The "T" Word

If April showers bring May flowers, then what do May flowers bring?  Pilgrims.  But also articles written at least every other day expounding the oft cited “sell in May and go away” maxim.  The upshot of the articles is that you shouldn’t do it, because, well, Market Timing is the devil, as Mama Boucher would say.

This is something we have been thinking about a lot recently in various contexts (market timing strategies, not Adam Sandler movies), so we thought it would be the perfect way to kick things off.

Market timing strategies are generally viewed about as positively as blood-letting is in modern medicine, and for good reason.  The crystal-ball method of investing, trying to sell at the very top and buy at the very bottom, is impossible.  Sorry, but it is.  That doesn’t mean people don’t still try it - and there are volumes of  explanations based in psychology and behavioral finance about why investors might engage in this type of strategy (intentional or not) - but it doesn’t work.  In fact, we’d suggest that market timing strategies are one reason you see charts like the below, and why most of your active mutual fund managers underperform the passive indices over time.

Source: http://www.investmentu.com/article/detail/45016/how-to-beat-the-average-investor-return#.VyfsA-ArKJd
 

Due to the impossibility of perfect market timing, most of the advice geared towards individual investors is based around the buy-and-hold approach -  just put your money in a diversified, low-cost index fund, and don’t touch it.  Anyone heard that one before?  We absolutely agree with that advice, to a point.  Diversified?  Great.  Low-cost?  Definitely.  Don’t touch it?...depends.  If you told me I was going to get 10% returns on my money every year, then sure, absolutely.  Invest your money and forget about it.  But if you told me I was going to get 1% returns every year with a lot of volatility...well, I would probably want to keep a little bit of a closer eye on those investments.  

That, in a nutshell, is our approach to portfolio management at the moment.  Buy-and-hold is a great strategy if you are buying at a level that supports decent future returns.  If future returns are expected to be rather unremarkable, it probably makes sense that you’re going to have to work your money a little bit harder to get satisfactory results.

The main point supporting a buy-and-hold strategy is that the long-term stock market returns here in the US have averaged about 10%.  Good news: that’s factually pretty accurate.  The average return on the S&P500 from 1928-2015 was 11.4% (as calculated here by Aswath Damodaran).  Bad news: you will not get the long-term stock market return.

Not to drag you all through the financial weeds (that’s our job!), but there is a sound mathematical basis behind why it’s reasonable to expect average stock market returns to fall short of 10% going forward.  In fact, the decade from 2006-2015 saw average returns of 9% (relative to the 11.4% average going back to the 1920s), and at current valuation levels, it’s our expectation that returns over the coming 10 years will average 0%.  Not a typo - 0% average returns over the next 10 years.

And what’s more, not all averages are created equal.  Buy-and-hold strategies specifically ignore the sequence of returns risk.  What do we mean by sequence of returns?  Consider the following three scenarios.  Each scenario unfolds over 4 years and has an average return of 5% per year.  But notice how the sequence of yearly returns affects the value of the portfolio!  For consistency, let’s assume the portfolio starts with $100,000 and you withdraw $5,000 per year to pay for a nice vacation.

Scenario 2 starts off with a loss in year 1.  By the end of year 4, the overall portfolio is down 10% compared with Scenario 1, despite the exact same average return over the four years.  This is what we mean by “sequence of returns” risk.

Those of you at or near retirement are most vulnerable to this risk, because negative returns in the years when you start withdrawing from your portfolio can have an outsized impact on safe withdrawal rates and the longevity of your portfolio going forward.  

So what can be done to mitigate this risk?  Without being too glib, avoid that -20% return in year one.  There are a number of strategies out there to hedge, or reduce, the potential losses to your portfolio.  One of those (and one that we fully support), could be considered a market timing strategy - try to be less invested when the market is going down, and more invested when the market is going up (so much for not too glib), by using valuations and return expectations to influence investing strategy.  High valuations aren’t necessarily a signal to sell everything and go away in and of themselves.  There’s nothing that says valuations can’t go even higher!  So our preference is to stay invested until we see the market signaling that it might be breaking down.

If valuations were at a level that suggested annualized returns of 7% or so over the coming decade, we would have no problem advocating a buy-and-hold approach.  But at current levels, we see a very real risk to those of you at or near retirement who are either a) expecting 10% returns or b) haven’t considered the impact to your portfolio spending pattern that a down year (-20%+ returns) might entail.  

For our younger readers out there who might be thinking “this doesn’t apply to me because I have 30 years before I retire”, consider the impact that a decade of 0% returns would have on your ability to build up that nest egg.

Einstein said the most powerful force in the universe was compound interest:

See?  Told you.  If you are saving $10,000 a year through your 401(k), IRA, brokerage account, or some combination thereof, how much will you have after 30 years?  You will have saved $300,000 (10,000 x 30), but at a conservative historic average of 7% annual returns, your portfolio will actually be $945,000.  Compound interest basically gave you $645,000.  Take that, gravity.

Now, let’s assume that returns for the next 10 years are 0%, and then they go back up to that 7% average for the remaining 20 years.  Your $10,000 per year savings will grow to $797,000.  That’s not too shabby, but it’s 15% less in savings by the time you want to be retiring and spending that money thanks to a full decade of zero compound interest.  For those interested, Fortune actually just published an article this week on this topic - the expectation that Millennials will have to either save a lot more every year, or just work longer due to lower expected investment returns.

It’s our view that an informed market timing strategy can benefit investors of all ages and risk tolerances.  Most pointedly, we are not advocating a strategy that tries to predict market tops and bottoms.  Rather, we believe that staying invested for the long run (buy-and-hold), is generally appropriate, except in cases where high valuations suggest disappointing future returns, at which time you’ll need to make your money work a little harder, possibly by incorporating a strategy that involves market timing.  Timing isn’t a four-letter word.  When used appropriately, it can potentially be a powerful tool for reducing portfolio volatility and drawdowns.  But unfortunately, that doesn’t lend itself to a nice little rhyming catchphrase.