A time for every purpose
Anyone reading this blog for a while knows we’ve long advocated that buy and hold isn’t always the optimum strategy for building wealth in stock markets.
It’s difficult for many to understand this, but building wealth in the stock market means you need to pay some attention to your investments and understand how markets work.
Understandably, the prospect of paying attention to your money and superannuation investments doesn’t exactly thrill everybody.
But there are very simple methods for successfully managing your capital.
Firstly it requires rejecting a well-worn investment cliché: buy and hold at all times.
It’s become a popular idea in part because people are drawn to the idea of a panacea which is simple and requires no thought, but the greatest strength of buy and hold (its simplicity) can also be its weakness.
Let’s deal with a few issues to demonstrate why buy and hold isn’t appropriate in all circumstances.
Repeated similar bets
As we have said investing in stock markets (or any markets for that matter) is like betting.
You don’t place one bet over your lifetime, but instead place a series of repeated similar bets.
Let’s look at the reality of the stock market.
With the stock market, you put money in and depending upon your timeframe you realise a profit or loss when the time comes.
Let’s say in the stock market you were required to place money in on January 1 and sell at the end of the day to collect the profit (or loss).
Then on January 2, 3, 4, and 5 you must repeat this process.
Your average return would be calculated by totting up all of the daily wins and losses.
This is roughly speaking how an average return might be calculated, although people tend to focus on annual returns.
But this isn’t the reality of how we invest in stock markets.
People often maintain that the best method is to put money in (ignoring the odds of success) and simply wait for it to compound.
But compounding requires multiplication not addition.
In the above scenario if you have $100 profit from January 1, then you’d invest your total capital on January 2, and continue in that vein.
Buy and hold die-hards talk about compounding, but then also talk of average returns instead of geometric returns.
Average returns are calculated by addition.
Compounding returns require multiplication.
Listen a bit more carefully to Buffett and you’ll garner that this has been part of his great genius over the decades.
That is, understanding that to compound wealth you need to buy more units by buying when prices are low and on sale (the Kelly Criterion), and then sit back and wait for the dividends to roll in.
It’s about time…
If you invest in stock markets then you also need to understand this vital point: if compounding is about time then how long should you hold an investment for?
When in the future do you expect to collect the winnings?
Your timeframe for investing is very important.
If you want to be invested for 10, 20, 30, or 40 years you need to understand the range of returns for those time periods and understand that what you receive depends greatly upon what the odds and expected returns are.
Put simply, you need to ‘bet’ more when the market offers a high return and reduce your bet when it doesn’t.
Reducing your bet means taking money out of the markets when they’re expensive and placing it in cash (or, say, an offset account) and waiting until markets become cheap again.
Now let us make you an offer.
You can invest with us and we’ll give you two choices.
(i) you can invest with us and we’ll give you somewhere around 10-15% per annum as an annual return; or
(ii) you can invest with us and we’ll give you anywhere from 0-5% per annum.
Naturally enough you’d choose option one.
However, we forgot to mention that if you leave your money with us for too long you automatically get option two.
Because stock markets operate in cycles, and the geometric return is invariably lower than people think.
Sometimes things are cheap and sometimes they are expensive, but trees don’t grow to the sky and they don’t keep powering higher indefinitely.
If markets were expensive you’d probably search elsewhere.
The fact is when markets are cheap there is a higher than average probability of outperforming returns.
And when the market is expensive (as it has been for a couple of years now) the probability of strong returns is very low.
So low, in fact, that some investors will lose money or spend some years recovering their original outlays.
Die-hard buy and holders repeat the well-worn phase ‘you can’t time the market’.
This is a valid up to a point, and there’s no question that predicting the future is inherently impossible.
But here’s the thing – you don’t need to be able to predict the market.
Remember the market return has two parts to it.
You get dividends and you get capital gains (much in the way that when you buy an investment property and you get rent and some capital gain).
Now many folks focus on, talk about, and hope for the capital gains.
At every stock market top and bottom – and in between – economists and investment professionals will all be asked about where they think the stock market will finish up next week, month, or year.
When markets are expensive (the price is high) then the potential returns (earnings) are lower, and markets are cheap the returns are higher.
Imagine receiving $10 as an annual dividend for outlaying $100, for a 10% return.
The same dollar income on an initial price of $200 is a 5% yield, while if you pay $500 the yield would only be 2%.
As prices rise (the more you pay) the lower the returns will be (value is what you get).
It’s that simple.
These basic pieces of information demonstrate that you don’t need to be able to predict the future.
If you realise that putting money to work in the stock market is a choice then you should wait for the best odds of getting a high return, especially because of the bulk of returns can come from income (dividends).
And that is why buying when the market is cheap – and everyone is fearful – results in considerably superior returns.
When the markets are as expensive as they have been recently then the odds and the dividends are effectively lower.
This means you should reduce your bet, or not bet at all.
So you don’t need to ‘time the market’ per se, but simply check the odds (the earnings or dividend yield on offer) and if the odds are terrible – as they are when the market is ‘expensive’ – then withdraw your money and wait for better odds.
We can tell you after 20 years there are great times when you want to hoist up the mainsail and ‘buy and hold’ – but importantly there are other times when the market is expensive, and you shouldn’t only buy and hold.
Once you understand how markets operate you can go in search of cheap markets with higher expected returns.
Today you can be a global investor and buy investments in many countries, not just Australia.
Some investors are now staring down large losses of about 35-40% or so…thus far.
This is sort of acceptable if you are 25 or 30 (although even then losing 35-40% isn’t ideal in the long run since you need to make a lot more to get back to your previous position).
It also may not matter too much to you if you’re in the retirement phase and have more capital and income than you’ll ever need.
But it’s not so much fun if, say, you’re planning on retiring in the next 5 to 10 years.
You now need to make approximately 60-70% of returns just to make you whole again.
Remember a 50% decline means a 100% return to get square.
No price too high?
In conclusion, be wary of being seduced into thinking you should only put money into stock markets at all times until you get to pull the winnings out late in the game.
Market cycles show that returns can vary considerably, but there are a few simple principles that we have explained in our book to assist you in avoiding expensive markets and finding cheap ones.
To find out more about our coaching programs see here.