Which investment strategy should investors in the stock market adopt in these turbulent times? Invest boldly (that is, allocate your cash resources to the stock market at once), gradually buy stocks (phase in your money) or wait for absolute certainty before venturing in?
Most rational, or should I say reasonable, people would opt for the wait-and-see strategy. Intuitively, it feels like the right thing to do. Emotionally, it is the most pleasing or least risky strategy. We are simply very bad losers; nothing is more demoralising than buying assets today that you could buy next month at, say, 75 percent of today’s price.
Obviously, you do not have a clear-cut answer to the question of what is the best strategy for today – you will know this only after the fact.
For now, it is probably best to combine a strategy with which you are emotionally most comfortable and the fine-tuning that comes with some knowledge of how markets typically behave. In fact, you can learn valuable lessons from such behavioural studies, making it more than worthwhile to tweak your investment strategy, instead of following one based on gut feel alone.
Let me highlight some behavioural issues of which you should be aware: first, our tendency to follow popular or consensus trends and, second, the specific characteristics of market returns.
We formulate our opinions about the prospects for the market by reading and listening to market experts. Moreover, we are exposed to media reporting that is invariably geared towards sensationalism and is contextualised for the present day. Yet very few of us make the important inference that the validity of such expert and media comments is likely to be reversed over longer holding periods.
For example, while certain sectors and stocks may be out of favour for the foreseeable future, a changing economic climate could make those out-of-favour stocks the major beneficiaries in the next cycle. And an alarm will not sound to announce the advent of such a new cycle.
A further issue arises from strictly following popular trends, sectors or stocks: if market experts deem those assets to be excellent investment opportunities, do their current prices not already discount the perfect scenario going forward – that is, very little risk premium is built into the price? In other words, they offer investors little reward for holding a risky asset; investors are expecting with near certainty that very optimistic earnings forecasts will be realised in the future.
Generally, this is where many investors are seriously burned by blindly following expert advice and popular trends and not considering the current price or making reasonable assumptions about profit margins, earnings growth, and so on. (Think of information technology stocks earlier this decade and more recently resources and construction stocks.)
Thus we, as investors, need to be aware of our limitations in calling the winners all the time. We need to be aware that overconfidence in our (or experts’) predictive abilities may seriously harm our returns. Hence I would state the case for following an “autopilot” stock market investment strategy – typically an index fund or an enhanced index fund – as your core investment strategy.
It is fun and gratifying to manage your own portfolio, but beware that the downside to that approach is equally stressful.
First, you become emotionally affiliated with your stock selections, making it difficult to sell some holdings when perhaps you should do so because market prices are buoyant, or to retain stocks when market conditions are depressed.
Second, it is unlikely that you will be able to build a truly diversified portfolio (unless you have a few million rand invested) that will overcome your tendency to have strong biases and preferences about certain sectors of the market. The outcome will consequently be a concentrated portfolio, which may work well for many years, until you encounter market conditions similar to those of 2008/9.
Let us turn to some characteristics of stock market returns. More often than not, returns may surprise you given the market conditions – for example, decent market returns during dire economic conditions. There is a much smaller direct or linear relationship between how stock markets perform and how the economy performs, contrary to what investment theories may dictate.
Market performance over short-term periods (which we tend to take very seriously despite our long-term intentions) is determined predominantly by sentiment (expectations) about what is most likely to pan out in the near future and not by what has happened until now.
Most investors are fooled by how market returns arrive in their investment portfolio, leading to gross behavioural errors. It is not a steady process of accumulation but short bursts of large positive and negative price movements that predominantly determine your returns from the stock market. And these large movements are not predictable – most large positive price changes do not occur during bull markets only. Similarly, large negative price movements do not happen only during bear markets.
For illustrative purposes, I reviewed the daily returns of the FTSE/JSE All Share index (Alsi) for the period July 1, 1995 to March 31, 2009. In total, there were 3 422 trading days (data points). Subsequently, I identified the 20 worst and the 20 best daily returns during this period. On the 20 worst trading days, the market lost 4.5 percent or more; on the 20 best days, the market gained at least 4.78 percent (see Chart 1). The importance of these outliers in determining the total market return is demonstrated clearly by the following facts: since July 1995 the Alsi produced an annualised return of 11.5 percent (excluding dividends). But if, for some reason, you could have avoided the worst 20 days, the return would have been enhanced to nearly 24 percent over the same period. It means that the difference between the two outcomes would have been that the latter outcome appreciated 3.5 times more than the ordinary buy-and-hold portfolio over this period.
