Stock market performance often seems unpredictable. One month stocks are up, the next month they’re down. Volatility seems to be the name of the game, right? Maybe, but there are some historical trends of stock performance that are actually quite noticeable if you crunch the data. One noteworthy trend is the “September Effect” – poor stock market performance in the month of September.

We first discussed the topic of this September swoon in prices in a prior post on stock market returns by month. Check out the data and the graphs in that post, and you can see that stock performance (S&P 500) in the month of September is not good over the long term.

Interesting findings from that post, specifically related to September, are:

• In the last 10 years, September is ranked 9th out of 12 months in stock performance
• During that decade, September is one of only 4 months with a negative monthly return (-0.97%)
• In the last 40 years, September is ranked 12th out of 12 months – dead last – in stock performance
• During those 4 decades, September was one of only 2 months with a negative monthly return (-0.77%)

Overall, it’s clear: September has offered low stock market returns over the short-term and long-term.

So, why is that the case? It’s an interesting question, as there have been some big drops in the market in September. Most recently, 2008 saw market drop 9.8% in September.  Most of remember that market decline of just a few years ago.  However, did you know that in 2002, the market dropped by even more in September? It dropped by 11%, actually.

Alright, so September hasn’t been the best month for stocks, over the long run. Maybe it’s best to enjoy the seasons changing, fall colors, the football season starting, or whatever suits your fancy. Just forget about making money in stocks in this particular month, right?

Not necessarily. September isn’t always a disaster. When I crunched the data some more, and looked at stock performance by month within the last decade, we can see that September has ranked across the board in returns, compared to other months in each year. Here is where the month ranked (out of 12) each year:

2010 – 1st

2009 – 6th

2008 – 11th

2007 – 2nd

2006 – 3rd

2005 – 5th

2004 – 9th

2003 – 10th

2002 – 12th

2001 – 11th

Clearly, it’s been across the board in that recent decade. There’s actually a good deal of variability in stock performance in September, on a year to year basis.  It’s no slam dunk that there will be September Effect each and every year. This is where overall data can be a bit misleading.

That being said, there have still been enough bad Septembers that the overall stock performance for that month over the long term, compared to other months, has been shaky.  It doesn’t mean that it will tank this year or next. Consider this for entertainment purposes if you will, but I’m still going to keep this in mind.  40 years is a long enough data set for me for me to at least take notice

My Questions for You:

Have you heard of the September Effect?

Do you believe in seasonal or historical stock trends, or do you believe that the market moves indpendent of such factors?

Would such information cause you think any differently about any pending stock moves during this time of year?

Have you ever heard of the Rule of 72?

It’s one of those personal finance calculators that’s been around for a while, and it’s about as basic as it gets. Yet, it’s been used by some people to quickly project results for a given investment over time.

The rule is essentially a quick way to determine how long it will take you to double your money at a current rate of return. It works as follows: start with the number 72, and divide it by the rate of return of an investment over time. The result will be the number of years it will take to double your money.

For example:

Let’s say you have an investment that will earn you a total annual return of 3%.  It would then take you 24 years to double your money (72/3 = 24).  Too long? Well, jack that rate of return up to 6%, and it will then take you just 12 years to double your money.

While I consider myself to be analytical, and comfortable with complex calculations, I do like such tricks such as the rule of 72.  They allow us to quickly, on the fly, do some basic calculations. In this case, we all could have quickly divided 72 by 3 (or 6) in our minds to get the answer in just a matter of seconds.

For whatever reason, this one in particluar has struck me as being nice for those of us who gravitate toward investment growth thoughts.  It”s a quick way to think about what money could become in the future.

