1 0 Tag Archives: S&P 500 index
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The Dogs of the Dow – Publish for back

A funny thing happens on January 2nd of every year. Hundreds and thousands of investors wake up and run to their computer like it’s Christmas morning. They’re in a huge rush to do a few quick calculations and determine their investment strategy for the new year. Based on this little bit of math they blindly make all of their investment decisions.

It’s a simple strategy. With a strategy based on the stocks that make up the Dow Jones Industrial Average, these investors are looking for high dividend yields. Their hope (like every investor) is to outperform the market.

So, what strategy am I talking about?

The “Dogs of the Dow” investment theory of course. In 1991 Michael O’Higgins published a book called “Beating the Dow.” Michael, according to his own biography, is widely considered one of the best investment managers in the US. He started on Wall Street in 1971 and founded his own money management firm in 1978. In this book he put forth a very simple strategy of buying the 10 Dow stocks with the highest yields.

Over the long-term, say 15 years, the Dogs of the Dow strategy had outperformed not only the Dow Jones Industrial Average, but the S&P 500 as well. Sounds great, huh?

The problem… it doesn’t work so well anymore.

In the last 5 and 10 year periods, the strategy actually underperformed the market. In the go-go days of the internet, people were less focused on traditional businesses that paid dividends. As a result, the strategy failed to beat the averages. Further, in 2004 and 2005, the strategy failed again – miserably.

Then in 2006 the strategy performed well, outperforming by 10%. This, unfortunately, brought renewed life to the Dogs of the Dow.

In 2007 the results were again unimpressive. The top 10 companies selected this year included: Pfizer, Verizon, Altria, AT&T, Citigroup, Merck, General Motors, DuPont, General Electric, and JP Morgan Chase.

A basket of these stocks, one share each, would have cost approximately $427.50 and you would be able to sell them today for $424.12. Including dividends the strategy returned a measly 3.5%.

The Dow as a whole is up this year almost 7% . . . not including dividends.

Just investing in the Dow outright would have produced better results than following the Dogs of the Dow strategy. Why did the results in 2007 fail so miserably after such a good 2006? You can directly tie the poor results this year to two stocks Citigroup (C) down 47% and General Motors (GM) down 17%.

A wolf in sheep’s clothing?

In reality this famous trading strategy is a simple one. It’s a very basic value strategy. These stocks are traditionally trailing the market but still have great businesses with some inherent value. On the whole, they tend to be out of favor for some reason. This makes them value plays. Ah, but we know value investing tends to time…sometimes more than 1 year.

And right now, the market is favoring growth stocks.

So here we are at the last trading day of 2007. Tomorrow, a new batch of stocks get selected for the Dogs of the Dow and investors the world over start their investing strategy all over again.

I suggest you leave the “dogs” to someone else.

Resist the urge to select stocks purely on one data point – it will save you lots of pain down the line. Look at the strategic reasons behind each investment rather than blindly following a general strategy.

You should never just buy or sell a stock only because of its yield, try to understand the company and its industry. With a little additional research I truly believe savvy investors can beat the market over the short and long term.

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08. Jan, 2011
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Fama–French Three Factor Model

Proponents of market efficiency divide risk into unsystematic and systematic. Unsystematic risk is not priced by everyone investing in the stock market. Here is an example to help you understand unsystematic risk. If you are considering investing in the stock market you could either buy specific stock in a specific company that you think will have a rise in price in the future. On the other hand if you don’t trust your stock ability you have the alternative of buying a basket of stocks that mimics the stock markets total combined movement. One way would to be to buy an indexed mutual fund like VFINX which is pegged to the S&P 500 which is a very large stock market index. The degree to which the stock moves relative to the general market is the unsystematic risk of the stock.

Systematic risk is the degree to which the stock changes in price relative to the general stock market as measured by an index like the S&P 500. Model calls this measure a stocks “beta.” The Fama-French Three Factor Model is a regression analysis that tries to separate out the systematic risk of a stock from the unsystematic risk by compensating for three factors. The first factor is a financial ratio called book to market. The second factor is the size of the firm as measured by its market capitalization. The third factor is the return on the market portfolio.

The book to market ratio is nothing more than what accountants estimate the company to by worth divided by the market capitalization of the company. The market capitalization of the company is the share price of the stock times the total number of shares the company has outstanding in the stock market. The return on the market portfolio is measured by some index like the S&P 500.

According to the efficient market school (which I do not agree with), size and book to market reflect systematic risk, meaning risk that requires compensation in the form of higher expected returns. If this is the case researchers should see that investors perceive small-value stocks to be riskier than large-growth stocks. The do see this which does lend some support to market efficiency. But investors consistently expect large-value stocks to outperform small-growth stocks and this is perverse. Basically, investors recognize that small upcoming companies are riskier but do not expect to be compensated for this risk as the efficient market model says that they should.

In a similar fashion, analysts tend to recommend growth stocks more favorably than they do value stocks. In the efficient market model of which the capital asset model (CAPM) is a part of, the profit from stock investing that investors expect should be as much as the risk they perceive that they are taking instead of the exact opposite which we find to be the case when actual research is performed on the matter.

This result caused the death of CAPM beta that was treasured by efficient market theorists despite the fact that the model resulted in the awarding of a Nobel Prize in economics to William Sharpe of Stanford University. Hirsh Shefrin has suggested that a behavioral beta be introduced into the model that might help explain these results that are contrary to market efficiency.

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07. Jan, 2011