“With broad asset classes, we want to take advantage of the mathematics of mean reversion. And so when any asset class runs too far ahead, it automatically gets trimmed back. And when it falls too much, it automatically gets bought. It just happens “automatically” through math.
Look, we know any individual stock can go to zero. But stocks themselves as a class aren’t going to go to zero. So when they get cheap, we end up buying a little more. And when they get expensive, we end up selling a little bit. And, over time, that creates a hundred to two hundred basis points for a portfolio over what just “set and forget” would do.” – Barry Ritholtz
If you listen to mass financial media there would seem to be only two types of investment strategies: (1) buy and hold and (2) market timing.
Buy and hold was the investment rallying cry throughout the 1980s and 1990s. It helped that this was one of the best periods ever in which to invest your money. Stocks and bonds both went up the majority of the time so being a buy and hold investor worked out great for all involved.
Happy days didn’t last forever as the technology bubble and subsequent crash that started in 2000 left stock investors with losses of over 50%. After recovering those losses and reaching new highs only a few years later in 2008 and early 2009 did we have another 50% correction in stocks.
This led many investors to declare the end of buy and hold and the beginning of market timing. It was so easy to see the crash in hindsight they will tell you. Buy and hold is for suckers so you need to be able to sidestep the crashes when they come.
Unfortunately the same people telling you to use this as a strategy are the ones who did not see the crash coming. But they will be quick to tell you about the next crash right around the corner every chance they get. Most investors fail to realize that market timing is very difficult to pull off on a consistent basis. You have to be able to predict the top and the bottom in the market and be right both times.
Since the market tends to have losses on a periodic basis it can be very hard for even the smartest investors to make these kinds of predictions. Trying to be a market timer can make every run of the mill correction seem like it’s going to turn into a crash. Fear and greed make off with all of your investment returns while you get crushed.
So if buy and hold and market timing both have their flaws, what is the alternative? The strategy that gets glossed over by most is to simply develop a disciplined investment plan that tells you what to do over time. Instead of guessing when to buy and sell you will know exactly what decisions to make based on your investment plan.
The three most important components of a disciplined investment plan are (1) dollar cost averaging, (2) rebalancing and (3) automation. Let’s take a look at each in more detail to see how they can help your investment results over time.
1. DOLLAR COST AVERAGING
You have probably heard by now from many market commentators what a lousy bet stocks have been since the year 2000. The S&P 500 is barely above the level it traded at before the tech bubble burst.
When you see this data on the news, remember that they fail to mention that normal investors don’t just take a lump sum of cash put it all in the market at once and see what happens.
Most of us put our money to work on a periodic basis into our 401(k) and IRA, usually on a monthly and or bi-monthly basis. This is called dollar cost averaging because you are spreading out your cost basis and averaging into the market. This might not be the perfect choice in all investment periods but we are not looking for the perfect choice, just the one that gives you the highest probability of success.
Let’s look at an example of dollar cost averaging to see it in practice. We’ll look at the 2000 to 2012 period that has produced poor stock market returns. From the beginning of 2000 to the end of 2012 the S&P 500 was up a total of only 23.78% or 1.65% per year. This is well below the historical stock market average.
For this example, assume you entered the workforce on January 1, 2000 and started putting away $500 a month in your company’s 401(k) plan. You chose to invest in a simple index fund that tracks the S&P 500 Index. By dollar cost averaging until the end of 2012 you would have contributed $78,000 to your plan.
Spreading out your purchases by dollar cost averaging into stocks you actually did much better than the market return. Your total return would have been 39.27% or 2.58% annually.
This is still not a great return on your capital but almost 1% higher per year than the market return. Mutual fund managers would love to outperform the market by 1% a year on a consistent basis. Your 2012 year-end balance would be $108,631 vs. only $96,548 had you invested a lump sum in 2000 (but again normal investors don’t invest this way).
Another way to look at this is the average cost you pay per share through dollar cost averaging. The average price of the SPY (S&P 500 ETF) over the same period was 105.65. Using the same $500 example of buying at the beginning of every month gives you and average cost per share of $102.22. The reason for this is that you are buying more shares when the price goes down and less when it increases, bringing down the average price you pay per share over time.
