The Investment Risk-Return Correlation

Q: Pam asks, “After my portfolio value dropped by 40%, I panicked and pulled out of the stock market. I have $150,000 sitting in my savings account, earning squat. I know I should put it back to work, but with the state of our economy, I don’t know what to do with it. Any thoughts?”

A: If you’re terrified of the volatile economic climate today and would be an insomniac if you were invested in the market, perhaps it’s best to keep it parked until you are emotionally and behaviorally ready to stomach the ride and stick to a strategy. Preserve your capital while you take some time to reassess your goals and risk tolerance, determine an appropriate (perhaps more conservative) asset allocation, and explore various investment strategies to find a good fit for your goals and personality.

First, let’s address the risk-return correlation. In subsequent posts, I’ll tackle the other pieces.

Generally speaking, the goal of an investor is to be compensated for the amount of risk they take. Better yet, the investor seeks out the best risk-adjusted return — I’ll discuss this piece later.

If you are willing to accept high volatility (investment risk) for a high potential return, consider investing in a diversified portfolio of:

  • aggressive growth funds
  • small cap stocks and funds
  • micro-cap stocks and funds
  • foreign company stocks
  • international funds
  • sector funds
  • precious metal funds
  • emerging market funds

If you are willing to accept moderate volatility (investment risk) for a moderate potential return, consider investing in a diversified portfolio of:

  • large cap stocks and funds
  • S&P 500 and Wilshire 5000 index funds
  • convertible bonds
  • high-yield (junk) bond funds

If you are willing to accept low volatility (investment risk) for a low potential return, consider investing in a diversified portfolio of:

  • high quality short and intermediate term municipal and corporate bonds and bond funds
  • US savings bonds
  • Treasury bills and notes
  • fixed annuities
  • money market mutual funds

If you are willing to accept very low volatility (investment risk) for a very low potential return, consider investing in a diversified portfolio of:

  • CD’s (Certificates of Deposit)
  • money market deposit accounts
  • interest-earning checking accounts
  • savings accounts

You Don’t Need A Broker: 9 Keys to Investing Successfully On Your Own

I’m sure there are investment brokers worth their high commissions and fees, but I haven’t experienced one. I burned through five brokers before realizing that no one cares as much about my money and my future as I do. Brokers are salespeople. Naturally, they care more about their bottom line than mine.

Most people I coach don’t realize that they’ve been paying a 5-6% sales commission every time they buy new mutual fund shares because the commission is built into the price, making it difficult for the investor to “see” it. And paying a sales commission has nothing to do with the performance of a fund; you aren’t buying a better fund simply by virtue of paying more for it.

Each year, I’d compare my broker-managed portfolio’s performance with the stock market indexes (Wilshire 5000, S&P 500, Dow Jones Industrial Average, NASDAQ, MSCI EAFE, etc.). I found that despite paying a decent sum to brokers for their expertise, my portfolio usually under-performed the standard index benchmarks. In 1999, I decide that it was worth my time and energy to learn how to manage my own investment portfolio. My efforts have paid off very handsomely. Here’s a down-n-dirty summary of what I’ve learned:

1. Start Today

Start as early as possible to take advantage of the astounding power of compounding growth. By reinvesting the gains you receive from the money you invest, you can double your money in less than eight years assuming a 10% average annual return. Take a look at the following example, then try this calculator to see how much postponing your savings plan could cost you.

Start Now:
Save $10,000 per year for 30 years
@ 10% annual rate of return
= $1,809,434 ending balance

Start Later
Postpone saving for 10 years, then save $10,000 per year for 20 years
@ 10% annual rate of return
= $630,025 ending balance

Cost of waiting = $1,179,409

2. Put Your Investment Contributions on Auto-Pilot

Instruct your bank to automatically transfer at least 10-20% of your gross income to your investment account each month. If you don’t think you can afford to do this then you can’t afford your lifestyle! Get creative, cut expenses elsewhere, and start paying yourself first.

