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The Big Idea
It worked once again during the market decline that began in 2008. In The Seven Rules of Wall Street, Sam Stovall, master investment strategist and expert on stock market history, presents seven familiar sayings that not only convey enduring truths but also serve as superb investment strategies.
In this engaging guide, Stovall subjects his chosen sayings to the facts of history and to his own personal experience. When it comes to building a portfolio, for instance, should you ¡°let your winners ride, but cut your losers short¡±? Absolutely. ¡°On average,¡± Stovall writes, ¡°the 'winners' beat the market by a near two-to-one margin.
Why You Need This Book
This fun and lively book provides an abundance of wisdom in remarkably few words ¨C proving that investing books can be as entertaining as they are educating. To support his conclusions, Stovall complements his sharp insight with the results of detailed back-testing, as well as tables and charts drawing on decades of stock market data.
Rule 1 ¨C Let Your Winners Ride, But Cut Your Losers Short
Contrary to popular opinion, it¡¯s been more rewarding to invest in those industries that recorded the best price performances over the past year, while avoiding those with the worst. In this case, ¡°Buy Low, Sell High¡± doesn¡¯t typically work in the short run!
No investment technique works all of the time. The Let Your Winners Ride, but Cut Your Losers Short rule underperformed the broader market three years in a row, from 1987 to 1989, yet it beat the market 10 years straight from 1971 to 1980, including the mega-meltdown years of 1973 and 1974.
Investors typically fail before rules do. In other words, investors tend to give up on a rule after one or two years of underperformance ¨C just when the rule is likely to work again. And to compound matters, they switch into another rule that just has a lengthy hot streak.
As luck would have it, that rule would then likely hit a cold streak.
So either embrace a single rule that you favor most and stick with it, or embrace two rules, directing half of your money toward one rule and the other half toward the second rule.
Rule 2 ¨C As Goes January, So Goes the Year
The first month of the year has been very accurate in forecasting the coming year¡¯s performance for equity markets, sectors, and industries. Developing a January Barometer portfolio for either sectors or industries is amazingly simple ¨C just select the three S&P 500 sectors, or 10 industries, that posted the best performances during January and hold them for a year.
You may also be surprised to find out that the January Barometer portfolios frequently beat the market whether the S&P rose or fell in January.
You even find out which sectors or industries to avoid. Just as with the Let Your Winners Ride portfolio, the performances of the industries and sectors in the January Barometer portfolio show that investors can save themselves a lot of heartache by avoiding the three sectors and 10 industries that posted the weakest performances during this opening month of the year.
Rule 3 ¨C Sell in May and Then Go Away
The market and most sectors typically take a ¡°price-appreciation vacation¡± during the summer months.
From April 30, 1990, through October 31, 2008, they could have turned a 5.8% return into a 10.0% annual compound rate of return. Sweet!
In 2008, while the S&P 500 fell by more than 30% from May through October, the S&P Consumer Staples and Health Care sectors fell by about half that amount, improving not only on their frequency of beating the S&P 500, but also the margin by which their average compound return beat the market.
Rule 4 ¨C There¡¯s No Free Lunch on Wall Street (Oh Yeah, Who Says?)
By diversifying among sectors that zig when others zag, some investors have historically been able to get both a higher return as well as lower risk. If Sir Isaac Newton had a law of motion related to the stock market, it probably would have sounded like ¡°for every level of return, there¡¯s an equivalent level of risk,¡± meaning that the higher the returns you hope to achieve, the greater the amount of risk you should be willing to accept.
If you expect a high-price return, then you have to expect to experience an elevated level of risk, either in the form of price volatility or the potential loss of your original investment.
Sometimes, however, one can find an investment strategy that delivers a free lunch: an investment that offers an improved return with lower risk. Investing in sectors with low correlations to one another has actually provided investors with above-average returns ¨C even when factoring in risk or volatility.