As you can see from the quote at the top of the page from Barry Ritholtz of The Big Picture blog, rebalancing forces you to sell your winners and buy your losers. It is a systematic process of taking gains and forcing yourself to buy low and sell high.
Rebalancing is a natural extension of a well-balanced asset allocation plan. There is no reason to set your mix of assets with a defined risk profile and time horizon if you do not plan on staying with that mix over time.
To take the dollar cost averaging example a step further let’s make this a more balanced approach and add some bonds to the portfolio along with a quarterly rebalancing policy. To keep things simple we will look at a 70/30 mix of the S&P 500 and the Barclays Aggregate Bond Index.
Over the same 2000-2012 time frame you would have invested $350 a month in the S&P 500 and $150 a month in the BC Aggregate. If bonds outperformed in a given quarter you sold some bonds to buy some stocks to get back in line with your asset allocation of 70% stocks and 30% bonds (and vice versa if stocks outperformed).
By rebalancing your overall results are even better than with only dollar cost averaging into stocks. Now your ending balance ends up being $112,926 at the end of 2012. You total return jumps to 44.78% or 2.89% per year. Here is the summary of all of the results:
Another benefit of creating a disciplined investment approach that includes rebalancing is that it forces you to diversify your portfolio. This example is a very simple one of just one stock index and one bond index.
Your returns actually would have been much better and more diversified by including commodities, REITs, small-caps, mid-caps, international stocks, emerging market stocks or a host of other investment styles. Adding a more global mix of assets makes sense to increase diversification, as well.
You should also notice in the quote at the top of the page that Barry says this process happens “automatically.” The final step in the disciplined investment approach is to automate as much of the process as you can. It takes the emotion out of your decision-making process which helps minimize the tendency to let our natural behavioral biases take over.
The behavior gap can cause us to let fear and greed take over at the worst possible times. A slow and steady investment approach through dollar cost averaging, diversification and rebalancing is not exciting in the short-term but building wealth over time doesn’t have to be exciting.
Make sure you automatically invest on a periodic basis to enjoy the benefits of dollar cost averaging. Any fund provider or 401(k) plan will have this feature. You can also set up your portfolio to be automatically rebalanced at set intervals. The example I used was quarterly, but you can choose semi-annually or annually if you are willing to let your portfolio weights drift further from their targets.
By automating these two features you are less likely to make wholesale changes to your portfolio that could cause mistakes. You still have to monitor your progress and performance but by making the buy and sell rules automatic you increase the likelihood of keeping your focus on the long-term.
We have been through a difficult period for investing in stocks. Bonds performed much better than stocks so it makes sense that bonds would have helped your portfolio. These strategies will not always give you the best results in the short-term, but that shouldn’t be your goal.
Dollar cost averaging and rebalancing will seem counterintuitive to investors in periods of rising markets. It won’t feel right. No one likes to sell and watch stocks continue to rise. The same thing happens when stocks fall. It doesn’t feel right to buy when markets are going down.
The problem is that it’s nearly impossible to predict the perfect investment mix and the perfect time to buy and sell. Admitting that you don’t know how the markets will react or perform in the future is a huge first step to becoming a successful investor.
You can use the past as a framework for setting your risk tolerance and time horizon for your investments while assuming that there are a lot of factors in the markets that you have no control over.
A disciplined investment plan is the best way to increase your odds of success in a future that is filled with unknowns. You get to make your purchases at different market levels which reduces the fear of buying at the wrong time through buy and hold.
A rebalancing policy takes away the market timing element that is nearly impossible to put into practice. And you get to automate these decisions to make sure you stick with the plan over the long-term.
In honor of the recent Berkshire Hathaway annual meeting, I will leave you with a great quote from Charlie Munger, Warren Buffett’s right hand man:
“It’s in the nature of stock markets to go way down from time to time. There’s no system to avoid bad markets. You can’t do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go.”
Taking Added Advantage of Reality