3. Maximize Retirement Account Contributions

How taxes are applied to an investment can make a big difference in the long run. There are tax advantages to retirement accounts which is why (in most cases) you should maximize your contributions to these accounts first, then add to your taxable accounts. Additionally, some employers match your contributions — which equals free money. This calculator compares a normal taxable investment to two common tax advantaged situations: 1) an investment where taxes are deferred until withdrawals are made, and 2) an investment where taxes are paid on money that goes into the account but all withdrawals are tax free.

4. Be Mindful of Fees and Do It Yourself

Invest $10,000 each year and use a broker to place your order and you might pay $575 per year in sales commissions. Alternatively, learn to place investment orders yourself and your commission savings, compounding 10% annually, would be an extra $104,042 in your pocket in 30 years. Invest in a low-cost equity portfolio using no-load mutual funds, Exchange Traded Funds (ETFs) and index funds. Even a small difference in the fees you pay on your investments add up over time. Use this calculator to see how different fees can impact your investment returns.

5. Diversify and Build a Balanced Portfolio

Speculative investments are like eggs: when they fall, they make a mess. Don’t place your bet on a single stock or sector. Spread your risk into a variety of market caps and styles as well as domestic, foreign and emerging markets. Proper diversification helps your portfolio weather any ups and downs the market can take. Asset allocation accounts for 94% of the variation in portfolio returns, while market timing and stock picks account for only 6% (Gary Brinson, Randolph Hood and Gilbert Beebower). Review and rebalance your portfolio annually to maintain your desired allocation percentages. The Asset Allocator calculator is designed to help you create a balanced portfolio of investments. Your age, ability to tolerate risk, and several other factors are used to calculate a desirable mix of stocks, bonds and cash.

6. Don’t Invest Money You Can’t Afford To Lose

Rises and falls in the stock market are normal and frequent. Don’t invest your emergency fund into the stock market because you don’t know when you’ll need to use it. Money you may need within the next few years doesn’t belong in the stock market either. Investing for portfolio growth is your long-term goal.

7. Cover Your Ass

Protect your growing wealth with adequate insurance. The number one cause of bankruptcy is major medical expenses. In addition to medical insurance, consider coverage for disability, life (consider a term policy rather than whole life), auto, homeowner/renter, business, and personal liability. Buy policies with the highest deductible you could afford to cover from your emergency fund — and invest what you save from the reduced rates.

8. Understand Your Assets and Liabilities

Most people consider the home they live in as an asset but the truth is, it’s a liability. And if you are counting on future home appreciation, it’s speculation. Stop thinking of your home as a savings account. Don’t believe the sales-pressure hype that homeownership is your best investment: you’re spending money on a property that isn’t producing income. If you insist on owning real estate as a part of your investment portfolio, buy an investment property that produces a positive monthly cash flow.

If you’re finding it difficult to squeeze your budget for investment contributions, downsize to a smaller home. Invest any remaining home equity, plus your new-found monthly savings, into your long-term-growth portfolio.

9. Don’t Invest Until You Understand

Question every piece of advice you are given through the filter of “what’s in it for them?” Unfortunately, there is no shortage of people who are skilled at separating you from your hard-earned money. It pays to be suspicious. If you aren’t committed to learning how to self-manage your investments, consider hiring a FEE-ONLY financial adviser (rather than a commissioned-sales broker) to assist you.

What I’ve offered today is a summary. I’ve shared my opinions and experiences. But don’t just take my word; ask questions and read investing books and web sites. Learn about different investing strategies and styles, assess your own personal risk tolerance, make a plan, then stick to it. Use your head — not your emotions — to guide your decisions. Practice investing first, using virtual online applications (not real money), as you wean off of your high-commission broker.


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Is The Recession Over? My Gut-Check Impressions on the Future of Our Economy.

