Personal Financial Planning: An "How-To" Guide (part 50)

Timing Your Investments
by
Charles Lamson

Once you find a stock you think will give you the kind of return you are looking for, you are ready to deal with the matter of timing your investment. As long as the prospects for the market and the economy are positive, the time may be right to invest in stocks. On the other hand, there are a couple of conditions when investing in stocks does not make any sense at all. In particular, do not invest in stocks if:

• You feel very strongly that the market is headed down in the short run. If you are absolutely certain the market is in for a big fall (or will continue to fall, if it is already doing so), then wait until the market drops, and buy the stock when it is cheaper.
• You feel uncomfortable with the general tone of the market---it lacks direction, or there is way too much price volatility to suit you, for example, this became a problem prior to and after the October 1987 crash, when computer-assisted trading started taking over the market. The result was a stock market that behaved more like a commodities market, with an intolerable amount of price volatility. When this happens, fundamentals go out the window, and the market simply becomes too risky. Do what the pros do, and wait it out on the sidelines.

Why Invest in Stocks?

There three basic reasons for investing in common stock: (1) to use the stock as a warehouse of value, (2) to accumulate capital, and (3) to provide a source of income. Storage of value is important to all investors, because nobody likes to lose money. However, some investors are more concerned about it than others and therefore put safety of principal first in their stock selection process. These investors are more quality-conscious and tend to gravitate toward blue chips and other non-speculative shares. Accumulation of capital generally is an important goal to individuals with long-term investment horizons. These investors use the capital gains and dividends that stocks provide to build up their wealth. Some use growth stocks for such purposes; others do it with income shares; still others use a little of both. Finally, some people use stocks as a source of income; to them, a dependable flow of dividends is essential. High-yielding, good quality income shares are usually their preferred investment vehicle.

Advantages and Disadvantages of Stock Ownership

Ownership of common stock has both advantages and disadvantages. Its advantages are threefold. First, the potential returns, in the form of both dividend income and price appreciation, can be quite substantial. Second, many stocks are actively traded stocks; thus they are a highly liquid form of investment---meaning they can be quickly bought and sold. Finally, they do not involve any direct management (or unusual management problems) and market/company information is usually widely published and readily available.

Risk, the problem of timing purchases and sales, and the uncertainty of dividends are all disadvantages of common stock ownership. Although potential common stock ownership. Even though careful selection of stocks may reduce the amount of risk to which the investor is exposed, the risk-return trade-off cannot be completely eliminated. In other words, high returns on common stock are not guaranteed; they may or may not occur depending on numerous economic, industry, and company factors. The timing of purchases and sales is closely related to risk. Many investors purchase a stock, hold it for a period of time during which the price drops and then sell it below the original purchase price---that is, at a loss. The proper strategy, of course, is to buy low and sell high, but the problem of predicting price movements makes it difficult to implement such a plan.


Be Sure to Plow Back Your Earnings

Unless you are living off the income, the basic investment objective with stocks is the same as it is with any other security: to earn an attractive, fully compounded rate of return. This requires regular reinvestment of dividend income. And there is no better way to accomplish such reinvestment than through a dividend reinvestment plan (DRP). The basic investment philosophy at work here is that if the company is good enough to invest in, it is good enough to reinvest in. In a dividend reinvestment plan, shareholders can sign up to have their cash dividends automatically reinvested in additional shares of the company's common stock---in essence, it is like taking your cash dividends in the form of more shares of common stock. The idea is to put your money to work by building up your investment in the stock. Such an approach can have a tremendous impact on your investment decision over time, as seen in Exhibit 1.

Today, over 1,000 companies (including most major corporations) have DRPs, and each one provides investors with a convenient and inexpensive way to accumulate capital. Stocks in most DRPs are acquired free of any brokerage commissions, and most plans allow partial participation. That is, rather than committing all their cash dividends to these plans, participants may specify a portion of their shares for dividend reinvestment and receive cash dividends on the rest. Some plans even sell stocks to their DRP investors at below market prices---often at discounts of 3 to 5 percent. In addition, most plans credit fractional shares to the investors' accounts. Shareholders can join these plans simply by sending in a completed authorization form to the company. Once in the plan, the number of shares you hold will begin to accumulate with each dividend date. There is a catch, however---even though these dividends take the form of additional shares of stock, reinvested dividends are taxable, in the year they are received, just as if they had been received in cash.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK,, PGS. 519-522*

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