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To the Maxim

January 25, 2008

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CON Many bleeding patients don't recover, and some of them die—you know that if you held on to your Bre-X stock certificate. Or shares in Nortel and Ballard Power Systems that you bought, say, back in 2000. The risk of buying a stock solely because the price has declined substantially is that you may be caught in a so-called value trap—the price is low, but still too high relative to the company's earnings, prospects and other fundamentals.

The upshot: Do some triage.

3. Diversify. Diversify. Diversify
PRO The mantra belongs to William Sharpe, who shared the Nobel Prize for economics in 1990. Basically, he's telling you not to put all your eggs in one basket. Buying just one stock or bond or property is risky. By spreading your money among a variety of asset classes (stocks, bonds and real estate, or funds that hold them), and among several industries, geographical regions and currencies within those asset classes, you cushion the impact of a downturn in any one.

CON Maybe you could shorten that mantra by at least one "diversify." The counterargument can also be found in the work of William Sharpe. In a 1972 article in the Journal of Financial Analysts, he looked at diversification and what's called non-market risk. In the case of stocks, the market risk inherent in owning any one stock is that most of them fall when the market as a whole declines. Non-market risks affect one company or industry—suppose Frank Stronach decides to develop another wacky sports car and Magna International's share price plunges, or North American auto sales decline and the shares of all parts makers suffer. Sharpe's article showed that non-market risk declines dramatically as you start adding stocks to your portfolio, but when you reach 25 or 30, the benefits of adding more become negligible.

The upshot: Portfolios are like your sock drawer—if it's full, you don't need more space; you need to throw out socks.

4. Follow the U.S. Presidential cycle
PRO U.S. presidents and their parties want to get re-elected, so they tend to introduce economic austerity measures during the first two years of their four-year term, then loosen the purse strings in years three and four. U.S. stock markets often follow suit. As measured by the bellwether Dow Jones Industrial Average, many bear markets since the late 1920s have begun or continued during the first year of presidential terms—1929, 1937, 1957, 1969, 1973, 1977, 1981 and 2001. By contrast, the Dow has climbed in most presidential election years. The cycle appears to have a big impact abroad as well. In a 1996 study, University of Western Ontario academics Stephen Foerster and John Schmitz looked at the period from 1957 to 1996, and found that the presidential-cycle pattern held true for 18 major stock markets, including those in Canada, Europe and Japan.

CON One of the most powerful influences on stock and bond markets is interest rates. Increases in interest rates put downward pressure on prices. If you glance at the historic interest rate statistics, dating back to 1954, on the U.S. Federal Reserve Board's website, you'll see that for each of the severe bear markets since then, the Fed increased interest rates that year or the year before. True, the central bankers look at the politicians' fiscal policy as part of the many indicators they consider when setting rates, and presidents certainly try to influence the Fed. But it really is an independent agency, and that has been frustrating for many presidents. As an unnamed Johnson administration official said shortly after leaving office in 1969: "If you can trust the president of the U.S with the atomic bomb, why can't you trust him with money?"

The upshot: Markets usually pay more attention to the Federal Reserve chairman than the president, and you should, too.

5. "Buy land. They ain't making any more of the stuff"
PRO Humorist Will Rogers's quip had logic to it, and for homeowners in just about every major city in Canada, it's hard to argue with results. The average price of a house nationwide, as reported by the Canadian Real Estate Association, climbed to $333,544 at the end of last October, almost double the level of $167,807 in January, 2000. Stocks, as measured by the S&P/TSX Composite Index, haven't done as well, climbing only by about three-quarters. Buying a home and paying off a mortgage also seems to force a financial discipline on many families that they might otherwise lack. According to one 1999 study, the median net worth of renters in Canada was just $14,000, compared to $149,000 for homeowners with a mortgage, and $252,000 for those who had paid theirs off.

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