I’ve been receiving emails lately from people asking questions like:

“Is the stock market experiencing a true recovery or is this just a bear market rally?”
“Do you think we’ll see a V, W, U or L shaped recovery?”
“Should we expect deflation or inflation?”
“When will my house be worth as much as I paid for it?”
“How should I invest my money? Stocks, bonds, cash, real estate, gold, or foreign currencies?”
“Is the recession really over?”

Some are saying that I’m prescient (have knowledge of events before they take place). As much as I wish this were true, it isn’t, I promise. I got out of real estate and stocks before many others simply because I stopped listening to mainstream and acknowledged the writing that was already plastered on the proverbial wall.

Like many of you, I hear and read convincing forecasts made by a variety of so called experts who support opposing arguments and recommendations. And each time, I try like hell to take a step back and take a gut check. What seems to make the most sense to me? Is there evidence to support it and if so, who or what is the source? What emotion am I feeling and what does this emotion “want” me to think? What is the worst thing that can happen if a particular forecast comes true? How can I reduce the risks associated with various outcomes? And last but not least, what decisions will allow me to sleep well at night?

I’m hesitant to share my recession outcome opinions with others for a few reasons: 1) I don’t want anyone to make decisions based on my guesses, 2) Discussion of possible outcomes often turns to politics — and political discussion tends to get overheated, 3) Some might take perverse joy from pointing to this post in the future, with a wagging finger, telling me how wrong my guesses ended up.

But I’ve decided that I’m as entitled to guesstimate forecasts as anyone else, so here it goes, for nothing more than entertainment value and for exposing my potential bias. Normally I provide hyperlinks to information, statistics and educated opinions that support my writing, but not today. If you want to read the news or hear what the “experts” are saying about this stuff, use Google, turn on the boob tube, crank the radio or grab any newspaper. There is no shortage of opinions thrown about. Please come to your own conclusions.

Here are my gut-check guesstimates on the future of the economy:

I think the stock market will climb a bit more, then retest the March lows. Minus some funky blips, I think we’re in for a long “L” shaped recovery; or really, one that looks more like a long bathtub:

(March ’09)    /\_____________/    (several years later)

Note: The bottom of my tub diagram should have an overall slow gradual curve to it plus a few wicked and jagged up-down points but I don’t know how to illustrate this with my keyboard. My bathtub edges should look taller, too. If it wasn’t so close to my bedtime, I’d draw you a picture instead…

I think we’ll continue to experience deflationary pressure. I think the Fed will continue to “stimulate” the economy but will face an upward battle trying to make it stick. If and when deflation is curbed, measures will be needed to tighten the money supply to prevent hyperinflation. I think these measures will be taken. From what I understand, it is easier to curb inflation than it is to stop a deflationary spiral.

I think housing prices have further to fall in most areas. Besides the probability of an overcorrection, Baby Boomers are beginning to hit retirement age and because much of their net worth in real estate and stocks has been wiped out, they will be downsizing en masse. McMansions will languish on the market or they’ll be repurposed into multi-family or extended-family units. Commercial property will be hit with a sledgehammer.

I think I will continue to stash most of my cash because with deflation, cash is king. When I do buy ETFs (only the ones that are experiencing upward momentum), I will keep tight stop losses in place. I will take a look at the currency market (certainly not my area of expertise) to see whether or not it’s a good fit for me. Overall, during this extremely volatile market, my main focus is capital preservation. This keeps me sleeping as snug as a bug in a rug.

In this economy, I think one of the best places to invest is in one’s own skills and education. I think vocational schools will see an increase in enrollment while universities see a marked decrease.

Entrepreneurs most likely to succeed will be the ones who bootstrap, sell low-priced necessity items, entertainment or services and keep overhead extremely low. Most of them will operate from in-home offices.

Because I think prices will continue to fall, I will continue to put off large purchases.

And finally, as painful as the process is likely to be, I think the Great Recession will ultimately be the Great Shake Up our society and planet needs to get on the financially and ecologically sustainable track. (Wow, that’s a mouthful.)

