With markets bouncing all over the place like Flubber, what can a semi-conservative investor do? There are a few techniques that at our disposal – let’s briefly review a couple:
Market Timing – The concept here is that the investor is able to call market tops and bottoms – or fairly close to it. It’s a great idea, one that I use extensively, but it is much different when in practice. There are no assurances that valuation, analyst forecasts, or technical analysis will work going forward. It takes a lot of time to attempt to 'read the market' - something that the average investor likely does not have the time or desire to do.
Rebalancing of Equity Portfolio – This may help keep the bears off your back porch – but the assumption is that your stock selection techniques can beat the market. What if your stock selection is only as good as the market? Then you wasted time and money rebalancing your equity portfolio with different stocks.
Regular Investing – Others say you should forget the market and invest at all times as you’ll never capture bottoms or tops. The idea is that you will be buying in good markets and bad for a cost-averaging effect.
Let us consider how one simple approach, similar to the one above, can provide a healthy alternative to market timing.
Market Timing vs. Bear Market Buying
Two investors each have $100,000 to invest. Both believe that a crashing market will eventually turnaround (i.e. they don’t believe that the market will tank and stay there indefinitely). One investor is excellent at calling tops and bottoms (man A) and the other is horrible at market timing (man B). For this purpose, both will be index investing.
Man A is able to trade the top and bottom within 15%. 100% of his money is in the stock market.
Man B has a system where he invests – or averages down – when the market tanks. 50% of his money is in an index fund (NYSEARCA:SPY) and 50% is in bonds. Man B adds to his index positions when the market drops. He takes capital from the bond investmnets and switches it to the equity market. Man B only invests more when the market goes lower on an absolute level (he doesn’t play the relative up and down swings). Here is his bond/equity rotation system.
- Market falls 10% - he switches 10% from bonds to stocks
Market falls 20% - he switches another 10% from bonds to stocks
Market falls 30% - he switches another 15% from bonds to stocks
Market falls 40% - he switches another 15% from bonds to stocks
Market falls 50% - he switches another 25% from bonds to stocks
Market falls 60% - he switches another 25% from bonds to stocks
Market Timing and the 2007/2008 Crash
In late 2007 the market was around the 1550 range and man A had an equity portfolio worth 100K.
- A 15% drop from the peak puts the value at 1317.5 - at which time he sells.
He is now sitting with 85K. The market bottoms out around 683 and springs back up 15% to 785. He buys back in.
The end of 2010 sees the index at 1115.
He has $120,663 which represents a 20.6% gain.
Bear Market Buying
Man B has 50% of his capital in T-bills. For the purpose of this article we will give him a 0% yield since we are draining his income account very fast in the down market. The other 50K tracks the S&P 500 index. Every time the market drops 10% (calculated from the peak) he switches from bonds to stocks as above.
S&P 500 is at 1550 and he has 50K in bonds and 50K in the market
S&P 500 is at 1395. He moves 5K into stocks. Total portfolio worth at 95K
S&P 500 is at 1240. He moves 5K into stocks. Total portfolio worth at 89.4K
S&P 500 is at 1085. He moves 7.5K into stocks. Total portfolio worth at 83.3K
S&P 500 is at 930. He moves 7.5K into stocks. Total portfolio worth at 76K
S&P 500 is at 775. He moves 12.5K into stocks. Total portfolio worth at 67.5K
The market finishes out 2010 at 1115. His combined portfolios sits with a worth of 91.6K. He is down over 8%. It would be a little higher when accounting for bond yields – but not much. Notice, however, how the buy and hold investor makes out. His portfolio drops down to 50K and finishes the year at 71.9K. The buy and hold investor is down over 28%. While he didn't beat out the market timing guru, he did substantially better than buying and holding - and he did not need to use interpretive methods to time the market.
The Need to Rebalance
Of course, once the funds go from bonds to stocks, he will eventually need to get some capital back into his income portfolio. How can he do this?
First, regular investment dollars could go directly into the income account only. Only during market corrections or bear markets is money transferred from bonds to stocks.
Second, it would be prudent to move some funds back into the bond account depending on market activity. He could do this in stages, perhaps selling back each tranche when it rises 20% from purchase. Or he could balance back to 50/50 when the stock market rises up half way from when it dropped. Or he could do so when the market finally returns to the peak of 1550 before the index fell. This is a personal decision.
Other Gain Boosting Methods
What are some other techniques to squeeze a little more gain out of this? One is to regularly rebalance your equity portfolio regularly provided you have a decent stock picking strategy (and not index trading). As an example, take the 'value investing' scan I have made public at Portfolio123.
- Annual rebalancing results in a compound annual growth rate of 15.54% (click on charts below to enlarge)
- Bi-annual rebalancing results in a compound annual growth rate of 19.84%
- Quarterly rebalancing results in a compound annual growth rate of 25.51%
- Monthly rebalancing results in a compound annual growth rate of 34%
Of course, you will need to consider how liquid the stocks are and how high your transaction fees will be when determining which is the most cost effective time period with the least amount hassle. Even if you do not like to re-balance often, consider doing it more frequently in a down market. You may not make a whole lot of excess gain during the down cycle, but you are more likely to be holding the highest jumpers at the beginning of the new bull stage if you rebalance frequently.
Some Risks Associated With This Strategy
There are some risks that come to this strategy that you should consider.
What if the market drops by 75% and you are only able to leverage down to the 60% mark? You do not have enough firepower to average down this far and will miss out on some gain.
What if the market goes down and stays down to never come back up? If you really feel that way, you shouldn't be in the market then.
Isn’t This Just Averaging Down?
But some will say, “isn’t this just averaging down”? Yes and no.
Averaging down on an isolated stock is generally bad. One falling stock (possibly in a bull or sideways market) carries more firm-specific risk and it may never bounce back. Averaging down in strong stocks when the broad market is falling is something else altogether as the good and the bad are getting 'valuation resets'.
Is This Strategy For You?
This strategy is for investors that are unsure about market timing. But even supporters of market timing need to be humble and acknowledge that it is highly unlikely that they will consistently be able to call tops and bottoms within 15% of the peak and trough. Even the market timing signal I use didn’t kick in until until the market moved up 35% from the bottom.
If you are a semi-conservative investor that wants an alternative to market timing that should beat out buying and holding – consider a good stock picking strategy, frequent re-balancing, and systematic rotation of capital into strong stocks during broad sell-offs to be a bear market buyer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.