How Uneasy Investors Can Wade Back Into the Market

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.

Comments

[Anthony Dad...:]

This is the time to start getting back in. Pessimism is so high. Of course we will be in a recession for some time to come, our problems are not going to be solved overnight. However, the market is a leading indicator and a hint of light at the end of the tunnel, will make people rush to buy stocks for the long term. Markets will move up very quick and will be very difficult to get in at low prices. If you have more then a 5 minute outlook, I would start accumulating blue chips now.

I am a contributor on www.thecreatingwealthb...

Jan 05 08:10 AM

[Steve in TN:]

There have been so many posters/investors claiming the bottom will be 4000 to 6000 on the DJIA. In every bear market those fears keep new money from being invested in equities until they realize all those predictions were way off the mark. This is why this article is so valuable; follow the author's advice and you will be in good shape.

Jan 05 08:26 AM

[Moon Kil Woong:]

SteveTN: I don't think posters/investors are scaring people out of the market by being bearish. I think people are reacting based on the circumstances they see around themselves. This crisis won't be solved by everyone being cheerful happy positive people. It will be solved as the market finds new opportunities for growth and expansion and cuts inefficiency and misallocated resources. That could take years as construction moves to green projects, bankers move to other services, and science comes up with novel technologies.

As for the article. I think people should be more cautious with investment and take a more proactive approach to managing their money. Going to someone who says you should be 50% this and 30% that is very basic an immature. You could be 30% in stocks but being in the wrong fund or the wrong set of stocks may not help one bit. Know what you are betting on and what you are risking for what outcome. The problem with couch investing is that buying something that says it's a growth fund or a bear fund, etc. may actually be some jr. analyst buying the S&P pairing about 50 stocks and charging you a .5% fee and transaction costs to boot.

Active management is the only prudent thing. If you can't do it then I suggest you keep a very little percentage in stocks in good times or bad. Because you are essentially gambling, and even worse, you are doing it blind. Only after you take this commitment should you start thinking about what percent of your portfolio should be in stock.

Jan 05 09:37 AM

[Smarty_Pants:]

"The key is to establish a process and stick to it no matter what."

This can be dangerous advice to those who don't have a sound grasp of what they're doing or what risks they are actually accepting.

If you have a 'procedure' to always pick up change you drop within 20 seconds of it coming to rest, and you drop a nickel which rolls to a stop in the middle of a lane of traffic in front of an oncoming bus, then sticking to your procedure "no matter what" is a bad idea.

constructe's final paragraph is a prudent approach that most overlook because they are only 'investing' because they heard someone tell them that they needed to do so for their retirement.

Most guys could probably explain the intracacies of "breaking the plane" of the endzone for a touchdown in football better than they could explain what it means to "invest" in equities.

End result is they sign up for the 401k plan and stick everything into Bluto's Buy and Hold Fund and forget about it until a statement shows up every quarter.

Jan 05 04:36 PM

[David Van K...:]

The author offers a a tactic for "getting back into the market." His tactic is dollar-cost averaging: re-investing a set percentage per month for however many months it takes Jones to get back to his 70% target percentage. Jones should "stick to [the plan] no matter what" the market does. The author also implies that the time to start implementing this tactic is immediately, because "all but the most risk-averse investors should have some exposure to risky assets at this juncture."

I'd suggest that Jones should first back up and think about his goals and strategies. What stage of life is Jones in? How did he arrive at the target figure of 70% in equities? Is it bad that Jones presently has 60% cash?

Only by wrestling with questions like these can anyone come up with a "sound" investment policy or strategy.

If 70% stocks is Jones' target, how did he get to 60% cash? Obviously, he sold stuff. As the author states, "he simply couldn’t take the pain any longer, bailing out almost completely in October and November."

So selling money-losing stocks, even if it was not part of Jones' putative strategy, really was (or became) the driving part of his actual strategy. Jones needs to recognize and acknowledge that. What Jones did (wittingly or not) is implement a new strategy. He needs to learn from that. Clearly, pain-avoidance must be part of Jones' strategy going forward. His 70%-come-hell-or-high-... equity target proved to be unsustainable for him. He shouldn't just go back to it.

Avoidance of pain is a valid goal--it drives a lot of what humans do in many areas of life. Jones needs to account for his already demonstrated need to avoid pain in his financial life.

In Jones' new strategy, he may again establish a 70% stock "target," but I'd suggest that he add flexibility. Call it his "stock money" target, meaning that is how much he'd like to have in stocks under ideal (non-painful) conditions. But now, his "stock money" can be anywhere from 0% to 100% invested in stocks at any given time.

Once he does that, then Jones will need to establish parameters about his new strategy's flexibility feature. Specifically, he needs to articulate how he will determine where in the broad range he ought to be at any given time.

Jones cannot avoid considerations of timing. Almost everybody says you can't time the market, but in fact practically everybody does it. Jones timed the market by selling. The accumulation of those selling decisions is how he got to 60% cash from a 70% stock target.

So Jones' strategy has to include some concept of timing, at least of individual stocks and funds, and probably of the market itself. Jones is now on the other side of the fence from the beginning of 2008: He's got all this cash, and he's worried that the market's going to go up and leave him behind.

Jones is still in pain-avoidance mode, except now the pain he'd like to avoid is watching the stock market go up while he's not in it. So Jones needs some way to decide when to get back in. That requires a notion of timing.

I can't supply that notion for Jones. I am not him. The author recommends that Jones get started now, pick a method, start buying equities, and stick to the process "no matter what." I suggest that Jones needs to re-examine his strategy and decide whether "at this juncture" he wants to be getting back into the market at all.

For myself, the time is not right yet. I am in Jones' situation (most of my "stock money" is in cash). I have my own notions of timing, and for me, the right time to start re-investing will be when I become more convinced that the market is no longer in a secular bear mode. My methods for making that determination are not perfect (since they involve peering into the future), but I am comfortable with them. The flexibility built into my strategy allows me to stick with it.

That's what Jones needs to get, a strategy that works for him. He will be able to stick with it because he is comfortable with it. I suggest he re-examine and modify (if necessary) that strategy annually as he moves into different life phases and learns more about himself. He learned a lot in 2008.

Jan 06 11:57 AM

[stox2buy:]

The prime time of investment opportunities for the so called: TECHNOLOGY sector, namely computer/network/inter... and personal devices and enterprise software(ERP) was long gone.

The next big thing coming is stem cell based regenerative medicine, this is a huge field as big as TECHNOLOGY if not bigger. From the hardware(tools) to treatments to drugs, this is the golden opportunity for those who do some study, dig in further, a lot have been going on yet a lot more will be happening as the new year unfolds especially in "adult stem cell" area.

Investment in tools, treatments or drugs now is like investment in TECHNOLOGY a decade ago in hardware, software and internet/mobile devices.

Investment in stem cell exectraction/preservat... tools is the safest and the 1st to be rewarded, then treatments and then in drugs. Treatments and drugs will have the biggest winfall but they are further down the pipeline in terms of timing.

Disclosure: long tool stock (KOOL), lurk on a few stocks in treatment and drug with stem cell/regenerative medicine flavor.

Jan 08 01:46 PM