As with any shortcut, however, there are pitfalls.  There are three that I see with the Rule of 72:

1. Taxes.   If you’re paying taxes on earnings, this needs to be considered in any calculation. So, if you’re earning 6%, but will pay some tax on that, your after tax rate may actually be somewhere in the neighborhood of 4% or so.  This needs to be factored in, or the Rule of 72 will give you erroneous results.
2. Inflation.  Let’s say you’re earning 3% after taxes for example. If inflation is 3%, you’re not really getting ahead. The $1,000 you have invested will turn into $1030 a year later, but will still buy the same amount of goods as $1000 did the year before. So, inflation needs to be taken into account.
3. Accuracy. This rule is meant to be a shortcut, so it’s not 100% accurate down to the decimal point. For example, if you wanted to see how long it would take to grow a $1000 investment into $2000, with a 3% rate of return, the Rule of 72 would tell you 24 years. If you calculate it manually, it actually comes out to almost 23 1/2 years. Close enough for an quick estimate, but important to note that it is in fact an estimate.

Personally, I find that many quick financial projections, particularly those that are intended to show the power of compounding over time, tend to ignore both taxes and inflation.  To the latter point, always keep in mind the time value of money.

In any event, as long as we’re aware of it’s limitations, the Rule of 72 can be a useful tool for quick projections of how long it will take us to double our money.

My Questions For You:

Have you ever used the Rule of 72?

Do you ever stop to question assumptions in such financial projections, such as I did with taxes and interest?

The price of gold has reached some pretty high levels this year, as we know. It’s busted through historical highs, albeit on a non-inflation adjusted basis. Still, gold has gone from almost an afterthought in some people’s minds to a high flying investment once again.

With this in mind, I did some reading on gold recently, looking at some articles online.  In doing so, I came across some stories that discussed some Warren Buffett quotes and conversations from earlier this year. Buffet had given his thoughts on gold as an investment, and how it compares to other alternative uses of capital.

Here’s a summary of his main points:

If you took all the gold in the world, it would be valued around $7 trillion. This would equal about 1/3 of the value of all U.S. stocks. By comparison, the value of all farmland in the U.S. is about $2.5 trillion. You could take that farmland, add 7 Exxon Mobils to it, and have an extra $1 trillion to boot. What’s a better use of funds? You could probably do more with these alternatives to gold, versus just staring at a giant block of gold that looks nice but doesn’t actually do anything.

When you look at it in those terms, it makes sense.  Gold, as such, has limited real world use. It’s considered a storage of wealth, but as an actual element, what does it really do? It doesn’t directly generate income, it doesn’t produce anything that directly generate cash flows. It’s a speculative investment that can go up and down in market value.

I’ve seen people pumping up gold lately, even hearing one guy talk about how there’s a lot more room for gold to increase in value. Basically, he’s totally bullish on gold, it would seem. Additionally, I’ve seen many more businesses out there which buy and sell gold. I even saw one a few months back in a local indoor mall. There was a kiosk that had a sign that indicated that the people running it would buy gold. In fact, it seemed like the kiosk was truly dedicated to gold and little else based on first impressions. Those types of businesses just didn’t seem as prevalent in the not so distant past, before the huge price appreciation occured. It reminds me of how all kinds of people got involved in the real estate industry while it was in full bubble mode.

Speaking of this price appreciation, I see that gold has surpassed $1660 per ounce as I write this! There’s a lot of uncertainty of where things are headed in terms of the global economy.  This debt crisis in the U.S. isn’t one of our better moments, and there have been all kinds of problems in Europe of late.

When I see how this has become such a hot market, I think of the Buffett comments. They make me pause to consider exactly why gold has maintained it’s place as a store of value over time, taken in context with what we’re seeing with the price of gold lately.

My Questions for You:

What do you think of Buffett’s comments earlier this year?

Do you ever think about the opportunity cost of owning gold, in this way?

What are your thoughts on where gold is at today, in terms of it’s value and it’s potential for continued growth?

There has been much talk lately about the price of gold, and how it has been reaching historic levels. Recently, it has closed at over $1,500 per ounce, which represents a huge increase over just a few short years ago. However, its performance pales in comparison to that of silver. Often in the shadows of gold in terms of investments, silver has shown staggering price increases in recent years.

If you looked at the price of silver 10 years ago, as of April 2001, you’d see it trading at just over $4 per ounce.  As of the most recent close at this writing (4/25/11), silver is currently trading at about $47 per ounce.  Think about that rate of return! Yes, it’s quite impressive. Those who invested in silver a decade ago have made out incredibly well.

Can you imagine a $40,000 investment turning into $470,000 in just a decade? That’s about what would have happened had you bought 10 years ago.

That type of return just seems hard to sustain. Look at what happened to tech stocks in the late 1990’s. Skyrocketed, then they plummeted.   Look at the once blazing real estate market, how people made a ton of money in it in the last decade before the bottom fell out in many markets over the last few years.  All good things must come to an end.  I wrote about this in my post on investment bubbles. This phenomenon has been in play since the Dutch Tulip Bubble of the 1600s.

Now, gold is reaching some pretty high prices as well, and many people have called this as a bubble waiting to burst. Whether or not that happens remains to be seen , but it’s being assessed that way by some people. I wonder what everyone thinks of silver?

Clearly, silver has increased in price at an even more prolific rate. Check out the charts below. They illustrate the following historical prices, as of April 25/26, 2001 to 2011:

1. Silver
2. Gold
3. Dow Jones Industrial Average
4. Gold/Silver Ratio
5. Dow/Silver Ratio

As can be seen, while gold has increased over time, silver’s recent increase is quite sharp.  The Gold-to-Silver ratio declined quite a bit since 2001, from 60 to 32. The Dow-to-Silver ratio has declined from 2,441 to 265!

This isn’t the first time silver has increased sharply in value. After trading in the $5 range in the late 1970′s, it spiked up in price dramatically in late 1979/early 1980, reaching over $49 per ounce. One reported factor in this decline was the attempt by the Hunt Brothers to corner the market. In any event, silver quickly retracted in price and dropped close to the $5 level within a few years. 

It appears that a silver bubble is forming.

This assessment is my own based on this analysis. I’m not an investment professional, and this is not a recommendation. That said, I’m really wondering when the price declines will kick in. Growth in silver prices seems unlikely to continue indefinitely, right? After all, what investment keeps going up without ever dropping?

My Questions for You:

What do you think of the silver bubble hypothesis?

Also, what do you think this phenomenon is telling us? Is it pure speculation, a sign of coming inflation, response to a weak dollar, or an indication that perhaps stocks have room to grow?

Have you ever had one of those situations where you thought you had a potentially good investment opportunity right in front of you, but for whatever reason you just didn’t pull the trigger on it?

I had one of those just two weeks ago to this day. It just seemed like an intriguing opportunity, but I never took the plunge .

The opportunity I’m talking about was the chance to invest in Japan after the terrible, tragic earthquake and tsunami in March 2010.

Those of you who are regular readers might remember my post from March 18 titled “Is This a Good Time to Invest in Japan? ”.  The whole premise of the post was that the prices in the NIKKEI 225 plummeted in the week after the disaster, and that I thought Japan was undervalued at that time. In other words, a market overreaction took place, leading to a good long-term buying opportunity. Sometimes we might listen to investor tips, other times – such as this – we make a determination on our own.

How low did it go? At the time of the March 18 article, the NIKKEI 225 index was at 8,962.67.  As of March 31, the index was at 9746.62.

That’s an 8.7% increase for the NIKKEI 225 in just 2 weeks!

By comparison, the S&P (where I have been, in an index fund) grew from 1,273.72 to 1325.83 over that time period. This represents a 4.1% increase in the same two weeks. Still pretty good.

However, the 8.7% for Japan is better than the 4.1% for the S&P 500!

This isn’t surprising. After all, I called it, right? I’ll pat myself on the backfor identifying this as a buying opportunity and putting it here on Squirrelers!

That said, once done with the pats on the back, I can start kicking myself as well. Except the kicks will be harder than the pats on the back

Why? Well, I never did anything about it. Despite taking a chance by calling this out as an intriguing investing opportunity, I missed the boat. Delayed by one day, then two days, then finally it was too late. The window of opportunity was gone. The analysis was sound, but the action was missing. Ultimately, risk-aversion took over.

Ideas and plans can be good, but they don’t help you unless you take action on them. Without action, ideas are just that – ideas. Another reinforcement of an old lesson.

My Question for You:

Have you ever thought it was a good time to make a particular purchase, only to not follow through on it? If not you, maybe you know of someone who has faced this situation.

Is this a good time to invest in Japan, particularly in Japanese stocks?

It almost seems like it’s unfair to ask such a question, considering the horrific events in that country on March 11, 2011. As if the 9.0 earthquake wasn’t enough, the tsunami just ravaged coastal areas in Northeast Japan and took far more lives than the quake itself. Additionally, the currently tenuous nuclear situation is a menacing threat on people in Japan.

Obviously, our hearts go out to the victims, families, and everyone coming to grips with these tragic events. Some of the video and stories I’ve come across are harrowing and very sad.

Having said this, the country’s stock market is actually still open for business. Japan’s economy is one of the world’s largest, and the country is home to many companies that are international powerhouses. The disasters have taken their toll on business, but things are still moving forward in many ways.

This gets me back to the opening question: Is this a good time to invest in Japan?

In the short-term, the eyes of the world are on the reactors and the battle to prevent further disaster. However, taking a long-term view, this might be a good time to consider Japan – based on data as of this writing.

Now, I’m not an investment advisor, so take this as just the plain ole Squirreler digging up some data. This data I find compelling is that of the NIKKEI 225, which is based on the Japanese stock market. Here are closing prices of this index at key points early this year, including recently:

January 4 (1st trading day of 2011): 10,398.10

March 10 (day before disaster): 10,434.38

March 11 (date of disaster): 10,254.43

March 14 (next trading day): 9,620. 49

March 15: 8,605.15

March 16: 9,093.72

March 17: 8,962.67

As you can see, prices from the beginning of 2010 until right before the disaster were fairly consistent, above 10,000. Then, the week after the earthquake and Tsunami, prices plummeted.

Looking at the numbers, the percentage decrease from March 11 to March 17 was 14.1%.

A decrease of 14.1% in such a short period of time is quite significant.

This is why I think that from a long-term perspective, investing in Japan may seems now seems intriguing.  When markets fall so quickly, buying opportunities can emerge. Overreactions do occur in markets.

Of course, under-reactions can occur as well. But I look at historical stock returns in our market, and when prices have plummeted, they have bounced back. Even in Japan’s market, which is not nearly what it was over 20 years ago, larger drops are eventually followed by some level of bounce back. Even if not to prior highs, they’re still bounce backs.

Plus, Japan has a history of resilience. The way the country developed into one of the largest economies in the world, despite having over 100 million people crammed into a land mass the size of the state of California, shows something. One can also look at success of Japanese automakers in overtaking ours here in the U.S.

Like in most markets, it’s hard to say if anybody really knows what’s going to happen.  It would be great to predict the future, and predictions at this point are just educated guesses. That said, there are compelling signs pointing to a potential long-term opportunity.

What do you think?

Do you think this might be an opportunity to make a long-term value investment?

Asset allocation changes over time for most of us. The mix of investments you have when you’re 25, for example will be different from what you have at 40. Likewise, your investments at 40 will be different from what they are when you’re 55.  Specific needs change over time, as does our desired exposure to risk.

This is where target-date funds come into play. You may see them as choices within a 401(k) plan, or within your child’s 529 account. The latter is where I was introduced first-hand to these types of funds, and was presented with these as an option. I didn’t choose to participate then, but recently decided to reevaluate these vehicles and take another look.

What are Target-Date Funds Anyway?

These are funds that are composed of assets within different classes (stocks, bonds, cash, etc), intended to help an investor with asset allocation based on a specific time horizon. The investments within the fund change over time, based on the target date of the fund. Asset allocation and rebalancing is done for you.

For example, if a fund is a 2030 target-date fund, it will probably be weighted more heavily in stocks today than it would be in 2020. As the time to target gets closer, the asset allocation is supposed to be geared toward the use of those funds at that time. Hence, more risk is taken further from the target date, and capital preservation becomes more important closer to the target date.

What do I Like About Target-Date Funds?