Over the long term, sectors with low correlations have recorded advances and declines at a different rate of pace, as if they each marched to the beat of a different drummer. Highly correlated sectors, on the other hand, ascended the staircase of price changes as if marching to the same beat.
Rule 5 ¨C There¡¯s Always a Bull Market Someplace
Not all investors are Fred Astaire on the dance floor. This rear-view mirror approach to investing has a time-tested track record for picking near-term winners. The intent is to maintain an ownership of all industries that have had the highest trailing 12-month price performance.
Your goal is to buy high but sell higher. In addition, the number of holdings never changes. This makes the management of the portfolio fairly straightforward. A drawback to this rule for industries is turnover. The portfolio requires monthly fine-tuning.
What this rule endorses is that instead of picking sectors, industries, or stocks by trying to forecast where we are in the economic cycle, projecting which company will win a government contract, or guessing which way the dollar will fluctuate, let the market tell you where to invest your money.
With Rule 5, There¡¯s Always a Bull Market Someplace, you can let the market tell you which areas to buy into and when to sell out.
Rule 6 ¨C Don¡¯t Get Mad ¨C Get Even!
How could you have invested in the S&P 500, yet avoided such long-lasting portfolio carnage? Get small-cap performance with large-cap stability.
What should an investor take away from this rule?
First, if you are a buy-and-hold investor who is looking to neutralize the influence of cap size in your portfolio, and take advantage of the historical outperformance of smaller-cap stocks over larger-cap ones, then you should invest in the equally weighted S&P 500 ETF.
Second, you might want to rotate between the equally weighted and market-cap-weighted S&P 500 indexes. The equally weighted S&P 500, like the small-cap indexes, will likely outperform the cap-weighted index periodically. As a result, you may choose to gravitate toward the equally weighted S&P 500 when you believe smaller-cap stocks are likely to outperform other stocks.
Third is the extra octane an investor receives when substituting equally weighted sectors for market-cap-weighted sectors in the portfolios. The Summary, Ranking the Rules, summarizes the performances, volatility, and frequencies of outperformance for each of the Seven Rules of Wall Street, using market-cap-weighted and equally weighted sector indexes.
How you implement the rule Don¡¯t Get Mad ¨C Get Even is just as simple as the ways you implement the other rules.
Rule 7 ¨C Don¡¯t Fight the Fed
The Federal Reserve controls the cost of cash. During periods of rising interest rates, there has traditionally been almost no place to hide. Yet when the Fed has begun cutting interest rates, the equity markets have usually soared. Will your portfolio be ready for the ride?
Learn to identify which sectors are traditional leaders and laggards during these periods of interest-rate adjustments.
What is the one thing an investor should monitor in order to gauge the health of the economy and the direction of the stock market? Interest rates.
The mandate of the Federal Reserve is twofold: to promote economic growth and to keep inflation under control. In other words, make capital (money) abundant enough so that consumers and companies will be willing to borrow money in order to expand and improve their overall quality of life.
If the economy were a car, the Fed¡¯s responsibility as a driver would be to maintain a safe speed.If the Fed wanted to speed things up, then they would step down on the gas by lowering interest rates. To slow things down, however, the Fed would need to tap or even slam on the brakes by raising interest rates and reducing the availability of capital.
The biggest challenge for the Fed is that our economy isn¡¯t a little red sports car that reacts nimbly to the application of the gas pedal or the brakes. Instead, the economy is more like a supertanker whose response time is remarkably slow. It also takes quite some time for the economy to slow down as a result of higher rates.
And the Winner Is¡
Of all the portfolios, the one favored the most is There¡¯s Always a Bull Market Someplace, which uses equally weighted S&P 500 sectors. Even more encouraging is that this portfolio allows an investor to evaluate and adjust his or her portfolio every month.
Good luck!
BusinessSummaries.com is a business book summaries service. Every week, it sends out to subscribers a 9- to 12-page summary of a best-selling business book chosen from among the hundreds of books printed out in the United States. For more information, please go to http://www.bizsum.com.