Okay, now it’s your turn. What do YOU see in your magic crystal ball? Please share your opinions and guesstimates in the comments. Have fun and play nice.

Relevant Post: Hyperinflation or Prolonged Deflation? Coping and Investing Strategies For Either Scenario

How to Make a Million Dollars While Eating Lunch

In response to my last post, Would You Ditch A Car For $1,000,000?, a reader made the comment: “As a grad student in an urban area, I don’t have a car (nor could I afford one) and I use public transit. … I wish there was a “big ticket” item like that that I could easily cut out of my life, but there just isn’t. Instead I try to cut back on small things and aggressively invest for cashflow.”

While savings do accumulate faster when you cut back on the biggest budget-buster categories (housing, transportation, insurance and taxes), the little things do add up. Take for instance:

My Million Dollar Lunch Recipe

  1. Replace your $9.50 restaurant lunches (sandwich, fries, soft drink, sales tax, tip and mileage) with a nutritious $3.00 lunch brought from home.
  2. Deposit your $143 monthly savings ($6.50 daily, 22 working days a month) into a Roth IRA retirement account.
  3. Invest in equities (stocks, mutual funds) at a 10%* annual long-term average rate of return.
  4. Let your account simmer for 41 years.

Recipe Yield = $1,000,837

Serve: During retirement with whipped cream and a cherry on top.

Total deposits = $70,356
Total interest earned = $930,481
Total taxes paid = $0
Total Saved= $1,000,837

Optional Garnishes:

  • Combine with a 20 minute walk to the park for lunch.

    Yield: 1,277,232 calories— enough to keep off (or lose) 365 pounds! (Calculated for a person weighing 140 pounds walking 4mph for 20 minutes (1.33 miles) 5 days a week for 41 years.)

  • Pack a lunch for your spouse.

    Yield: An additional $1,000,837

  • Add a group of supportive friends for lunch to work on the Baby Steps to Financial Freedom together. Yield: Financial freedom – with friends who will have the resources to enjoy it with you!

Isn’t it amazing how much money you can amass by investing small amounts over long periods of time?

Once you think in terms of investing instead of spending, look for ways to duplicate this process in other ways. Consider the following actions:

  • buy staples in bulk and invest your savings

  • invest your employee bonuses

  • invest unexpected financial gifts and inheritances

  • invest your tax refunds

  • buy a term life insurance policy instead of a whole life one and invest your monthly premium savings

  • buy a used car instead of new and invest the difference in price

  • borrow books, movies and music from your local public library and invest your savings

  • save and invest your pocket change

Imagine this: Starting with $0 and depositing $5,000 annually in a Roth IRA account over 41 years (at a 10%* annual rate of return compounded monthly), you will have $3,081,554.

Total deposits = $210,000
Total interest earned = $2,871,554
Total taxes paid = $0
Total Saved= $3,081,554

Choose affordable and cost-effective options and rather than feel deprived, feel excited that you get to invest the difference in yourself and your future.

~ Bon Appetit!


*The actual rate of return is largely dependent on the type of investments you select. From January 1970 to December 2008, the average annual compounded rate of return for the S&P 500, including reinvestment of dividends, was approximately 9.7% (source:

Total savings are calculated in actual dollars (not inflation-adjusted). A common measure of inflation in the U.S. is the Consumer Price Index (CPI), which has a long-term average of 3.1% annually, from 1925 through 2008.

Would You Ditch A Car For $1,000,000 (One Million Dollars)?

A study found that households with 3 or more cars are the single largest group among American car owners. The national average is 2.28 vehicles per household. Obviously, Americans are very much in love with the automobile.

According to the AAA, the average American spends $9,369, excluding loan payments, to drive ONE medium sedan 15,000 a year. In arriving at this estimate, AAA figures in fuel, routine maintenance, tires, insurance, license and registration, loan finance charges and depreciation costs.

