Friday, November 4, 2016

Timing the Market Is Costly, Risky and Difficult

Why Am I Overweight in Fixed Income?

Back in November of 2015, I spoke to you how I am interested in growing my fixed income exposure. I wanted to achieve that, in order to protect myself from deflation. I believe that we are at risk of a deflation, if we continue to get industries disrupted, if economies continue to languish, if we continue to get increased automation that replaces workers and therefore their incomes and demand for goods and services. I also believe that global trade could push prices lower, as global competition pushes producers to compete on a more equal level.

Over the past year I have been investing in Certificates of Deposit, US Agency Bonds and Treasury Inflation Protected Securities. I have also took advantage of a few savings accounts that offer higher yields today like NetSpend ( First $1,000 yields 5%, but used to be $5,000 a few months ago) or Insight Savings. I also keep three months expenses in my savings account, for my emergency fund. My checking account has roughly one to two times monthly expense. Most of the fixed income exposure I have is in taxable accounts. The only exception includes TIPs and a bond market fund I own in my 401 (k). I used to allocate 10% of my paycheck to the bond fund, but I have been gradually increasing that to 20%, and now it is at 30% of my paycheck. I will likely continue doing that either until S&P 500 drops below 20 times earnings or until my fixed income exposure in the 401 (k) exceeds 20% ( currently it is a lot less than 10%).

As a result of my high savings rate, and reallocations ( moving dividend income around), my fixed income exposure has been reaching 10% - 15% range. This essentially took a little over year and a half to achieve. Given that I am in my early 30s, I think that this is the highest I am willing to keep it at this moment.

Another reason why I bought fixed income in the first place is as a protection in case we get deflation that mirrors the 1929 – 1933 one in the US or the 1989 – 2016 one in Japan. I am concerned more about extended periods of time that could result in permanent capital impairment to my nest egg, rather than short-term fluctuations in values and economies ( I define short-term as something that spans anywhere from a few months to a few years).

I invest for the long term. In my case, assuming I make it to my 80s, I am investing for the next 50 years. Incidentally, this period is much longer than the amount of time I have been alive on this earth. And looking back at the past 50 years, I am pretty certain that few people from 1966 would have predicted the things that happened between 1966 and 2016. Yet the 30 year old from 1966 probably had to make some estimates about life in the 2010s, despite not knowing what the future entails. I am in the same boat today.

Because I invest for the long run, I can afford to ignore stock price fluctuations, but instead focus my attention to investments that could generate the maximum amount of benefit for me for the next 40 – 50 years.

This very likely means that I will not be able to correctly predict any of the future bear markets we will experience from now until 2066. Therefore, it is unlikely that I will be able to sell high, and then buy low. Noone can do that successfully anyway. Market timing is a fools game.

I believe that investors should simply stay the course. When you try to buy and sell too actively, you increase the risk of making a mistake by an exponential factor. This means that people who sell today in anticipation of a correction will either:

1) Sell out too early. By the time a full blown correction/bear market happens, this person may be able to buy low, but they may end up doing as well as someone who simply stayed the course. This is costly, because this investor may get into the habit of forecasting tops, and missing out on future rebounds in economic and business activity.

2) Get out of equities on time perfectly, and then buying back on time perfectly. If this happens once in an investors timeframe, it is unlikely to be repeated again. You get lucky once, but chances are you will be unlikely to get lucky again. I got lucky once, but the amount of capital I had was much lower than today.

3) Get out of equities at the right time, but you end up buying back at the first dip. Then you watch your equities go down more, kicking yourself about your decision.

4) Get out of equities at the right time, and you end up missing out on the bottom, because you think that stocks will go even lower.

As you know, I have been writing about investments for about 9 years. I have observed a lot of investors in the meantime. Many were feeling uneasy about the financial crisis in 2007 – 2008. I am aware that some may have sold early, or too late. The problem is that many of those investors who sold, didn’t get back into stocks at all, or went back to stocks several years after the bottom in 2009. This  was when prices were much higher. I am also aware that there are many permabears, which have been forecasting doom and gloom since at least the late 1980s and early 1990s. These people have missed out on a great run in equities. The funniest thing about permabears is that they only look at stock price graphs when they evaluate when to buy and when to sell. They completely ignore dividends, and the power of reinvested dividends.

Dividends have historically accounted for 40% of annual stock returns. If you miss out on the power of reinvested dividends over long periods of time, you are missing out on the power of compounding. For example, if you have a stock yielding 6%, that never grows dividends, and never increases in price, a stock chartist would call this stock a dog and ignore it. But a patient long-term holder who reinvests dividends will have doubled their money in 12 years. The power of reinvested dividends is the reason why S&P 500 investor who bought right before the Crash of 1929 would have recovered by 1944.

Other reasons against selling include my experience, where I have found that the companies I have sold for one reason or another, turned out to do much better than the companies I replaced them with. This is a common finding from academic finance as well. The only thing that is certain when you trade too much is that you will pay a lot in commission and taxes. As we have seen with actual examples from the worst mutual fund in history, these are great ways to squander your capital. On the other hand, the static portfolio of blue chip dividend stocks that was set up in 1935 for the Corporate Leaders Trust has done phenomenally well for its investors.

All of this pondering made me start thinking about the future.

For example, I have reached my level of net worth and income, after accumulating assets for a little over nine years. I had done this in an effort to get to a point where I could be financially independent (FI). FI doesn’t mean doing nothing for me however. I may actually end up working much harder, once I have the security/safety net that a nest egg provides.

If I continue working and saving for another decade, I may essentially look at a future amount of cash savings, which may be equivalent to the amount of net worth I have today. So in reality, I have 85 – 90% of my net worth in stocks today, and 10% - 15% in fixed income. Over that next decade, I may earn and save an amount equivalent to 100% of my present day portfolio value. Those savings all come to me in the form of cash. This means that if you look at it from accrual accounting point of view, I have less than a 50% allocation to equities in 2026. If I then work for an additional 10 years, and my equities continue not growing, I will end up with something like 2/3rds of my money in 2036 in fixed income. (given the low interest rates, discounting at 2% will not materially alter these asset allocation percentages). This means that for someone who plans to save for at least a decade, and has invested for a decade prior to that, chances are that they are only halfway done with their journey. So given the relative low amount of current investments, relative to their full future potential, timing the markets may not be as worthwhile to you, even if your investment skills are much better than those of George Soros. It is time in the market that would do the magic for your future self.

Let’s put this example in dollars, as percentages could be confusing. Imagine that an investor today has a portfolio worth $200,000 today. They accumulated that over the past decade. Now let’s assume that this person can save $20,000/year ( let’s assume these are all real dollars that never lose value to inflation). This means that this person will have accumulated $400,000 within a decade ( $200,000 today and $200,000 over ten years). In reality, as peoples incomes grow over time, they may be able to actually save more as long as they are working.

This of course is a ridiculous way to look at things. But I have a point, I promise.

All I am trying to do is show that timing the market is an inferior strategy to time in the market. I define time in the market as the ability to plow money into your stock portfolio every two weeks or once per month (whenever you have the money to do so). This method of dollar cost averaging takes care of the ups and downs in stocks, makes sure the investor is invested at all times, and they are simply buying and holding for the long term. Countless studies have shown that the passive long-term buying and holding of equities can deliver a higher chance of wealth for the vast majority of investors out there, than actively trading in and out of investments. Dollar cost averaging is an investment process that is replicable/repeatable by anyone, and does not require any specialized investment skills, other than patience of course. Timing the market can only be done successfully by a very tiny minority of individuals out there.

I just wanted to show you that the amount of cash you may be trying to time the market with today is small relative to the amount of earnings power you will have to deploy at some point in your investing career. So rather than endlessly worry about timing the ups and downs of the stock market, and stock market crashes, you should worry about staying the course, and making sure you nest egg compounds so that it can provide for you in the future. It is unlikely that keeping most of your nest egg in cash or fixed income for extended periods of time would maintain its purchasing power.

Several investors I follow today are selling off large chunks of their equities, because they believe that “the stock market is overvalued”. I disagree with them that this is a good way to invest. This is because many of the indicators being cited are not good predictors of future performance. For example, the widely followed Schiller CAPE has not been found useful in timing the market (Source: Prof Damodaran). Research has shown that merely buying and holding has done better consistently than timing with CAPE. I have previously also discussed that the Schiller P/E is not useful to investors.

Let's walk through a few hypothetical examples. Imagine that you graduated college and started work in 1994. You then plow $10,000/year and put it into S&P 500 at the end of every year. By the end of 1999 you feel uneasy. You decide to sell everything and keep it in cash, waiting for a bear market.

