Omar´s Outlook - Jun 2017
On “Buy & Hold” and Other Investing Myths
A little while ago I had a discussion with an investor whom I’ve known for a couple of decades now. While we were chatting, he posed a very pertinent question:
“When I first starting investing, I was told that the key to success is to buy good assets and never sell them. If they go down in value at any time, it’s just an opportunity to buy more (this is called “dollar cost averaging”). Over time, the compounding effect will make me rich.
The problem I see now is that while that approach seemed to work for quite a number of years, my stock market investments have never really recovered from the losses incurred in the Global Financial Crisis.”
Apart from this particular investor’s comment, one other issue has prompted me to write this blog article.
Over the last 12 months, I have been integrating into our practice a number of clients, all relatively old and mostly retired, who came to me - according to our “risk profiling” process – with usually “moderately conservative” to “balanced” investment portfolio preferences. Yet despite this, they had been invested almost solely in equities (shares), on the mainstream assumption that regardless of intermediate market volatility, they would be receiving dividends and that, “over the longer term”, any falls in asset values would be irrelevant because the market always eventually recovers.
When one looks at the 15-year chart of the ASX 200 index (large, “blue chip” stock), the problem with those justifications becomes quite obvious, and illustrates very well the point made by my investor friend above:
This price history chart goes to the very core of the fallacy that is continually espoused by the media as well as by the majority of investment advisers, with reference to “buy and hold,” “dollar cost averaging,” and “compounding.”
It does not take much effort to understand that for an asset that is declining in value, buying more of it at lower prices can only work if it does, in fact, recover at some stage.
Sadly, quite often dollar cost averaging turns into what professional traders call “catching a falling knife” - that is, the price of the investment does not recover and thus you may well average your exposure down to actual zero & lose all your money invested in that asset.
In colloquial English, this is also known as “throwing good money after bad”.
The next very important consideration is that when you are invested in any asset that can lose principal value during your investment time horizon, you will not be able to truly compound returns.
In other words, compounding may only occur in investments that do not lose principal value. These are the so-called “defensive” asset classes, of which the most common are bonds (also known as “fixed income” or “debt securities”) and cash & term deposits.
Furthermore, the major problem is the loss of time needed to achieve your investment goals. When a large correction (>10%), or an outright bear market (fall by 20% or more), occurs in the financial markets – and those happen relatively frequently, often with little warning - getting back to even can be rather difficult in itself. A simple calculation shows that if your investments lose half (50%) of their value, they will need to double (that is, go up by 100%) in order to recover back to square one.
Alas, even this is not the main problem.
While capital can undoubtedly be recovered following a bear market, the time to reach your investment goals will necessarily be impacted in a negative way also.
For younger people, this means having to work and save longer. For retirees, it means running out of money faster or having to tighten your belt; in some cases quite significantly.
So what is the moral of the above stories?
Basically two things:
The first one is “timing” - as opposed to “time in”.
Getting timing right truly makes a difference between an outstanding and an atrocious investment. Even the best investments often have periods where their value falls; being able to avoid even a small proportion of such negative events will do wonders to your portfolio.
The difficulty of course is is that to achieve exact timing is very hard, and sometimes downright impossible – truly an “inexact science”.
We therefore need to approach the problem in a more roundabout way; namely we take at least some volatile assets out of our portfolio when market risk is high & they appear overvalued, and we park the resulting cash into defensives. When the fundamentals change, we reverse the process.
This approach may well reduce returns in the short term, but will help eliminate the chance of a significant, or in some cases even catastrophic loss.
To give a pertinent example, on the basis of a number of fundamental measures and economic indicators, the banking sector of the Australian stock market appears to be significantly overvalued.
This prompted me a couple of years or so ago to start pointing out the warning signs, and then recommending a gradual reduction in exposures to that sector.
In fact, bank stocks fell quite notably (by some 15% on average) between April 2015 and November 2016:
However, in lock step with a similar move in overseas financial stocks following the Donald Trump electoral success in the USA, Australian banks have since staged a solid recovery – despite what is starting to look like another trend reversal over the last four or so weeks:
While this does make our Sell/Reduce recommendation from last year look wrong in the short term, given the clearly slowing property market, stagnating wages and subsequently credit growth, new bank tax introduced in the recent Federal Budget and a number of other items I could mention, I do believe our “timing” call will be proven right on the longer term.
This is what I meant when saying that exact timing is usually not possible; however the fundamentals do tend to always prevail over the full market cycle, and getting timing right at least in the aggregate does make a huge difference to the final outcomes.
The second issue is asset protection.
As already outlined above, a younger investor may, after a catastrophic investment loss, yet recover if s/he learns from the experience.
This luxury however is not available to retirees. Consequently it is essential that overall investment risk be reduced as much as possible, in order to prevent catastrophic losses to occur in the first place.
It is well known that investors’ sentiments at any given time are driven by two emotions: “Fear” and “Greed”.
When the markets are in a bull run, greed tends to take over, risk is forgotten and conservative, value-conscious advisers with a long-term outlook tend to be shunned in favour of stock brokers and even various real estate spruikers.
For retired investors though, perhaps not outright “fear”, but certainly “apprehension” and the acknowledgement of market action history needs to take over from “greed” in order to avoid tears, pain and perhaps even a serious decline in living standards.
To that effect, we encourage our clients to first assess what their lifestyle goals may be and how then those may be accomplished with the least possible risk.
This approach does mean that doubling your money will almost certainly not be on the cards; but then again, that should not be the objective if you are already retired.
The sad fact is that if you have not managed to secure your desired retirement lifestyle funding during your working life, it is unlikely or even outright impossible that you will do so by employing risky investment strategies in retirement.
As an investor, it is your job to step away from your emotions and look objectively at the market and the economy around you. Is it currently dominated by “greed” or “fear”?
Your ultimate returns – and by extension your lifestyle - will depend greatly not only on how you answer that question, but how you manage the inherent risk.
As advisers, we can help you with those decisions, but only if you yourself do truly understand the stakes.
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