22 years ago, my husband and I sold one of our cars to pay for our wedding and honeymoon. We intended to replace the sold vehicle eventually — after we built up our credit score so we could get a car loan — but as time went by, we discovered that sharing one car between the two of us was no big deal. We learned to carpool, drop one another off, take turns, group errands, walk, bike, take the bus, work from an in-home office, go places together. Surprisingly, 22 years later, we still share just one car.

It would be difficult to figure out exactly how much my husband and I have saved over the past 22 years (with the effects of inflation), but it is easy to calculate how much more we can save if we continue to share one vehicle:

If we continue to share one car instead of owning two for the the next 29 years, invest our compounded annual savings and earn an 8%* annual rate of return, we could save an additional one million dollars**.

Would you be willing to ditch a car for a cool million? Let us know in the comments.

*The actual rate of return is largely dependent on the type of investments you select. From January 1970 to December 2008, the average annual compounded rate of return for the S&P 500, including reinvestment of dividends, was approximately 9.7% (source:

**actual value with annual investments adjusted for inflation @ 3.1%*** annually.

***A common measure of inflation in the U.S. is the Consumer Price Index (CPI), which has a long-term average of 3.1% annually, from 1925 through 2008.

Hyperinflation or Prolonged Deflation? Coping and Investing Strategies For Either Scenario

Rebecca commented:

I enjoy these posts – thanks for adding a voice of reason given the vast propensity to imagine the solution to the problem is doing more of the thing that caused the problem. We’ve collectively been telling ourselves the same stories so long it’s hard to ram home still that they *are* just stories; it’s good to keep hearing stuff like this to remind us. Like Anna, I’d love to read your thoughts on surviving the possibility of heightened inflation over the coming years – its impact on savings and so on. I know you suggested in a previous post you were concerned with this matter. Any thoughts?

Many fear hyperinflation, but after digging into the topic, I don’t think it’s as likely a scenario as prolonged deflation. From what I’ve been hearing, talk of hyperinflation might be driven more by politics than economics.

We are experiencing deflation right now. Using the 12-month change in the Consumer Price Index as the measure, inflation has been negative for three consecutive months. I think the more likely scenario will be like Japan: low inflation, low interest rates, and falling house prices for at least a couple more years.

… Japan, during what came to be known as its “lost decade.” A gigantic real-estate boom in the 1980’s came crashing down in 1991, bringing many other prices with it. Efforts to restart the economy foundered time and again, as businesses were not able to generate the kind of profits that would reignite prosperity’s cycle of hiring and spending. Not until 2005 was the deflationary era finally declared to be over. ~ New York Times

Because I’ve been sitting on a considerable sum of cash since I made my exit from the stock market during the first half of 2008, I’ve been mulling over this topic. I’m still trying to wrap my head around the implications of hyperinflation and prolonged deflation. I am not an economist, so please take my thoughts and opinions with a grain of salt. In other words, this post is not investment advice; just my best guess and opinion.

During deflation, debt is the enemy. Deflation is better for those with savings accounts because it increases the value of the money they have saved. Deflation rewards people like me (with cash) and retired seniors (who no longer need to worry about rising unemployment rates and would benefit from living cost containment).

During hyperinflation, the last place one wants to be is in cash. Inflation is better for those who owe money because it reduces the value of the money previously borrowed. Inflation is better for those in debt — including the US Government. So naturally, the Fed wants to create and maintain a moderate, steady rate of inflation.

Many people worry that the amount of money the Fed is spending to stimulate the economy will create hyperinflation. I think these fears are unfounded, at least for now. Last I heard, the Fed created about a trillion dollars, which sounds enormous, but is actually small when compared to the approximately $10 trillion drop in housing values and ~$10 trillion drop in stock market capitalization.

