How Uneasy Investors Can Wade Back Into the Market

Includes: DIA, QQQ, SPY
by: Kevin S. Price

At the conclusion of a punishing year in the financial markets, investors are more than uncertain; they’re deeply, stubbornly uneasy.

A brutal bear market. Short, sharp rallies that fail as quickly as they materialize. The collapse of major investment banks. The improvisation of the federal government. The crimes of Bernie Madoff. These and other developments have left rank-and-file investors without much confidence in financial assets or the very system on which they’ve staked so much of their present and future retirement security.

Because the challenges of prudent investing are (always!) more emotional and behavioral than technical or informational, a disciplined, systematic approach to asset management has never been more important.

At Interlake Capital Management, we run money in two styles, a “true alpha” portfolio and a “pure beta” portfolio. Because alpha-seeking styles are so idiosyncratic—and so well-covered elsewhere in this preview of 2009—I’d like to draw special attention to the beta side of the equation. How should investors handle their market exposure in 2009?

The first (and most obvious) point is that all but the most risk-averse investors should have some exposure to risky assets at this juncture. Bailing out in a state of panic can be a perfectly legitimate response to market conditions, as long as you do it before everyone else, not after.

But let’s assume that an investor arrives at the end of 2008 sitting on more cash than he or she should have (according, that is, to a personalized, risk-appropriate investment policy). How and when should that investor trade cash for equities? Given the impossibility of timing major market troughs, there are two plausible ways to realign one’s market position and investment policy: (1) all at once, in one big move or (2) gradually, in a series of smaller commitments.

With uncertainty and unease still pervasive, we think the second option is likely to be the more prudent choice. Not because it’s sure to deliver higher short- and long-term returns, but because it’s more conducive to investor confidence, and thus, indispensably, follow-through and steadfastness. Rather than expose investors to the whipsaws of a volatile market (and the risk of serious regret), a gradual, systematic return to a “fully invested” posture should exploit persistent volatility through large-scale dollar-cost-averaging.

Let’s assume Investor Jones is sitting on 60% cash, 30% fixed-income, and 10% equities, in part because he simply couldn’t take the pain any longer, bailing out almost completely in October and November. Because Jones’s long-term investment policy calls for 10% cash, 20% fixed-income, and 70% equities, he needs to realign his portfolio with his policy. How should he do so? We would recommend that Jones commit, here and now, to shifting 5% of his portfolio back to equities on a set schedule, say, once a month for the next year.

There’s nothing magical or inherently preferable about that schedule. One could just as easily move 10% every month for six months, or 15% every two months (for a total of 8 months from beginning to end of the re-entry process). It isn’t the number or the timing that matters most; it’s having a number and sticking to the timing, regardless of how the market turns along the way.

If equity prices fall further, good merchandise will be had for less, thus bolstering confidence in the overall strategy. If equity prices rise, the early acquisitions will appreciate correspondingly. If prices move higher and lower, producing little net change over the period of reinvestment, so be it. The key is to establish a process and stick to it no matter what.

Assuming one’s policy targets are sound, we think this kind of lumpy dollar-cost-averaging can help overcome the psychological demons confronting investors amid so much market wreckage.