We often criticize governments and armies for getting ready to “fight the last war.” To some degree, they all do it. It is inevitable and reflects a mistaken assessment of what the next war will be like. And this is likely to continue until someone comes up with a reliable method of predicting the future.
Investors often behave in much the same way, in that they tend to extrapolate the markets’ most recent direction. When the market is going up, despite well established evidence that markets fluctuate, investors are reluctant to moderate their exposure to equities. When the stock market is going down, investors tend to be reluctant to step in, despite being fully aware of the markets’ long history of eventual recovery and new all-time highs.
These traits are not limited to individual investors. According to a recent article in The Wall Street Journal, over the last five years large corporate pension funds quadrupled the share of their portfolios invested in hedge funds. By reducing their exposure to equity markets, through the hedging process, these funds significantly underperformed during the recent stock market rally. In plain English, they reverted to market timing and got cautious at the bottom of the market.
Market timing has always had great theoretical appeal and a dismal record in practice. Essentially, no one has been able to accurately predict the timing and duration of market swings over an extended period.
There are alternative strategies.
Buy and hold. Under this strategy, once a portfolio has been established, and knowing that, over time, the positive moves in the stock markets will more than offset the downdrafts, you make few if any changes. This has been, by and large, the Warren Buffett approach. He has done a very good job of identifying long term winners and simply held on through thick and thin. This could prove to be an attractive strategy for investors with a long time horizon.
Another strategy, that probably makes a lot of sense for the average investor, is rebalancing. The theory behind this concept relies on reducing exposure to equities (and adding to fixed income) as the stock market goes up, and reversing the process on the way down. Theoretically, if an investor’s target asset allocation is 60% equity and 40% fixed income, selling equities on the way up and adding on the way down, can maintain the target allocation and improve returns.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA®