Hazardous To Your Wealth

In this article, we'll look at five things you're likely to hear on CNBC or read in Barron's to see if you can really make money listening to what everyone knows is true.

1. Diversification will help limit your losses in a bear market
Diversification works very well in long-term academic studies. The problem? It fails to protect your portfolio at times when you need it the most. Ralph Vince, author of The Handbook Of Portfolio Mathematics, studied the correlation between various tradables. He found that over long time frames, the prices of gold and crude oil show little tendency to move together -- one zigs when the other zags -- which leads to slow but steady profits in theory. However, on days with very large moves in the stock market, these two futures usually trade in the same direction as the other, with both losing or gaining a notable amount based upon the news driving the move in stocks. Vince found that the same was true for diversification among individual stocks, such as Ford and Pfizer, or Citibank and Microsoft -- on most days, they show no relationship to each other, but on large move days, they move in line with the overall market. So when the Dow Jones Industrial Average (DJIA) falls 3% in a day, almost all stocks go down in price and diversification does little to limit the damage to your portfolio.

2. Some industries, like casinos, are recession-proof
Most commentators insist that addictive entertainment such as tobacco, alcohol, and gambling are businesses that can withstand economic downturns. Economists say that demand is relatively inelastic for vices, giving academic credence to this idea. However, academic studies by sociologists show that raising taxes on cigarettes leads to fewer smokers. The same is true of alcohol, where higher costs limit consumption. And casinos throughout the country are reporting declining revenue as the economy has suffered. To dispel this myth with some hard numbers, Moody's has downgraded 17 casino companies this year.

3. Foreign stocks often go up when the US market is down
The Standard & Poor's 500 fell 12.8% in the first six months of 2008. The MCSI World Index lost 11.7% and the MCSI Emerging Markets Index lost 12.7% over that same time frame. The World Index includes stocks in 23 countries, while the Emerging Markets Index represents 26 countries. All major European and Asian markets lost more than the S&P 500. Brazil and Russia were able to eke out small gains. After accounting for the impact of the dollar, the results remained the same -- all major world markets except for two declined in the first half of 2008. In an increasingly interconnected global economy, traders are finding it harder and harder to limit risks geographically.

4. Never sell on Monday
The title of a book by Yale Hirsch, Never Sell On A Monday, was subtitled "An almanac for traders, brokers and stock market watchers" and offered tests showing, among other interesting facts, that Mondays were the worst day of the week. In rerunning the test now, using the DJIA back to 1900, we get the same results; Mondays are the least likely day to show a gain in the average. Mondays showed gains only 35.8% of the time. The theory behind this advice was that investors looked at their portfolios over the weekend and placed sell orders with their brokers to get out of positions on the following Monday. By waiting until later in the week, the investor would get a better price for their positions. One problem with the test results is that although the DJIA closed up only about a third of the time on Mondays, about half of the total points gained in the past 108 years occurred on that day. Better advice might have been to sell on the close on Monday in order to benefit from this phenomenon. But if we ran the test from 1986, the time Hirsch published his results, through June 2008, we find that Mondays are now the most profitable days. With the first day of the work week up 57.6% of the time, Friday was now the worst day of the week, up only 51.6% of the time over the past 22 years. The bottom line is that this idea seemed to stop working as soon as it was published. It's unlikely that the markets changed because of the research, but it is certainly true to say that the older research is no longer tradable.

5. Sell in May and go away
Every April, commentators remind us that the coming six months are historically weak and that the DJIA has made most of its gains from November through April. The problem with this is that the market still goes up, on average, from May 1 through the end of October. In fact, more than 60% of the time, these six months deliver gains for the investor. This adage seems to be a case of the average returns reflecting a few bad periods. The "Sell in May" strategy did not outperform a simple buy & hold approach until 1987. Many will remember that the S&P 500 dropped by 22% on a single October day that year. The minicrash of 2001 was confined almost entirely to that time frame, as the market declined about 17% between June and October that year. The following year, the S&P 500 would fall more than 20% during those same five months. These outliers provide the bulk of the statistical support for this market theory. Testing with good software takes only a few minutes in many cases. It is well worth the time to determine if what everyone knows is worth knowing, and in most cases, we'll discover that it isn't.

Vince, Ralph [2007]. The Handbook Of Portfolio Mathematics: Formulas For Optimal Allocation & Leverage, John Wiley & Sons.