The same holds for the reverse position. When missing the 20 best days over the review period, the annualised return of the Alsi would have been trimmed to a miserable 2.5 percent. Alternatively stated, the ordinary index portfolio would have appreciated three times more over the period.
Thus an investor needs to avoid the worst trading days, but you should be in the market not to miss the best trading days. Something like avoiding the bear markets and investing during bull markets? No, not a chance if you consider when these outliers (best and worst trading days) occurred.
Chart 2 shows undoubtedly that the best and worst days occurred more or less around the same time. Typically, a large loss was followed by an equally large gain soon thereafter, and vice versa.
Thus it is unlikely that an investor who experienced large losses and withdrew from the market would have been in the market when the sharp rebound in prices occurred shortly afterwards. In fact, the pattern depicted in chart two makes a mockery of trying to time entry or exit points in the stock market. Market timing is a futile investment strategy and, although it sounds emotionally gratifying to many investors, it offers very little, if any, enhancement of returns; it is more than likely to cause the opposite outcome.
Consequently, what should you know when you decide on your investment strategy?
First, outliers matter a great deal in determining your total return from the stock market. Typically, when markets are volatile, as they are at the moment, you are running a great risk if you are not in the market. After a burst of relatively large negative returns, a large rebound is a real possibility.
Second, the stock market will test its lows and start its bull market journey long before the economy has recovered officially; typically, six to nine months ahead of the economic cycle. Therefore it does not make a great deal of sense to wait for statistics to confirm that the economy has recovered. Moreover, most of the large market gains are likely to materialise soon after market lows have been reached.
Third, there is a significant inverse relationship between market returns over, say, five-year holding periods and the stock market’s primary valuation metric, the price/earnings (PE) multiple. Simply, the higher the PE multiple at the start of an investment period, the higher the chances that the subsequent market returns will turn out to be disappointing or meagre. Conversely, the opposite holds.
However, there is one caveat. The market’s current earnings base (as the denominator in the formula) may be skewed by extraordinary periods of earnings growth and economic prosperity, such as we witnessed from 2003 to 2007. Therefore it would be more appropriate to average out earnings growth over, say, seven-year periods – that is, to “normalise” the earnings base. The relative expensiveness of the market is then measured more realistically than would be the case if we simply used the current data. Such an approach is depicted in Chart 3 and is referred to as the trailing PE ratio.
By April last year, the market’s valuation rating had been downgraded to levels similar to those in the bear markets of the early 1990s, 1998 and 2002/3, yet it was not as low as it was during the politically unstable and economic turbulent periods of the 1970s and 1980s.
In Chart 4, the stock market’s trailing PE ratio since 1960 is plotted against subsequent five-year market returns. A significant inverse relationship is found: the lower the trailing PE ratio at the start of an investment period, the higher the subsequent five-year period returns, and vice versa.
By April 2009, the market’s trailing PE ratio was at a multiple of 15 – neither expensive nor extremely cheap – but the overwhelming historical evidence pointed to reasonable return expectations going forward. By August 2010, the Alsi had risen by more than 35 percent and the trailing PE ratio was at 19.
Hence it will not be surprising that we boast of very pleasing market returns in the five-year period from April 2009. At least the tendencies of market returns to revert to the mean and to conform to historical patterns over longer holding periods are strong allies of this view.
Thus, while from an emotional standpoint we may not feel comfortable with risking our hard-earned money in the volatile stock markets today, the his-tory and characteristics of stock market returns lead us to believe that such times are the most promising entry points. Therefore do not postpone or stop your investment plan altogether in times of volatility. Maintain your strategy. In fact, if you decide to use a phase-in approach, perhaps speed up your implementation period.
* Daniel Wessels is a partner at Cape Town-based financial advice company Martin Eksteen Jordaan Wessels.
* This article was first published in the 4th quarter 2010 edition of Personal Finance magazine.