Looking a Gift Horse in the Mouth


By Christine Song of Small Investing Insights

October was what I call a “straight up” month – the market soared over 10%. October also happened to be my birthday month so it was quite a gift this rally. Now don’t get me wrong, I’ll take positive returns any day of the week. You can’t buy birthday cake with relative performance. But while it’s great to see your stocks go up, not all positive performance is created equal – are your stocks rallying for the right reasons?

When I ask this question, I’m often met with an “are you kidding me?” look – do you need a right reason? Just be happy your stocks are going up, thankyouverymuch. However knowing why your stocks are going up when the market takes off will protect you on the downside when the market turns south.

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These “straight up” months are often called “junk rallies”. Yes junk as in lower quality and these riskier stocks tend to lead the charge. In October, investors (a moody bunch) decided that the world wasn’t going to end (Greece got bailed out – hooray!) and when investors feel better about the future, they take on more risk. So they went shopping for lower quality/riskier companies like ones with more debt or more cyclical sales because the probability of bankruptcy goes down when things look macroeconomically brighter, all else being equal.

If you find your portfolio outperforming for non stock specific reasons, be careful – you may be holding a handful of junk. This will feel great in a month like October, but hurt when sentiment reverses and lower quality stocks drop like a cinderblock as investors do the inevitable “flight to quality” dance. When a portfolio manager loses money, she’s in the hot seat because everyone wants to know what went wrong. But equally important is understanding the reasons when she outperforms. This is a great check on your money manager – is she sticking to her strategy.

Successful investing requires a disciplined strategy so call me crazy but when it comes to investing I will look a gift horse in the mouth.

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