The Fed realizes they need to be careful — if they dilute the economy with too many dollars, they risk creating hyperinflation. Hyperinflation would be tough on everyone, including the Government, because foreigners would stop lending money to the US — unless they were sufficiently rewarded for taking on the heightened risk of investing in dollars.

Compensating foreign investors for taking on inflation risk means raising interest rates. But increasing interest rates would push homebuyers and homeowners with adjustable mortgages right over the edge. Mortgage rates have increased recently and if they keep increasing, we should see home prices fall further. Prices fall as interest rates rise, because a given monthly payment covers a smaller mortgage at a higher interest rate. Collapsing property values simply are not synonymous with hyperinflation.

According to this recent article in the New York Times:

For the short term, investment experts agree, deflation is more probable, with unemployment still climbing and the economy still mired in a recession. There’s talk of green shoots, but most everyone agrees that an earnest recovery is a long way off.

No one knows for sure what is more likely to occur: prolonged deflation or hyperinflation; or when the economy might change course. So how can we prepare for either scenario?

If you think hyperinflation is likely, you could invest in:

  • shorter-term fixed-income investments
  • TIPS (Treasury Inflation-Protected Securities)
  • foreign stocks and currency
  • real estate, REITS (real estate investment trusts)
  • commodities
  • precious metals
  • gold

During hyperinflation, the last place one wants to be is in cash.

If you think deflation is likely, you could:

  • raise and hoard your cash.
  • live below your means.
  • put off big purchases until prices drop more. You are, in essence, actively making money just by not losing it.
  • rent a home rather than own because home prices, like other hard assets, will continue to drop in value during deflationary times.
  • de-leverage yourself: pay off your credit debt as soon as possible — and don’t start building it up again. You don’t want your debt to expand at the same time dollars are becoming more valuable!
  • invest in dividend paying stocks. But it can be tricky to find a secure dividend paying stock in a deflationary environment.
  • play the currency market (certainly not my area of expertise).
  • play the short side using things like inverse index funds that move in the opposite direction of the market. Caution: While there are possibilities for making huge returns in this market, the rallies in a bear market can whomp you. Your timing must be precise.
  • build a CD ladder. The longer the duration the more risk there is, but at least your principal is protected.
  • invest in yourself and your education. Staying employed in such a downturn is the most important thing.

During deflation, debt is the enemy.

What am I doing? What do I plan to do?

Over the course of the past few years, I have positioned myself as best I can for the current economic deflation: I sold my home, paid off all of our debt, pulled out of equities and hoarded cash.  Today I am in a wait-and-see holding pattern and once deflation is curbed, I am in a great position to change course accordingly: I have cash ready to buy the hard assets (when they are cheap) that will help me weather inflation.

What about you? Do you think prolonged deflation or looming hyperinflation is more likely? Why?

Will the Great Recession Trigger the End of Buy-and-Hold Investing?

More specifically, does the commonly given investing advice to “buy and hold” really work?  Or have the rules changed?

During the past several decades, the prevailing advice has been something like this:

“Diversify your investments, buy stock in good companies, and hold them until you retire. The value of stocks (and real estate) always go up over time.”

Sure they do… until they don’t.

People who steadfastly held onto their stock portfolio from peak (10/9/07 DJIA at 14,164) to most recent trough (3/9/09 DJIA at 6,547) saw almost 54% of their portfolio vanish.

In just 17 months, over 12 YEARS of DJIA gain disappeared. (DJIA closed at 6528 on 11/26/96.)

Buy-and-hold investors would need to see a gain of more than 116% to bring their portfolio back to the 10/9/07 DJIA peak (14,164) from the latest DJIA valley (6,547).

Of course, those who diversified among various asset classes and markets will come up with different numbers, but this is a global recession. Diversification helps very little when everything is falling. There have been very few places to hide, much less make a profit.

