too difficult to identify the next winners. C) day trading also prevented a 30% return. It was a game of chance that I played without a strategy and I was fortunate to break even. D) a trial of investing in leveraged ETFs resulted in losses due to negative compounding. Leveraged ETFs were very high-risk investments that I made without a sound strategy.
- I abandoned the goal of a 30% annual rate of return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad market ETFs and 20% stocks for the long term.
- ‘Good’ companies attract and retain investors for many years. I search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, participating in investment club discussions, using stock screeners, and attending investor conferences. I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
- Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since I don’t depend on making withdrawals from the SmallTrades Portfolio, I increased my exposure to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.
Copyright © 2017 Douglas R. Knight