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On Market Timing and Risk Management

On Market Timing and Risk Management

| September 13, 2018
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A potential client asked me recently how I planned to time the stock market.  Here is my response which will help you understand my investment philosophy if you too are considering working with me. 

I have learned through observation and careful studying of the evidence that predicting the future in the markets is impossible to do consistently.

As a result, my financial planning and investment management is based on sorting the knowable from the unknowable, and acting accordingly.

For example, we know that we should be able to closely estimate how much you will need per year, after taxes, in retirement. 

I believe that ideally in retirement you will want to have at least ten years of expenses set aside in relatively safe investments, such as tax-free and taxable bonds. We could put more into safe assets, but you’ll have to be comfortable with the trade-off of not participating on the equity side. 

Bonds aren’t sexy, but they are paying again with rising rates, so your money wouldn’t be dormant and would be more tax efficiently deployed.  I also don’t believe in buying too much in the junk space, as those tend to act like stocks in bad markets.  Finally, I think that maintaining a lower level of interest rate risk still makes sense because we need to maintain liquidity for down periods and we are currently in a rising rate environment.  Taking some individual bonds with a longer term can be okay, but we don’t want to be too overweight long duration and thus constrained in a crunch. 

We know the US market, in the worst crash since the great depression, was back to even in about five years. The dot-com crash took about seven to get back to even. 

We should also assume similar drops will occur every decade or so, and we should plan for the recovery to take longer than the previously mentioned examples. 

Even if things don’t look good, we need to work hard to avoid being seduced by pessimism. 

When applied to a portfolio, a negative bias often hurts results.  Even if we call a crash, we usually miss part of the upside beforehand, and usually some of the recovery (buying when the market is crashing is harder than it sounds in the actual moment). 

Thousands of people deploy billions of dollars of research yearly to try and divine the future.  Sometimes they will have a good run, but over the long term, their results are usually close to a coin flip and often worse.  Finally, doing this type of guessing introduces the unnecessary timing risk into the portfolio.  Investing already has enough risk, so we don’t need to add any that you aren't compensated for.   

We know that when the market drops more than 15% on an intra-year basis, it’s usually best to hold and not panic to avoid locking in losses. 

Discipline is paramount during these times. 

It’s neither fun nor easy to hold in down markets, in fact, it may be even more distressing to you in retirement because you are no longer working and will have larger absolute dollar fluctuations. 

However, this approach works, and your current investment balances are a testament to this fact.  So, if we have safe money available for you to live on during the down times (10 years worth), they are very survivable events with less emotional stress. 

We will also let your risk allocation tick higher, within reason, as we utilize or draw from your safe money. It’s there for insurance, and we have been effectively paying via a lower expected return; therefore, this capital should be deployed when needed. 

I also see clients spend less on discretionary spending in severe down periods to reduce the withdrawals from their portfolios.  This has also been shown to be beneficial to long-term portfolio health.

In the end, we know there are no unicorns.  So we pragmatically plan for what we know, and what we know we cannot know. 

If this makes sense to you, or if you would like to learn more about adopting an evidence-based investment process please reach out. 

Thanks for taking a look!

Tom

 

This article represents opinions of the authors and not those of their firm and are subject to change from time to time, and do not constitute a recommendation to purchase and sale any security nor to engage in any particular investment or legal strategy. The information contained here has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy.

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