I recently wrote about my decision to aggressively revise my investment portfolio from a very Stock orientated one (90% allocation) into a much more defensive one, phase one of this was simply to liquidate the Stock positions and phase two will be to buy some bonds. Please be aware that I am not advocating Bond Funds here, since I think that these vehicles are not safe for our money during this current economic climate. When I plan to hold Bonds it will be actual Bonds.
My decision has led to a lot of disagreements from the personal finance ‘experts’ that we find on the blogosphere, the reason that they disagree with my choice is because a Passive Investment Strategy has been drummed into them and they cannot see the wood from the trees. I too think that there is a lot of good things to be found within Passive Investing, however the fatal flaw, which I think is instrumental to the manner in which people perceive this strategy is Risk.
The common thinking is that you should plow your money into every asset that you can, regardless of its cost and if it drops you will buy more (and therefore dollar cost average) and if it rises you will be buying less. They say that you cannot ‘time the market’.
Timing the Market is a term used for people who are seeking to predict when the market will rise or fall. The exact tipping point is clearly impossible to calculate, but what everybody agrees upon is that it will go up, down or stay the same. However, the very basic, and brutally simple truth of the matter is this.
It doesn’t matter if the market goes up or down, what matters is what point you entered and exited the market within the swing. If you enter the market when the DJIA is 5000 (today it is over 15,000) then selling everything when it hits 8,000 is great – you made a profit! Certainly you could have made more, but also you could have made less too.
However, if you bought at 10,000, and sold at the same 8,000 then you just lost money that you have to reclaim before you can reach break-even point and then go onto make a profit.
The danger that people associate with taking the active approach to investing is your ability to make calm and calculated financial decisions when you are watching your retirement and life savings vanish – can you keep to a plan and not sell when you are down? If the answer is no, then you should Passively Invest. This way, if the market drops you don’t react, just buy the same amount each month or year and when it comes back up you will be OK.
That is the power of Passive Investing, it protects you from yourself.
However, if you are able to keep a cool head and exit the market at a high (higher than you entered it) and then, when it is crashing and everybody is losing their heads selling you re-enter the market and buy, then you can make even larger profits. But believe me doing so is not easy, simply from a behavioral perspective.
Creating your own Index Points
Looking at a single stock (this works for a fund or Index equally) you take your Entry price, and your Exit price, this is your benchmark. If we took Ford Motor Company (Ticker F) that we bought at the start of the year for $12.95 per share, it is currently trading at $17.48 per share the difference between the two if you sell today is a profit of $4.53 per share.
- Buy 1000 F @ $12.95 for cost of $12,950
- Sell 1000 F @ $17.48 for income of $17,480
- Profit of $4,530
If you were to Sell, then rebuy at any price lower than $17.48 you could acquire more than 1,000 shares of the stock. The new Index point for your stock is $17.48, if it decides to continue to rise then you would be losing out on potential gain, and you would sit on the sidelines unless other external factors changed (Macro Economic changes such as legislation that would create new, future revenue streams)
When the markets crash, you buy back into Ford in one of two ways, you can either buy as much stock as your $17,480 allows for, or you could buy the same fixed amount of 1,000 shares at whatever price point you opt to enter.
You cannot tell what the lowest or highest price of the stock will be- but you can tell if the current price is less than your Index Points.
If you sell at $17.48 in Sept 2013, and the stock rises up to $21, then drops to $15, you could buy in as you are below the $17.48 Index point. If it then further drops to $11 you are still better off than if you bought at $12.95, let it rise to $20, and watched it drop to $11.
Trading like this is best done shielded within a tax protected account such as IRA, else Short and Long Term Capital Gains will destroy the profit.
I know from the above it appears the example is day trading/gambling. But cast that concept from your mind, replace the ticker F with the ticker VTI and realize when markets are high, they are likely to revert to the mean through cyclical adjustments.
The question, are you capable of timing the market is this:
- Are you willing to sell when everything seems great?
- Are you willing to hold what you didn’t sell when everything is going to hell in a handbasket?
- Are you willing to buy when nobody else wants to?
Fundamentally, the decision to sell when everything seems great (IE now, when the markets are at all time highs) is not a gamble, it as risk reassessment when it can do you no harm. If you decide to stay in the market and think you can stick with it through the highs and lows and when it crashes you have the same risk reassessment you just cut your own throat. You can only reassess risk when it is safe.
It is safest to reassess risk when you are winning.
When the markets are slumped and the country in a recession it is best to be bold, and buy as much as you can afford, because the market will always cycle with time, and your gains will multiply. You need cash or other equivalents not impacted by the stock market crash to be positioned to do this, if you are in stocks fully you cannot benefit.
My recommendation to you, if you can regimentally follow a Passive Investing Strategy and not panic when the market crashes, by all means hold your positions and buy more through the good times and the bad. This is a safe approach. But if you can take your chips off the table every now and then, and put them back in when things seem dire, you could earn gains that are far beyond the average.
The risk of timing the market, is not how much upside you left on the table, it is if you panic, think the market is crashing and sell when down. Me, I am panicking, thinking the market will crash, but am up.
In closing, I am not out of the market, I just switched my asset allocation from 90% Stock to 50% Stock. If it goes up further I will not earn as much, but if it goes down then not only would I not lose as much, but I get the 40% balance to buy extra, cheap positions at that time.
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