Fri 11 Aug 2006
As individual investors, we have a unique advantage that most institutional investors don’t have… the ability to staand aside when the market is not favorable. That means either not trading, or getting out of your buy-and-hold investments and moving to cash or cash equivalent investments.
The “conventional market wisdom” (a.k.a. cliche) says that you should always be invested. If you aren’t, you’ll miss the upside bias of the stock market.
Not true, according to Crestmont Research’s book Unexpected Returns. In one of the early chapters they debunk the logic that goes something like this — if you missed the 15 best performing days of the year (by being on the sidelines) you would have missed all the profit for the year. This is a misleading argument as any time you look at a number distribution, there will always be a subset of large numbers that equate to the total gain for the year. They reverse the argument and point out that by avoiding the 10 worst day of the year, your annual performance doubles.
To move past that specific point, sometimes there are times that it makes sense to stand aside and wait for the market to stop acting so wildly… Doing so will help you realize lower volatility on your investments, and most likely increase your risk-adjusted returns.
If you’re not actively managing your investments, the “always invested” plan is probably best… it would be sad if you moved to cash and forgot about it when the market does finally start acting better… so take this advice only if you stay current with what’s going on.
Another good point is that you should have a plan when deciding to stand aside. You should try to describe the conditions when you’ll move out of cash and back into your original investments. You can do this quite easily — pick a time frame (I’ll sell in May and buy again in November), pick a price (I’ll buy if the Dow goes down to 10,500), pick a technical indicator (I’ll buy when it’s back above it’s 50 day moving average), pick a “fear gague” (I’ll buy when the $VIX is 20% higher than it is now), or preferably a combination of these (I’ll buy if the Dow hits 10,500 or if it crosses above it’s moving average).
We have a rare advantage over institutional investors. Consider using it when the markets aren’t behaving well.
In parting, I’ll share a quote from Jeremy Grantham in his 3Q letter to investors:
In the meantime, we continue to recommend as much risk avoidance as your career or business risk can tolerate. In particular, we recommend overweighting cash and cash equivalents, which we know is the toughest career risk of all ? ?Is this what we are paying these guys for?? ?Is this the most creative idea they can come up with?? Well, er, yes, it is, unfortunately.