Investing-The New Rules: Price Drops are Good News

Stock Price Drops Are Better Than Stock Price Gains

Price drops are good. Price increases are bad. Seem counter-intuitive? Not according to Rob Bennett. He explains all in this week’s Investing–The New Rules.

---

Investing — The New Rules
Stock Price Drops Are Better Than Stock Price Gains

#16–August 16, 2010

---

An angel comes down from heaven and gives you the power to cause stock prices to go up by 10 percent over the next six months or to cause stock prices to go down by 10 percent over the next six months.

What to do, what to do?

Ask the angel for some time to think it over. You will be strongly tempted to opt for seeing prices go up. It’s a trap! Don’t go there!

In the long-term, the price of stocks is determined by the productivity of the U.S. economy. For as far back as we have records, our productivity has been sufficiently strong to finance an average annual price increase of 6.5 percent real. That’s probably what we are going to see over the next 20 years or so.

---

---

So we have a good idea where stock prices are going to be in the year 2030. To determine whether we are better off seeing in the next six months a 10 percent price rise or a 10 percent price drop, we need to determine which will make us richer in the long term, when we will need the money to finance our retirements.

If prices go up at a quicker pace than the pace that produces a 6.5 percent annual gain, we have to see price drops down the road to counter the effect. Seeing a 10 percent price increase up front will insure smaller price increases or even price drops down the road. Seeing a 10 percent price drop up front will mean there will be no need for price drops down the road and that tomorrow’s price increases will be bigger than the 6.5 percent price increase justified by the economic realities. If you assume that the 6.5 percent return is a lock for the average long-term return (it’s not actually a lock, but dramatic things would have to happen for the number to be more than a little bit larger or a little bit smaller than that), any short-term price increase or price drop will be canceled out in the following days and years.

The mathematical reality is that it makes no difference whether we see good returns in the early years of a 20-year time-period with bad returns in the late years or bad returns in the early years with good returns in the late years or stable returns through the entire time-period. Any return pattern that generates a 6.5 percent annualized real return is going to produce the same dollar-value portfolio at the end.

This much tells us that there is no benefit in asking the angel to generate a 10 percent price increase. The price increase would obviously be a good thing if you were planning to sell all your stocks in six months. But most of us are invested to finance an event (retirement) that will not take place until a good number of years down the road. For most of us, a price increase is no better or worse than a price drop.

But wait.

---

ALSO at DBKP:
* Investing–The New Rules: The Lily Tomlin Approach
* Investing–The New Rules: Young Investors Taking Hardest Hit
* Planning for Retirement: Retirement Riddle
* Investing–The New Rules: The Godfather Visits InvestoWorld
* Investing–The New Rules: Determining Stock Value Using P/E10
* Investing–The New Rules: The Monster That Ate the U.S. Economy
* Investing–The New Rules: Stocks Are Not Worth Buying Today
* Investing–The New Rules: Sarah Palin Will End Economic Crisis
* Investing–The New Rules: Dollar-Cost Averaging is a Loser
* Investing–The New Rules: John Bogle’s Evil Twin?
* Investing–The New Rules: Stock Return Predictor Not a Case of ‘Too Good to be True’
* Investing–The New Rules: The Stock Investor’s Weather Report
* Investing–The New Rules: Harness the Power of The Stock Return Predictor
* Investing–The New Rules: Get the Odds on Your Side

---

A price increase is no better than a price drop for stock shares that we hold today. But most of us do not today hold all the shares that we will hold on the day we retire. We are in the process of buying shares. For shares not yet purchased, there is another factor that we need to consider — the purchase price we pay for the shares.

If you tell the angel you want a price drop, you will be paying a lower price for the shares you purchase until the time comes when the effect of the price drop has been overcome. That’s good. Paying a lower price means that you will enjoy a larger gain at the end of the process on those shares (remember, you end up with the same dollar-value portfolio no matter what sort of return sequence applies — obtaining that portfolio at a lower price is an obvious plus).

It’s just the opposite if we see a price rise, of course. If stock prices go up, you will for a long time (until the inevitable countering price drop takes place) be paying more for any shares you purchase. That will lower your return on those shares.

Price drops are good news. Price increases are bad news.

Why then do we cheer price increases and boo price drops?

We think of ourselves as seller of stocks rather than buyers of stocks. Our focus tends to be on the shares we already own. The owners of things being sold always want the highest prices possible to apply.

But we are wrong to adopt this attitude. If you are a few months away from retirement and you plan to go to a zero stock allocation on the day you retire, it makes sense to think of yourself as an owner/seller of stocks. However, if you’re like most of us, you will be buying stocks for many years to come (that’s true even of a good number of retirees). For so long as you are buying stocks, you should be looking at things from the standpoint of a buyer. Buyers prefer low prices, not high prices. The logical thing is for most stock investors to root for low prices.

Price drops are good.

Price increases are bad.

This isn’t opinion. This is mathematics.

Now are you beginning to understand why I argued in the first article written for this column that today’s knowledge of how stock investing works is primitive? It’s not so much the things that we don’t know that are killing us, it’s the things that we think we know for certain that just ain’t so.

by Rob Bennett
images: dbkp file

Rob Bennett often writes about behavioral finance. His bio is here. And please don’t even think about not reading these Important Cautionary Words.

Back to DBKP Front Page.

Your Ad Here

Sphere: Related Content