You keep saving $10,000/year, and manage to put everything to work at the end of 2002. You then reinvest everything until the end of 2015. By the end of 2015 you have a net worth of $714,000.

Let’s compare that to a friend who simply reinvested $10,000/year into S&P 500 from end of 1994 to 2015. They would have a net worth of $521,000.

And let’s compare that to a friend who also started in 1994, and reinvested everything through 2007. The friend then sold out at the end of 2007, and kept everything in cash afterwards. They would have a little less than $319,000 in their possession by the end of 2015.

As you can see, there is a difference if you were able to call in the dot-com bubble early, and buy at the bottom, over buy and hold. The difference amounts to a little over $200,000. Unfortunately, if you were able to call in the 2007 top, but failed to put that money to work for you afterwards, you would have lagged a simple buy and hold strategy by $200,000. And if you panicked when Lehman went under in the middle of September 2008, sold out of everything, and never went back to investing, you may be even poorer.

While you may end up doing better than a buy & hold investors if you are a good timer, this opportunity is not “free” because you are taking substantial risks in the process. The risk is that in your trying to get that extra $200,000, you may actually make an error and end up costing yourself $200,000 (or even a higher amount). Even if you add in modest interest rates paid for holding cash, the opportunity cost of an error still looks very large.

I didn’t even calculate the opportunity missed for someone who merely stockpiled $10,000 in cash each year since 1994, merely because the stock market "was too high". And based on reviews of books and articles from the 1990s I have done, there were a lot of people who thought that stocks were “high” as early as the mid 1990s (some have been bearish on stocks as early as the early 1980s). If you sold out at the end of 1994, because the “stock market was high”, you would have missed out on more than quintupling your money (five times).

In case you think I am too harsh on those who sold out, I want to remind you that I actually hope they are correct, and we do get a bear market soon. If stock prices go down 15% - 20% from here, it would present a good opportunity for long-term investors in the accumulation stage like myself. When your future retirement income is available at a discount, you should get happy. Who wouldn’t like to have great companies, available at a discount?

I do disagree with those who are selling today, and hoping for lower prices, which may or may not arrive. And they may or may not take the advantage of those lower prices. But the decline in stock prices will definitely be taken advantage of, by patient buy and hold investors in the accumulation phase. The only super power you need to have, is the patience to continue executing your plan, even if you are under fire.

I am still holding on to my stocks ( directly in taxable accounts and through mutual funds in my 401 (k)) because I believe that equities will provide decent returns over the next decade. While there has been some short-term weakness in revenues, and profits for companies, a large part of that could traced back to the strong US dollar, weak international economies, and the weakness in energy prices ( which affects energy companies, and many developing companies that export commodities)

The reason why I am holding, despite the fact that equities may “look overvalued” is because:

1) Equities offer a better reward potential for the risk you take, relative to fixed income.

2) I believe equity earnings in 2026 will be higher than earnings in 2016.

3) I believe that dividends in 2026 will be higher than those in 2016, driven by fundamentals in point 2) above

4) I believe that higher earnings in 2026 will increase the value of companies I own in my portfolio

5) I am getting paid a 2% - 3% dividend per year to hold on to my stocks

6) I believe that all of this could translate into an equity portfolio doubling in value within the next 10 - 12 years

7) If I panic and sell, I will miss out on the power of compounding, and I will be selling low

8) By sitting still, I am taking advantage of the power of compounding in income and wealth accumulation. If prices fall from here, I will take advantage of them, by buying low. If prices go up from here, I will have kept a large portion of my assets invested at lower prices ( between 2007/8 - 2016).

9) It makes sense to hold some fixed income for diversification purposes, depending on age, risk tolerance etc. But this should not be used as a timing tool – in other words the percentage of my portfolio allocated to fixed income should stay relatively constant from year to year. In my case, I do not expect to own more than 20% in fixed income, until I am in my late 30s/early 40s (unless I plan to make a major purchase, such as a house, as it requires a 20% downpayment). If I get older, I may end up owning a little more fixed income as well, which is typical asset allocation advice.

Relevant Articles:

Time in the Market Trumps Timing the Market
Preparing for a Stock Market Correction
Interest Rates Affect Stock Valuations
How Dividend Growth Investors can prosper even if interest rates increase
Time in the market is your greatest ally in investing

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