Thursday, August 28, 2014

Point of No Return

As Burton Malkiel points out in this article, popular sentiment is growing that the stock market is reaching or has passed fair value. As he also points out, beware your attempts to "time" the market--selling out to buy back in after the "inevitable" dip.

The stock market will go up and down and up and up and down and up and down and down and up and . . . Of course, history shows that those downs don't fully counter the ups. The composition of ups and downs in both frequency and magnitude matter. Historically it has been the case that the rides up are slower and longer while the trips down are sharper and shorter. I've discussed this before. While that pattern isn't always followed, the strong historical trend has been an upward bias in returns--the long-term trend in the stock market is positive.

Add to that the fact that the market is very efficient, and you are left with virtually no reason to try to time the market. Yet, many are not convinced. They still feel compelled to sell out with the belief (hope) the market will decline allowing them to buy back in cheaper. My advice then comes in the form of a question: What if you're wrong? What is your contingency plan for that?

It better be to find a point to throw in the towel and get back into the market. Of course, you'd like to know how to recognize you were in fact wrong. After all, just because the market has risen from where you exited doesn't mean it won't come down still.

Here is perhaps a little guideline. Looking at the monthly total returns for the S&P 500 since January 1970 through June 2014 (44.5 years or 534 months), I isolated all of the drawdowns for the index. I then ranked them and calculated the implied percentage gain for each. This last figure would be the amount the index would need to increase in order to overcome the drawdown. For example, if the market declines 25%, it would then need to increase 33% to get back to even. A 50% decline requires a 100% increase from that new low point. Here are all 36 drawdowns for the period charted:


Your reentry point might be once the market has gained some threshold amount above the point in which you sold out. Because the general trend is for the market to grow, you would want to buy back in once that threshold of growth has been achieved no matter how difficult it feels to do so. And it will feel difficult--you sold out at a lower point for a reason. Your complaint might be that just when you thought you were out, the market pulls you back in.

To give you some comfort, though, notice how rare very large drawdowns are. Couple that with the fact that over this time period (January 1970 to June 2014) the S&P 500 increased over 8,300%. Like I said, are you sure you want to time the stock market? If you do, consider that once the S&P 500 has increased about 20% from your exit point only five times in the past 44 years has it dropped so much that it would return to your exit point. And that drop needs to happen ASAP. The index's average growth over this period was about 10.4% per year or about .83% per month. You risk being left behind for good.

When it comes to beating the market, market timing as a strategy isn't even on the map. The implication is discipline beats (mythical) exceptional skill--most value added by professional financial advisers (perhaps as much as 90%) comes from simply finding appropriate asset allocations, fulfilling it with appropriate (not sensational) investments (styles and classes are more important than particular names and issues), and KEEPING with it in good times and bad.