Dateline: 07/02/99
Which would you rather invest in? A stock that steadily gains 12% a year with little fluctuation? Or a stock that is steadily declining but with wild fluctuations in price? Most of us would probably go for the slow but steady stock. But, in fact, if the fluctuations are predictable, you can make a lot more money by actively trading the second one.
Suppose, for example, there are two stocks whose prices move as shown. But with Stock B we are able to pick the tops and bottoms and trade accordingly. The two rightmost columns show the trades.
| Date | Stock A | Stock B | Trades With B | Value of B or Cash |
| Jan. 1 | $10.00 | $10 | Buy 100 shares | $1000 |
| Jan. 31 | $10.10 | $12 | Sell 100 shares | $1200 |
| Feb. 28 | $10.20 | $6 | Buy 200 shares | $1200 |
| Mar. 31 | $10.30 | $11 | Sell 200 Shares | $2200 |
| Apr. 30 | $10.40 | $5 | Buy 440 Shares | $2200 |
| May 31 | $10.50 | $10 | Sell 440 Shares | $4400 |
| June 30 | $10.60 | $4 | Buy 1100 Shares | $4400 |
| July 31 | $10.70 | $9 | Sell 1100 Shares | $9900 |
| August 31 | $10.80 | $3 | Buy 3300 Shares | $9900 |
| Sept. 30 | $10.90 | $8 | Sell 3300 Shares | $26,400 |
| Oct. 31 | $11.00 | $2 | Buy 13,200 Shares | $26,400 |
| Nov. 30 | $11.10 | $7 | Sell 13,200 Shares | $92,400 |
| Dec. 31 | $11.20 | $1 | Buy 92,400 Shares | $92,400 |
Now, of course, I've deliberately picked prices to make a point. You're not likely to find a stock that fluctuates with the consistency of Stock B here. But let's make that point.
$1000 invested in each stock at the beginning of the year and held to the end of the year would net a return of 12% on Stock A and a loss of 90% on Stock B. But accurately trading Stock B, even though it is in steady decline, nets a whopping 824% return on your investment.
Well, so what. Who can accurately predict the tops and bottoms of a stock anyway? And there, of course, is the rub.
There are two distinct investment philosophies. One is value investing. Pick good quality stocks and hold them for the long term. But even value investor par excellence Warren Buffett sometimes sells some of his holdings. Value investors like Buffett look for undervalued stocks and hold them for the long term, but have no qualms about selling them if they become fundamentally over-valued.
The other school says that one can make greater gains by actively trading stocks. Speculators hold to this philosophy. Chris Bunka, in his book The Outsiders Guide to Speculative Stocks, makes the point that "most speculative stocks will never be successful". So why invest in them? Bunka explains that by understanding speculative stocks you can successfully trade them.
As noted in my review of the book here in March, speculative stocks have a definite life cycle, and if you can understand where the stock is in the cycle, you can trade accordingly. The cycle can last several years and does not fluctuate with any of the frequency or volatility of my example, so some patience is required.
In practice, a speculator would get in at the early growth stages of a stock's life cycle and bail out somewhere near the top. Then, rather than waiting for the stock to decline and a new play or life cycle to develop, he would look for another investment.
When I started doing these pages nearly two years ago, I was a big fan of the value investing approach. It's a lot less headache to simply buy a stock and hang on to it rather than worrying about whether you should sell. But while I still think a value approach should comprise the bulk of your investing, I also think there is some room for speculative investing. It's a lot of fun to boot.
There are other trading approaches besides Bunka's. There are technical analysts who try and understand where a stock is going by charting its history and seeing whether the stock stays within certain parameters. These methods use such things as Bollinger Bands, moving averages and resistance points to make trading decisions.
Then there is momentum analysis. Traders using this method look for stocks that have developed momentum and sell when the momentum has dissipated.
But I have noticed that even value stocks fluctuate in price. A stock like Microsoft, Nortel Networks, TD Bank or BCE Enterprises can and does have its price fluctuations. What if we could combine a value approach to investing with a trading strategy to take advantage of price fluctuations? Or even better yet, a value play in a volatile sector like gold? Barrick Gold, for example is a solid blue chip company with an excellent track record. (See my discussion of Barrick here in May) But because of the volatility of gold the mineral, Barrick often fluctuates even though it uses a hedging program and does not sell any gold at market prices.
Venturing into this area may be a potentially profitable area, but how you decide on when to buy and sell is of key importance. Pat McKeough of The Successful Investor warns that using sell signals generated by computer programs or some notion of over-valuation based on high conventional indicators such as P/E ratio can lead to disaster. Not disaster on the downside, but disaster by missing out on the upside.
"In my experience," he writes, "this approach may lead you to sell stocks that are headed for a sluggish periods. But it will also spur you to sell stocks that are headed much higher. It's about equally effective in helping you sidestep 10% to 20% losses and 300% profits". (The Successful Investor - June 1999) A sobering thought!
Next week I will chart two or more of these stocks over the past year and see how they have fluctuated and whether we can develop a trading strategy based on the study. I have no idea how it will turn out as I haven't done it yet. I'm hoping to find a formula for buying and selling in and out of the same stock several times over the year, but I may find that it is easier said than done. Stay tuned!
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Value Investing Net Links - My collection of links to websites about value investing.
Small & Microcap Investing - My collection of links to websites focusing on small and microcap stocks.
High Tech Links - My collection of High Tech Links at Investing: Canada.
Canadian Internet Stock Average - my charts of Canadian Internet stocks and how they have fared since January First.
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06/23/99 - Consumer
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06/21/99 - Introducing
Our Mutual Fund Database of Key Links
Here's a handy guide to our newest feature
at Investing: Canada.
Canadian Mutual Fund Database - A database of mutual funds with links to a variety of sites offering relevant information on each. This index is a work in progress and will be revised and changed continuously. Recently updated to include 32 companies.
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