Friday, October 28, 2011

Buy Low, Sell High

This is traditional stock market wisdom.  The hard part, of course, is figuring out when a stock is low and when it is high.  If you buy a stock and then then the market drops 10%, you may wait a long time for it to recover.  This is why day traders (and even week traders) have to have guts of iron.

I did a bit of day trading back in the 1990s, trading 500 and 1000 share blocks of DSC stock, at a time when computer program trading meant the stock was doing rather dramatic, and somewhat predictable movements up and down, like a drunken sine wave.  I stopped doing it because short-term capital gains on these stocks, in combination with being a highly paid, highly taxed professional, meant that almost half the gain went to federal and state income taxes.  The risk was substantial, and gaining $3000 on a trade meant keeping about $1800 of it.  It only took a few missteps to wipe out most of that gain for the year.

I have long been intrigued by how equity prices and bond prices have a little counterpoint dance: a rising economy lifts stock prices, but also (usually) interest rates.  When interest rates rise, the value of existing bonds drops.  (Think about it for a moment, and this is completely logical: a bond pays a certain fixed interest rate for the rest of its life.  If you can buy recently issued bonds at a higher interest rate, existing instruments with the lower yield will be less desirable.)

In theory, you could buy stocks when the market is down, sell them when the market is up, and use the proceeds to buy bonds.  When the market drops, usually the interest rates fall, and the value of the bonds goes up.  Sell the bonds, and buy stocks.  There are mutual funds that do this, and because they are buying and selling hundreds of thousands of shares of stock and millions of dollars worth bonds at a time, they get some economies of scale that left them make a profit on even tiny market movements.

Individual investors are not so fortunate on the economies of scale.  Even worse--what if you make a mistake about the market bottom?  You buy a stock at $24, and instead of the market recovering, it drops a lot more.  You do not want to sell that stock at $21, but you also do not want to hold it indefinitely, producing little or no income.  At least if you buy bonds at the wrong time, you are earning interest from those bonds, while you wait for the next stock market drop to increase bond prices.

I am beginning to think that these preferred stocks with high yields may be a partial solution to this problem.  If you buy a stock with a 7% dividend (and that describes many of the preferred stocks, such as some of those that I bought recently) and you have misjudged whether the market has reached bottom or not, you are at least getting a return on your investment while waiting for the stock price to rise again.

By the way, yesterday was a great day for up.  I gained as much in my 401k and Schwab portfolio as I normally make at my day job in six months.

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