The following is courtesy of Marotta Asset Management.
Normal market volatility has returned, and with it investors are tempted once again to jump in and out of the markets.
Shifting a significant portion of your assets between different types of investments to try and maximize profits may seem like a smart investment strategy. But academics, for example Burton Malkiel, author of "A Random Walk Down Wall Street," believe timing the market is impossible. Active traders and get-rich-quick advocates disagree. They claim to have seen it work in practice.
Most average investors, unfortunately, make the worst possible timing decisions because of their fear or pride. These feelings can dim the vision and distort the thinking of even seasoned investors, fooling them into concluding that their recent experience represents an inevitable trend.
On average, U.S. stocks provide a 10 to 12% return, so you may think you have found the answer by investing all your money in aggressive growth stocks. But since 1937, the S&P 500 has only had four years when the returns were between 10 and 12%. Usually they come in wildly over or under the average. So if you're counting on 10 to 12% returns, you'll find the ride extremely bumpy and the likelihood of meeting your projections nearly zero.
More commonly, returns over a four-year period are 18%, 18%, 18%, and then down 10%. In statistical terms, market returns form a bifurcated bell curve with two peaks, one well above 12% and another well below 10%.
None of the standard statistics you learned in college can explain this excessive volatility. Market corrections such as those that occurred in 1987 are so uncommon, they could never happen under the rules of standard deviation, and yet they do. Hence the bell curves of market returns are sometimes described as having lumpy tails, meaning that extreme events happen with some regularity.
Mathematicians challenge the assumption that market returns fit any sort of Gaussian bell curve. Benoit Mandelbrot formulated the math that describes the seemingly infinite variance found in the markets. Nassim Nicholas Taleb, in his bestselling book "The Black Swan," recently popularized these ideas. Taleb suggests you stay humble about your predictive powers and have the rare courage to say, "I don't know."
The primary application of volumes of mathematical analysis is to remember that the markets are inherently volatile and we just don't know what they will do next. The math suggests they are probably even more capricious than we have yet seen historically. Financial news organizations report that the markets are currently dropping, but all we know is they have been dropping. To say they are doing so now implies that their past downward momentum somehow influences their current movement, which is not the case.
The U.S. economy may face a serious recession and the markets may continue to fall. But the markets may just as likely be done dropping and will appreciate again soon. You can miss over half of the growth during a decade if you discount the top five days of each year. Those best days often come at the end of downward trends. By jumping in and out of the market, you risk missing the lion's share of a portfolio's growth. Therefore it is to your advantage to remain invested according to a diversified asset allocation.
Staying invested does not necessarily mean staying invested in your current asset allocation, however. Going forward, the best defense is always a well-diversified portfolio. If you did not have enough foreign stocks, you should sell U.S. stocks and buy foreign. If you did not have enough hard asset stocks, you should sell U.S. stocks and buy hard asset stocks. But if you've had a balanced portfolio and now your U.S. stocks are down and your bond portfolio is still up, you should sell bonds and buy U.S. stocks to rebalance your portfolio.
If you have set up an appropriately diversified asset allocation, then whenever you are unsure about what to do, simply rebalance your portfolio. This contrarian move will help you buy low and sell high and save you from chasing performance.
For example, imagine your portfolio has only stocks and bonds. If stocks have done well, applying a rebalancing strategy will help you sell some stocks when they are high and put money into bonds when they are low. If stocks have performed poorly, then rebalancing to sell some bonds and buy stocks will most likely be smart. Rebalancing will save you from trading too much to chase recent market performance, nearly always a poor idea.
Although implementing a dynamic asset allocation may allow you to boost returns, the average investor usually does not have the time or the expertise to analyze the numerous factors needed to construct this kind of model. In this situation, the help of a fee-only financial advisor can really make a difference.
Lastly, if you think hiding money under your mattress, as it were, is a risk-free way to build wealth, think again. Cash has been one of the riskiest investments since 2002. Many investors try to stay safe by putting their money in a bank account or investing in CDs. But like any other investment, cash carries its own set of risks.
Cash is dangerous because the dollar can be devalued. When our currency decreases in value, we experience inflation and the purchasing power of our dollars is compromised. Having the same amount of dollars doesn't do you any good if your money won't buy as much as it did before.
Michael Joyce, former chairman of the National Association of Financial Advisors (NAPFA) and current president of the NAPFA Consumer Education Foundation, spoke in Charlottesville last weekend. He reminded the audience of the wisdom of this maxim: The person invested entirely in U.S. Treasury bills sleeps well tonight but eats poorly in 10 years. Treasury bills may be a safe and stable investment, but they won't help you with the goal of building real wealth.
As far as the statistics go, I suspect that the reason for the anomaly is that statisticians tend to assume that the systems they're analyzing are more or less stable. Entities like financial markets, on the other hand, are much more likely chaotic, and formal chaos theory hasn't had much influence outside of physics (its original domain) and pure mathematics.
The two-bump profile of stock-market returns (which are based on arbitrarily-delimited periods, but that's another issue) remind me of the Lorenz strange attractor (http://en.wikipedia.org/wiki/Lorenz_attractor ), one of many chaotic models that has two semi-stable regions that can ping-pong back and forth on unexpected and seemingly small influences.
Posted by: Christopher Smith | February 08, 2008 at 04:32 AM