1. Initial allocation and subsequent rebalancing is done for you. This is a compelling proposition. Instead of having to work on these tasks on your own, it’s taken care of by a professional. Even if you’re smart with money, this may have some appeal.
2. They save you time.  This is important, as we realize that time is money to a large degree. Having to constantly make sure your asset allocation is appropriate, based on an updated account balance and time to target, can take some time.
3. They can leverage scale.  Larger funds can use the volume of funds invested to diversify in ways that could go beyond the means of a typical investor
4. They’re good for novices. If someone has very little experience and knowledge about investments and the different classes and vehicles available, it makes sense from a risk management perspective.  A total amateur could wreak havoc with his or her finances by making ill-informed decisions.

What don’t I Like About Target-Date Funds?

1. Potentially infrequent rebalancing.  Do they rebalance monthly? Quarterly? Annually? Depending on your preference, considering historical stock returns, these funds may not rebalance enough in increasingly volatile markets.
2. May not match with your risk tolerance.  We each have our own risk tolerance, and it may or may not match up with that of the fund.
3. Might discourage learning.  When people take the intellectual curiosity out of the exercise of choosing investments, and leave all decisions to others, it might foster a habit of minimizing time on financial learning. It pays to be dialed in to where your money is going and why it’s to be invested they way it is.
4. Limits individual control.  That might be a good thing for some, but not for many investors. You might have your own views on different investment vehicles at any one point in time, and more importantly – more specific knowledge of your own personal situation.

My Choice

As much as I like some of the features of target-date funds, I prefer to have more control. If you have a foundational knowledge of personal finance, and like the feeling of direct control over decisions about your money, you may want to consider what it would be like to turn over these responsibilities to someone else.

On the one hand, this is what we do with mutual funds anyway – at least the non-index fund types. However, when the time horizon comes into play, personal goals and needs create unique circumstances for many of us that may not fit into a one-size fits all solution.

So for me, I choose not to go with target-date funds.

That said, if someone is a novice without a comfortable knowledge of basic investment principles, I think these could be a really good choice.  I’m sure there are those that might totally agree, as well as others who might totally disagree with my assessments:)

Questions for You:

Do you own any such funds?

Are you inclined to be able to hand over asset allocation/rebalancing to someone else, or do you feel the need to exert more personal control over the direction of your money?

photo credit: MikeBehnken

We are all familiar with investment bubbles, given that we’ve seen how sharp price increases in real estates in the early-to-mid 2000s were followed by a big drop in prices. Some folks have really been hit hard, as their homes have declined in value to a point where they’ve lost quite a bit of money. People that bought near the peak, and borrowed money to do so, discovered that the real estate bubble threat was in fact real.

Have we learned lessons from this experience? Or, will history repeat itself at some point in the future – even soon?

My prediction, based on history, is that there will be investment bubbles that emerge once again in our future. Not just one here and there, but plenty of them. It’s the way things have been with people over the last several centuries – and perhaps prior to that too, for all we know.  Let’s take a look at two historical investment bubbles of note:

Dutch Tulip Bubble, 1600’s.  As Holland grew in prosperity, certain Tulips began to increase in popularity. From there, the bulbs became hot commodities in a very short period of time. While the supply of bulbs didn’t increase, the number of people interested in purchasing them did. Soon, these people ran up the price of the bulbs to extraordinary amounts. By some accounts, people were paying multiple times their annual salaries, just for a tulip bulb.  Eventually, the lunacy gave way to a crash in prices, and many people were left in ruins – with tulip bulbs to show for it.

South Seas Company Bubble, 1700’s.  As England was in debt, it worked a deal with the South Sea Company to service its debt in exchange for “rights” to trade in places such as Asia, Africa, and South America. Stock was issued, and investors were caught up in the euphoria over this monopoly that had incredible potential (albeit in some business that was quite unsavory).  The stock price reached dizzying heights, before doubts crept in and the decline started. It was held up for a while by legislation (“Bubble Act”), but prices eventually dropped like a rock. Big money was lost by many, except perhaps those who sold high and took off with their money.

Clearly, investment bubbles have been occurring for many years.

