Don't be Another Bull Market Genius
Be Wary as Another Wave of Fortune Comes With the Next Market Cycle
Aug 5, 2009
Market cycles are inescapable. Although it has been proven many times, such as in the period of the US stock market rising from the ashes of 1987 to its inevitable repeat in 2001, many still gaze in wonder as portfolios once richly promising luxurious retirement plans offer doubt as to whether one will have enough to retire with dignity.
Rather than be a culture full of bull market geniuses, it would be better to understand why stock prices rise and fall, and how investors can protect themselves when the next market rise ends.
Supply and Demand in the Stock Market
It sounds simple, and it is. Sometimes an investment security, such as a share of stock will rise simply because so many people want it.
For example, Toronto-Dominion Bank (TD Bank) was selling for $25.86 in the first quarter of this year. Currently, it is near its 52 week high as it closed yesterday at $60.25. Similarly, Ford Motor Co. was trading at just over $1 in the fourth quarter of last year, finishing yesterday at $8.30.
One reason the share price of these companies is going up is because more investors want to own them than wish to sell them. For those skeptical of such an explanation, it is simply put in the following hypothetical scenario of a public company:
ABC Corp. is going public, breaking down into 100 shares worth $10 each. Mr. ABC, the company's founder, owns 60 shares while the rest is evenly divided among four investors.
ABC Corp. does well and the company makes a strong profit. More investors want to hold shares of this company. However, the owners do not want to sell unless they can make a profit since they, too, like owning the company. Demand for the stock as a result of the company's great performance causes the share price to increase, and shares sell at rising rates due to demand, increasing the value of the owners' portfolios. If no one wanted the company, but the investors wished to liquidate, then the share price would fall.
As for TD Bank and Ford, it does not hurt that the former offers an annual dividend greater than $2, nor does it harm the latter that it recently came out ahead of its two domestic rivals, GM and Chrysler.
A Little Diversity Can go a Long Way
While such companies as TD Bank and Ford Motor Co. may appear to be good bets for one's money, the truth is that investors do not know where the companies will be in one year.
With so much uncertainty, it is best to have several nests for one's eggs. These should be divided among liquid and non-liquid securities, and tailored towards one's tolerance for risk.
Low risk, low liquid investments include:
- Savings bonds
- T-bills
- Certificates of Deposit
Low risk, highly liquid investments include:
- Savings accounts
- Money market accounts
What is considered to be high risk is more of a subjective matter. For example, many people consider real estate more risky than mutual funds, but homeowners in Jacksonville, North Carolina would be likely to disagree as home values have risen despite the housing slump.
Additionally, buying stock may seem risky to some, but properly diversified investors with money in companies that have low risk, highly liquid investments (meaning cash) are more likely to feel secure during the a market downturn, and may be inspired to buy shares when prices fall.
All investing incurs risk. Even those who hide US dollars under their pillow are losing value due to inflation. If one is going to be invested as the market turns up again, it is best to understand that a frenzy of stock selling will decrease the value of a company's shares. While knowing this, a properly diversified investor will be able to ride out the next downturn, and possibly even capitalize on it.
* This article is intended for informational purposes only. Please consult a licensed investment professional.
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