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To the Maxim

We test 10 old saws to see which ones cut it

JOHN DALY
January 25, 2008

What's the difference between an investing maxim and an investing myth? The short answer is that the first makes you money and the second loses it. The trouble is, some advice sounds so pithy and convincing that you think it has to be true, especially if it's offered by someone who's made a killing in the market.

Step back to the heady days of 1999, the year the AIM Global Technology Fund topped Canada's mutual fund rankings with a smokin' 219% one-year return for its U.S.-dollar version (when converted back into Canadian dollars). If you'd invested $10,000 when the fund was launched in November, 1996, your investment would have been worth $52,100 at the end of 1999. No worries that stocks held in the fund were trading at a stratospheric average of more than 100 times their earnings per share. "Technology will always offer tremendous opportunities," enthused the fund's manager, Bill Keithler, at the time.

"If you refuse to pay the multiples, you miss huge moves up in the market. The market wants to own these things, and will pay almost any price."

And you know what? Keithler was right. Well, he was right for two months. By the end of February, 2000, that $52,100 would have grown to $68,304. Then the great 1990s tech boom started to crack, and by the end of the year, you would have been down to $36,130. So, should you have hung on for the long term? You still have to wonder how long the long term will be. At the end of last November, the $10,000 invested in the fund at inception would have been worth $15,077.

Are there maxims that actually work? We examined 10 of them and weighed the evidence, pro and con. It appears that almost all of them do pay off—for some of the people, some of the time. And some maxims are better than others. Sometimes.

1. THE TREND IS YOUR FRIEND
PRO This buy-high-and-sell-higher approach is a counterintuitive favourite of so-called momentum traders, who try to buy during upswings for a particular stock or the market, and short-sell during downswings. As renowned early-20th-century speculator Jesse Livermore said: "Always sell what shows you a loss and keep what shows you a profit." If a stock is climbing strongly, it's probably doing so for good reasons, and other buyers will want in. Some modern statistical research backs that up. In a study published in The Journal of Finance in October, 2004, academics Thomas George and Chuan-Yang Hwang found that stocks that hit their 52-week high prices subsequently tended to outperform those that hit their 52-week lows. One big reason: Investors are at first skeptical of positive news like a new 52-week high, and it takes a while for a rally to pick up steam.

CON Conservative, long-term value investors are wary of stocks that have surged in value. It's not the trend itself that bothers them; it's the level of the share's price relative to a company's or industry's earnings and to other fundamental indicators. They know they may miss out on some big short-term gains, as revered value investor Warren Buffett did in 1999 and early 2000, when shares in Berkshire Hathaway, his holding company, had plunged by almost half while the tech-heavy Nasdaq Composite Index more than doubled in value. But strong trends can also reverse sharply. The Nasdaq gave up its big gains by the end of 2000, falling back to around 2,500, while Berkshire Hathaway A shares almost doubled, back to about $70,000 (U.S.) apiece. "We have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint," said Buffett. "Try to control your excitement." Seven years later, the Nasdaq is trading around 2,500. As of late December, Berkshire Hathaway A shares were worth $137,980 (U.S.).

The upshot: The trend can be your friend, but maybe not for long.

2. Buy when the blood is running in the streets
PRO If you're aiming to buy low and sell high, it would make sense to try to pick the point of maximum pessimism when individual stocks, industries or entire asset classes have fallen out of favour. Take General Electric, which was trading near $40 (U.S.) when CEO Jack Welch retired in 2001, sank to $22.17 (U.S.) in early 2003 as successor Jeffrey Immelt struggled, and has climbed back to around $36 (U.S.) lately. Or how about McDonald's, which hit a low near $12 (U.S.) in early 2003 as anti-fast-food activists ganged up on the company, but soared to all-time highs of more than $60 (U.S.) a share last year? One successful method of picking low-priced stocks is the so-called Dogs of the Dow strategy: You buy the 10 highest-dividend-yielding stocks in the Dow Jones Industrial Average at the end of every year—usually, the yield is high because the share price has declined. You then hold the shares for a year and buy new dogs the next December. From 1928 to 2004, the average annual compounded return for the Dogs of the Dow was 13%. That was almost two percentage points higher than the Dow industrials, and 2.5 percentage points better than the Standard & Poor's 500 Index.

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