In the late 20^th and early 21st centuries, we have seen bubbles that are more ingrained in our minds:

Dot Com Bubble, late 1990’s/early 2000s.  This was quite a goldmine for those who sold at the right time, but a wealth destroyer for those who purchased at the wrong time. Companies with poor earnings (if any) had their stock prices pumped up based on future potential. Ultimately, the mania went out of control, and prices dropped. Here’s how the NASDAQ performed during the bubble, with the following closing prices during these months (Source: Yahoo! Finance)

• February 1999 – $2,288
• February 2000 – $4,697
• February 2001 – $2,152
• February 2002 – $1,731 

Housing Bubble, early 2000’s to Present. This is so recent (and the effects continue today) that we know what the effects have been on people. Home prices in some areas have dropped by well over 50% since their peak. In many cases, homes just aren’t selling, and people are deep underwater on their mortgages.  It’s a boon for first-time homebuyers or those just not currently owning but looking to buy.  For the rest – particularly those who bought at the peak – it’s been less than desirable. For some of this group, it’s been devastating. 

All of this historical information leads me to think of one more bubble:

The Baseball Card Bubble, 1980s. This probably eluded most people back in the day, and these days I wouldn’t be surprised if most people don’t know about this micro-market bubble. I do, since I was a baseball card collector as a kid – before moving on to the teenage years, when I soon dropped collecting all together for more exciting pursuits

As a huge sports fan, I started collecting cards and really enjoyed the older cards since I liked the game’s history. Then, the current cards started to skyrocket in popularity. Back in 1983-1987, it was crazy.  I recall that packs of cards were cheap, less than 50 cents each. However, if you got the right card, you could make nice chunk of change. For example, when Mark McGwire was a rookie in the 1980s, his card was worth as much as $50. Can you imagine? Now, you probably could get them for $1 without much trouble.

Personally, I “invested” in a large amount of Barry Bonds cards back in 1987 when he was a young player breaking in. Who would have known he would eventually be the home run “champion” around 2 decades later? I outlined this story in my post “The One That Got Away”. Not much was invested, but nothing was made, despite the player’s amazing statistics.  The baseball card bubble had already burst, and prices had plummeted.

Lesson Learned: Investment bubbles do happen, and we have to watch carefully for signs of them

My questions for you:

1. As we look forward, do you think we might be looking at “The Gold Bubble of 2011 or 2012?” Prices are staggeringly high compared to a decade ago.
2. Are there any other investments that you think may stand to lose significant value in the coming years?

photo credit: bortescristian

Stock returns by month are not as variable and unpredictable as one might think, over the long run.

Sure, performance from one month to the next can be quite different. Some months see prices increase, other months see prices decline.  Yes, there are peaks and valleys that appear when you view charts of stock prices. This even happens from day to day, and within days as well.

However, this assessment of stock prices is often made from visual perspective. When you graph prices with a time-series approach, it’s easy to come to that conclusion because it’s true – and very visual.

What happens when you assess performance on a monthly basis, comparing the months to each other over time? Are there some months in which the market performs better than others, over the long term?

Yes, based on my analysis of historical data of the S&P 500.

Here’s what I did: I pulled data (source: Yahoo Finance) showing the opening market value and the closing market value for each month, dating back 40 years.  From there, I downloaded the results into an Excel spreadsheet, and ran pivot tables on the data.

I first assessed the years 2001-2010, in order to see if there was a discernable difference by month.  Here are the results for these past 10 years:

As you can see, the “January Effect” seems to be, in reality, a drop into negative territory when you look at the past 10 years (note that January 2011 is not included here). However, March, April, and May have shown good performance. Additionally, November and December did quite well.

Interesting stuff. The most recent market performance over 10 years shows that some months have been better for the market than others.

After doing this, I thought that while 10 years is the most recent and possibly most relevant time frame, the analysis should be expanded a bit to include more years. So, I incorporated all of the data which I had pulled, and analyzed performance from 1971 to 2010.

Here are the results for a 40-year time period:

When the time period is expanded out to increase the sample size, it’s clear some months have shown better S&P 500 performance than have others.  November to January seem to be good months, then March and April as well.