It really bothered me to hear financial advisers and personal finance bloggers recommend people stay the course and hold onto their stocks — and even buy more — as prices were falling. While real estate and the markets generally do rise over the long term, that is not much consolation if your retirement is near. Buy-and-hold investing has put those who are retired, or are close to retirement, in a huge pickle because they don’t have time on their side to recoup such giant losses.

I’m lucky that I don’t buy into the buy-and-hold hype. I used to, though, and I paid the price. Remember, no one, not even your investment adviser, cares as much about your money than YOU do.

During the first six months of 2008, I incrementally moved most of our stock portfolio to the safety of FDIC-insured cash accounts, limiting our losses to less than half as much as the buy-and-hold-ers have suffered. I follow momentum trends in the market, and as the trends were heading downwards, I got out and headed for safety. Buy-and-hold investors use a passive strategy;  I limit my losses by actively and systematically managing our portfolio. I invest to make money, not to sit back and watch as it all disappears.

Before the Great Recession, I was able to profit by keeping my portfolio 100% invested. This has been the first time I’ve ever held cash in our long-term portfolio. Up until this Great Recession, there were always some sectors and markets trending upwards, even as others were tanking. Momentum trend investing kept my money working for me, moving to the new market leaders as they emerged.

The investing strategy I use assigns a score to no-load mutual funds based on their 1, 3, 6 and 12 month returns. I will remain parked in cash until markets show consistent upward momentum trends, triggering the scoring system to indicate positive numbers again. Then I will move my cash incrementally and systematically into equities.

If you’ve made it this far into my article, kudos! I know that investing jargon can be hard to wrap your head around. To help explain — and review — how I choose to invest, in a fun, story kind of way, please read a reprint of an article I wrote on my old blog in March 2008, when I was in the process of moving out of equities and into cash:

How I Make Money Following the Herd: The Trend is My Friend



(photo by p.joran)

A couple of days ago (Ed: this would have been in March 2008), I ranted about the financial herd behavior that created the unsustainable housing market bubble. But today, I have a confession to make that might make me sound like a hypocrite. Allow me to explain by way of comparison with one of my previous hobbies.

When we lived on a small hobby farm, I participated in stock-dog herding trials. Did you ever see the movie, Babe? Yep, me and my faithful Border Collie moved a flock of sheep across fields, around fences, and into small pens. We often competed in shows to demonstrate our skill and teamwork.


As long as my dog and I kept the flock of sheep moving together as one unit, we could herd them anywhere. Their desire to stay together was intense. Though we never tried it, of course, we probably could have moved them straight off the edge of a cliff — as long as the flock did it together.

The investment strategy that I’ve been using for the last several years involves following the same “herd” that often drives me nuts. Yep, I purposely join the very same herd that creates unsustainable and irrational market bubbles.

But here’s the critical difference — I bail out of the herd when they start flinging themselves off the cliff.

At first glance, this might sound like market timing. And we know how difficult it is to time the market successfully. I don’t have the time nor desire to be a day-trader, either. So what is the difference between market timing and the investment strategy I use?

Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements.”

So I’m not a market-timer because I don’t aim to forecast the market. I look at what the market is doing, not what the market might do. I enter the market after a trend properly establishes itself. I jump on the trend and ride with it. (Baa… Baa… Baa!) If there is a persistent turn contrary to the trend, I follow a mathematical signal and exit that trend.

I’ll explain this by returning back to my sheep herding analogy:

I join the already formed flock after it’s developed direction and momentum. I follow the flock as it heads towards greener pastures. I watch the front of the flock. If the leaders of the flock start to stampede off a cliff, I bail out and take a different direction. I look for another forward-moving flock to follow.

I don’t think momentum investing is in vogue with the majority of individual investors. If I had to guess what is most popular, I’d say it’s the passive strategy of buy-and-hold index investing. I am a previous buy-and-hold index fund investor myself. There is nothing “wrong” with this strategy. After all, the long-term trend (note the word “trend” again) of holding the total market is up. A buy-and-hold-index portfolio is easy to manage, enjoys low expenses, and often saves on taxes.

Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices…”Following” is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then “follow” it.

Van K. Tharp, author of Trade Your Way to Financial Freedom

Momentum investing is different than buy-and-hold because it exploits investor herding behavior. As a previous shepherd, I intuitively understand this concept. Rather than buy-and-hold the total market through all of its peaks and valleys, I baa-baa-baa my way to the bank.

The ultimate goal of investing is often touted as buy low and sell high. Some would argue that today’s market provides an excellent time to buy while share prices are comparatively low; and that selling now could be locking in losses.

Conversely, by following a momentum strategy, I aim to buy as shares move up and sell them when even higher.

Richard Driehaus, the founder of Driehaus Capital Management, Inc., is widely considered the father of momentum investing. This Chicago money manager takes exception with the old stock market adage of buying low and selling high. According to him, “far more money is made buying high and selling at even higher prices.

Momentum investing, Wikipedia

Richard Farleigh, author of Taming the Lion, showed that markets continued in an existing direction around 55% of the time and reversed themselves the other 45%.

Similarly, Dal Company (NoLoad FundX) states that “Upgrading outperforms the market, as measured by the S&P 500, only about 55% of the time when measured on a monthly basis. But we end up far ahead in the long run because when we outperform, we do so by a larger measure than when we underperform.”

Now that might not sound like much, but for an investor 10pc represents a massive advantage. If you get 55pc of your calls right and manage your portfolio properly by riding winners and cutting losers you will make a lot of money.

So what does this mean for the investor? First, it argues against contrarian investing, which says you should look for opportunities where the market has overshot one way or the other. If prices move with the trend more than half the time, you start your search with an immediate handicap.

…stick with your winners. Trends go on for a lot longer than you might expect.

Tom Stevenson, Telegraph Media Group Limited

In other words, momentum investing entails buying winners and selling losers!


(photo by ianlord)

What does the “flock” indicate about today’s market conditions? How am I responding with my own investment portfolio?

In sheep herding terms: When a Border Collie puts too much pressure on the flock by moving too quickly or too erratically, the flock panics and sheep scatter everywhere. Sometimes individual sheep get hurt in the mayhem.


Investing: Wall Street shows the market swinging wildly up one day, wildly down the next, back and forth. Investors are feeling too much pressure. Panic is prevalent and money is scattering here, there and everywhere.

In sheep herding terms: When sheep scatter, the shepherd instructs the dog to stop dead in their tracks for a moment to allow the sheep to get over their panic and drift together to form an orderly flock once again.


Investing: Market trends have all but disappeared at the moment and little seems to “stick”. By halting my investing temporarily, I’m waiting for investors to stop their panicked scatter, calm down, and form identifiable trends once again.

In sheep herding terms: When the flock is calm and moving together again, the shepherd instructs the dog to get up and move forward.


Investing: When investors and the market have calmed down, stabilized, and show cohesive movement in identifiable sectors, I will resume my momentum investing by following the new market leaders.

How do I control risk?

I’m diversified. I invest in mutual funds and ETFs. I limit any one mutual fund or ETF holding to a maximum of 10% each (5% max. in more speculative sectors).

I’m systematic. I have predetermined entry and exit marks that help to keep me from reacting emotionally. I limit my upgrading to once or twice per month.

I cut my losses. During periods of high market volatility, I reduce my exposure to the market by cutting back on my positions. My objective is to preserve capital until more positive price trends reappear.

Disclaimer: My investment strategy and portfolio allocations are not right for everyone and should not be construed as advice. If you’re not sure how much risk to take, or whether your investments accurately reflect your life goals or appropriate timeframe, get some individualized help. Many 401(k) providers have investment professionals available to talk to participants about their allocations. Or consider talking with a fee-only financial planner. You can find one online at the web site of the National Association of Personal Financial Advisors, or the Garrett Planning Network, a group of advisors who charge by the hour.