By Steve McDonald
There is an unofficial rule in the stock business called the “Odd Lot Theory”. It states that when small investors buy into a stock it’s a sell signal. A “small investor” is defined as someone who buys small lots (hundred share orders rather than thousands of shares) or odd lots (less than one hundred shares).
The reasoning is that the small investor is consistently wrong about when and what to buy, so if the little guy is buying, it’s time to sell. This unofficial rule has been painfully accurate during my 25 years in the markets.
The small investor consistently takes too little risk or too much risk or buys in after the market or an individual stock runs up. These are the only consistent qualities of this class of investor and they always result in losses.
Take a look at what the small investor has been doing lately.
A recent Wall Street Journal article, “A Taste for Risk-Again,” listed the activity of mutual fund buyers, the favorite of small investors, since last year’s sell off. Purchases in emerging markets, China, and junk bond funds, sectors that have already seen big run ups and that are considered high risk compared to domestic large cap funds, have sky rocketed.
Investors in the first five months of 2009 have poured $4.9 billion into diversified emerging market funds compared to pulling out $2.6 billion in the same funds last year. Investments in the riskier junk bond funds are up 10 times over last year.
At the same time, large cap U.S. stock funds have had $11.2 billion withdrawn in ’09 in addition to the $52 billion withdrawn last year.
What’s the explanation for this surge? Small investors are trying to recoup their losses from last year by jumping in late on higher risk investments. See the pattern? Too much risk, too late.
At the other end of the risk spectrum, the risk adverse small investors who took their losses and ran from the market last fall have been hoarding cash. The savings rate in the U.S. is up from 0% of after tax income in 2008, to 7% in 2009. The cash sitting on the sidelines is gigantic and all of it is generating an after tax and inflation loss.
Despite the run up in the market since March of this year, the best companies in the world are still available for pennies on the dollar and are offering huge dividends. As always, the small investor wants nothing to do with these high quality, lower risk investments.
Merck for example is off about 55% from its January 2008 high. It has a dividend of about 5.7%, that alone is almost three times money market or savings rates, and it’s literally one of the best companies on the exchange.
Merck, and a hundred others just like it, is appropriate for just about everyone and could be a core holding in almost anyone’s portfolio. At a 55% discount it is essential.
Large cap, dividend paying stocks are one of the best places for small investors. It gives them income and stability they can’t get in any other investment and a risk level that is perfect for all but the most risk adverse. But, as usual, the small investor is 180 degrees out of sync with what he should be doing.
The small investor historically will not be interested in a stock like Merck until it is at or near its 52-week high and the dividend is in the one to two percent area, exactly where you should be taking profits.
The Odd Lot Theory works. Use it to change how you are managing your money rather than being a victim of it.
Good luck.
Steve.
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