I really enjoyed this analysis as it epitomizes the problem facing investors today. Investors are currently faced with a “binary” choice given an overvalued, overly bullish and extended market.
- Stay out of the market and miss out on short-term gains but remain protected against a future “mean reverting event;” or,
- Chase the market for short-term capital appreciation but potentially suffer severe capital destruction in the future.
It is an impossible choice.
Let me explain.
In an overly valued, extended and bullish market, the logical choice would be to go to cash (sell high) and wait for a “mean reverting” event to redeploy capital (buy low) at much better valuations. The chart below shows, even using a simplistic process for doing so, the long-term returns have far outpaced those of “buy and hold” investors.
Yes, as notated, investors would have “missed out” of the market for nearly 3-years in 2000, almost 2-years in 2008, and 6-months in 2016. Yet, using even a simplistic method of risk-management, in this case a 12-month moving average, the net result greatly outweighed the mainstream “buy and hold” approach.
But it’s impossible for most individuals to actually do.
The reality is that most investors “sold” the lows in 2002, and 2008, and waited far too long to get back “in.” As has always been the case, investors tend to do the exact opposite of what they should.
“Buy high and sell low.”
As study after study shows, investors are driven by their emotions of “greed” and “fear.” Those emotional biases are fed by the mainstream media who consistently berate individuals for “missing out” and “not beating the market.” Yet, scream “panic” at the first sign of trouble.
This drives investors to consistently do the wrong things at the wrong time. Repeatedly.
Currently, investors are riding a nine-year-old bull market with an inherent belief they will be smart enough to get out before the next bear market begins. This is the very essence of the “greater fool theory.”
Unfortunately, most individuals will once again be “eating their sardines.” As discussed previously:
“While the answer is ‘yes,’ as there is always a buyer for every seller, the question is always ‘at what price?’
At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity.
When the ‘robot trading algorithms’ begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.
Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.“
Currently, the markets remain above their 12-month moving average which keeps portfolios allocated on the long-side.
However, such will not always be the case.
Trying to beat a “benchmark index” is a fool’s errand and should be left to the “fools.”
1) The index contains no cash
2) It has no life expectancy requirements – but you do.
3) It does not have to compensate for distributions to meet living requirements – but you do.
4) It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
5) It has no taxes, costs or other expenses associated with it – but you do.
6) It has the ability to substitute at no penalty – but you don’t.
7) It benefits from share buybacks – but you don’t.
In order to win the long-term investing game your portfolio should be built around the things that matter most to you, and your money.
– Capital preservation
– A rate of return sufficient to keep pace with the rate of inflation.
– Expectations based on realistic objectives. (The market does not compound at 8%, 6% or 4%)
– Higher rates of return require an exponential increase in the underlying risk profile. This tends to not work out well.
– You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.
– Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.
Investing is not a competition and, as history shows, there are horrid consequences for treating it as such. So, do yourself a favor and turn off the media. Focus instead on matching your portfolio to your own personal goals, objectives, and time frames. In the long run, you may not beat the index from one year to the next, but you are much more likely to achieve your investment goals which is why you invest in the first place.
Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and a strategy tends to have horrid consequences.
Personally, I hate the “taste of sardines.”