One Last Hurdle
Is it the euphoria induced by a fast start out of the 2013 gate that has individual investors finally ready to join the party? Maybe it's the steadily improving employment and housing data that's supplying the renewed confidence in the economy. Or possibly, it's the paltry interest earned on savings and bond investments that have become too depressing while watching equities continue to soar. Regardless of why so many investors are joining the party, the question to ask is, should I be one of them?
The pessimists will say this rally is exhausted, and a pull-back is both healthy and imminent. On the other hand, the optimists will point to a stellar corporate earnings season as a sign the rally will continue. We'll save you the suspense -- the market will not continue to rise 5% month (80% annualized), nor are we going revisit the March 2009 lows any time soon. Reality will lie somewhere in between. But buying into a fierce rally, such as the one the market has experienced since mid-November, gives many returning investors an uneasy feeling that may prove to be the final obstacle on their road back to equity investing.
I Don't Want to Buy at the Top
Investing at the top of the market is a common fear among individual investors. The last time the S&P 500 index saw 1,500 was December 2007. What a terrible time to have put money into an index fund. The market traded lower by more than 50% over the following 15 months, and didn't revisit 1,500 until just days ago, a round trip that took over 5 years to complete. It's understandable then why investors are so frightened of investing at the top of the market; with consequences so dire, why not just continue waiting for the pull-back? The answer -- market tops and bottoms can only be accurately identified long after they've happened. And more importantly over the long run, with a good investment strategy, it won't matter nearly as much as you probably think it will.
Simple index funds obviously had a terrible fall and a long recovery, but what happened to investors that followed a time-tested, long-term investment strategy? What were their consequences of investing at the top? At Bloodhound Investment Research, we have created and track a number of model strategies utilizing common-factor investor approaches -- fundamental growth, low beta, strategic high-yield, etc. While all strategies experienced a sell-off of some kind, many were muted, and all recovered in significantly less the time than the S&P 500. Even more impressive is their performance to date; many strategies have actually provided real returns in excess of 50% during the market recovery. The table below illustrates the "consequences" of a January 2008 investment using a superior investment strategy.
Jan 1, 2008 investment
Total Return since Jan 1, 2008
S&P 500 Index
Earnings Growth Leaders
Enhanced Value Line
Large Safe Companies
Low Beta Income
Moderate Risk Growth
Moderate Risk high Growth
Sector Exclusion Growth
Strategic High Yield
Strong Operating Margins
Value Line Mid-Cap
In each case, investors in a tailored, concentrated strategy were back in positive territory in less time than the overall market. In most cases, investors were earning double digit returns while the indexes remained underwater. The point being that a "lost decade," as many refer to the 2000s, for the market did not need to translate into a lost decade for your portfolio.
Maybe I'll Just Wait for the Pull-back
The flip side of avoiding the top of the market is trying to buy at the bottom, or at least buying on a pull-back. There are plenty of examples to illustrate the perils of this strategy, none better than the bull market of the mid- '90s. By the beginning of 1995, the market had climbed 40% over 4 years with relatively little volatility. Investors, still scarred from the crash of '87, had largely sat on the sidelines as the market doubled off the lows of Black Monday. With valuations getting seemingly rich, many investors waited to buy at the pull-back. Not unlike the beginning of 2013, the market rallied 5% in the first 6 weeks of '95, while buyers continued to wait patiently for their opportunity to enter at cheaper prices. As it turns out, the largest pull-back that year was a miniscule 2.5%. To add to the market timer's pain, it wasn't for 18 months that a pull-back of any substance occurred, and not until after a market gain of 48%.
Late last year, quantitative research firm Dalbar produced the report, Quantitative Analysis of Investor Behavior. Their analysis of individual investors' investments in mutual funds suggested that market participants too often react to market movements, try and time the market, and therefore, do not remain invested long enough to derive the benefits of the markets. The S&P 500 eeked out a 2.12% return in 2011. Yet, the "Average Equity Investor" actually lost 5.71%. Similarly, the Barclays Bond index returned 7.84% in that year, but the "Average Fixed Income Investor" only generated a 1.34% return. The underperformance wasn't solely restricted to 2011. The average investor lagged their benchmark in each of the 3-, 5-, 10- and 20-year periods. The S&P was up 7.8% over that 20-year period, whereas the average investor gained 3.5% -- underperformance by more than half.
On Monday, Morningstar released a similar study, Mind the Gap: Why Investors Lag Funds. Although the results are not as dramatic as those revealed in the Dalbar report, they shared a similar thesis. Behavior analysis suggests that investors' emotions lead to misguided decisions. Analysis through December 31, 2012 indicates that investors in U.S. equity mutual funds personally underperformed the funds they were invested in by an average of 100 basis points annualized over the last 10 years. That difference over 10 years amounts to $2,000 on a $10,000 investment. International fund holders did even worse, underperformed by three times as much.
Analyze, Evaluate, Invest
It's a fact, the market will have a significant pull-back at some point. In fact, on average, a 10+% draw-down occurs about once a year. The problem is predicting whether that 10% draw-down will be measured from a peak of 1,510 or 1,800. But with a time-tested investment strategy, picking market tops and bottoms is unnecessary. Stated simply, investors should evaluate the risks of an investment strategy and understand how the strategy historically performed during up-, down- or sideways markets. If it worked well during each market, and repeatedly worked well, then invest in accordance with its rules and without subjective judgments or emotion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.