What about February, as well as the summer months? Performance in these months, over the last 40 years, has clearly lagged that of the aforementioned good times of the year.  There’s a pronounced difference in prices, with February being a clear dip in the middle of good months, and September being the lowest point of multiple poor performing months.  Keep in mind that these are averages, of course, so there could be individual years where performance could be all over the place.

But about those averages I just mentioned….is it worth considering these historical performance averages when making decisions to buy or sell stocks? I’m not an investment professional, so don’t take this as advice, just as my own analysis and thoughts. For me, it gets thoughts racing about a year-long strategy:

1. Buy in February, with the intent of capitalizing on solid gains over the next few months.
2. Sell in May, and take the summer off:)
3. Buy again in October, after the September Swoon.
4. Sell in January, and engage in profit-taking.
5. Repeat Step 1.

Note that I’m not recommending a step-by-step approach like this. A year-long strategic plan like this is too much, and every year is different. The supporting data points are averages across time.

However, at the minimum, these trends are worth considering when making (or not making) buy and sell decisions. It’s compelling enough for me to consider that monthly historical S&P 500 performance data like this might tip the odds slightly in the favor of the informed investor, when he or she is considering when to buy and sell stocks. 

The past doesn’t always repeat itself, but it’s important to learn from it to predict future behavior

Here’s a little quiz for you:

Let’s say you own 1000 shares of stock, valued at $10 per share, for a total value of $10,000.  Lets’ also assume 2 possible scenarios for the stock price the next day:

Question: One a scale of 1 to 7, rate your relative likelihood to sell or hold for each of the 2 scenarios below. For reference, the scale is as follows:

1 = definitely sell

2 = very likely to sell, small chance of holding

3 = somewhat more likely to sell than hold

4 = equal chance to sell or hold

5 = somewhat more likely to hold than sell

6 = very likely to hold, small chance of selling

7 = definitely hold

Scenario 1:  The stock goes up $0.50 to $10.50 per share, giving you a total value of $10,500.

What’s your answer, on the 1 to 7 scale?

Scenario 2:  The stock goes down $0.50 to $9.50 per share, giving you a total value of $9,500.

What’s your answer on the 1 to 7 scale?

Did you have a different answer for each scenario?

If your answer choice number was lower for Scenario 1 and higher for Scenario 2, you might be exhibiting what’s known as the Disposition Effect.

The Disposition Effect refers to the notion that many people have a tendency to sell stocks that increase in value a bit too quickly, while holding on to stocks that decline in value a bit too long.

This is rooted in the idea that it’s easy to capture gains, but painful to accept losses. When a stock drops in value, it becomes difficult to accept, and people are willing to hold out to make sure that their losses get recouped. I recall several people telling me about how they expected to make money on tech stocks around 2000, but started to lose money in a hurry. They held on, hoping to recoup their so-called “gains”. It didn’t happen, and people wasted a lot of time holding on to losers that eventually dropped further.

I have noticed a variation of this myself, thinking to back times when I played blackjack on a few trips to Las Vegas. I’m not at all a big gambler, and might wager $40 or $50 per day TOPS as purely entertainment. And I mean that’s the upper limit, as the odds are stacked against you. Anyway, if I started with $20 on a $2 minimum bet table, and won 3 hands in a row, I would want to pull away. Take my $6 in profit and run! However, if I lost 3 hands in a row, I would want to keep playing because I rationalized that things “had to even out”. I would stay in the game with $14 left. The odds as they are, you’re more likely to drop than get back to the original level. There is no measure of evening things out, on such a limited set of chances.

With stocks, it’s a different game than blackjack, of course, and there aren’t house odds that set against you. But the idea is that many people tend to sell the winners too quickly, and hold the losers too long. Instead of riding the momentum of a strong stock, people take profits and run. The same folks might hold on to a poorly performing stock, only to see it push down further after meeting some resistance.

Keep the Disposition Effect in mind, when deciding to sell stocks. Also, remember this concept when buying stocks as well; perhaps we can make money as others behave irrationally, and take advantage of opportunities? I’m more of an index fund person, but if you like to buy and sell stocks, it’s something to consider.

How about you?

Where did you rank in the quiz? Do you tend to exhibit any of these characteristics, or do you think you’re free of the Disposition Effect.