Q&A - Stock Market Decisions
Topic: Investment Planning & Management
Q: I'm confused by knowing when to be in the stock market and when to be out. How do professionals make this decision? How should I?
A: Many different ways. The process of establishing and adjusting a portfolio's commitment to major asset classes is called "asset allocation." When this is done with a long-term planning horizon, it's called "strategic asset allocation." When efforts are made to periodically change commitments to one or more asset classes in order to improve performance or reduce volatility, it is called "tactical asset allocation." When such efforts involve attempts to capitalize on short-term market swings, it's called "market timing." While the latter phrase has a certain negative connotation within financial circles, the process of adjusting portfolio commitments to stocks goes on every day, whether by design or as a natural consequence of the investing process. The "why's" and "how's" of such practices vary widely. It's good to understand some of them in order to determine the approach best suited to your portfolio and your investment temperament.
On one extreme are those who contend that every investor should make a long-term strategic decision based on their goals, time horizon, and risk tolerance about how much of their capital to invest in the stock market (and other capital markets). Then they should stick with that decision through good and bad markets alike unless their goals or financial circumstances change, perhaps rebalancing periodically to restore the intended commitment level. If you've planned your future finances assuming average market returns, then you've already allowed for bad market periods (particularly if your planner has used "Monte Carlo Simulation" or similar techniques in your analysis) and you should still be able to achieve your long-term goals. This approach is highly rational but often ignores the influence of human emotion. It can take a lot of courage to sit through some of the stock market declines we've seen in our history, including this most recent one. Too often investors, who thought they were in it for the long haul, bail out after the stock market suffers a major decline and then wait too long to get back in. The best defense against this type of breakdown is to be actively engaged in the financial planning process so that you develop some degree of intellectual comfort that you will still be able to achieve your goals in spite of periodic market declines. Those who don't have that assurance are far more likely to abandon a buy-and-hold investment strategy at just the wrong time.
Others advocate adjusting the percentage of a portfolio devoted to stocks based on an assessment of market conditions and prospects, increasing commitments when markets are down hard (like now) and decreasing stock allocations at market tops. That makes sense, but it's a hard strategy to execute. What's high and what's low remain elusive and relative concepts. If investors could recognize "high" and "low" when they saw them, investing would be a lot less challenging. Remember how market gurus were claiming the market was overvalued for most of the latter part of the 1990's? Those who listened to that counsel and reduced their stock exposures missed out on one of the greatest bull markets in history. Sure, stocks were overvalued. But they got even more overvalued. Remember also, back in early 2000 when most people thought the stock market could only go up, even though valuations were absurdly high by historic standards? Under this approach, you would have wisely cut back your stock exposures in the Winter of 2000 and you would be increasing them now. How many people do you think really cut back their stock positions before the market started to come apart? To summarize, If you're going to use this approach, then you need to develop or adopt some objective measures of market valuation so that you can make adjustments that are based on something besides your emotional response to the current state of affairs.
Another school of thought claims that one should let the market itself tell when to change stock commitments. If the market is rallying and doing well, increase stock exposures. If it is declining and showing signs of weakness, move to the sidelines and wait for things to improve. A related approach to investing in individual stocks is to establish firm guidelines to govern the purchase, holding, and sale of stocks. In healthy markets there will be many "candidates" for purchase and few for sale; in poor markets, there will likely be few promising buys and lots of sell candidates among portfolio holdings. Sticking to these individual stock purchase and sale criteria would serve to dynamically adjust the portfolio's stock allocation based on current market conditions. Simply put, you'd own more stocks when there are more stocks worthy of being owned and fewer when there are fewer. The advantage of this approach is that it requires no judgment about what's high or what's low or what the market will be doing in the future. It requires only a viable set of rules and an objective assessment of what the market is doing now, then responding appropriately. The disadvantages are (1) that an investor could still allow his or her own emotional responses to influence their assessment of the market's current condition and (2) this approach can take a lot of time and effort... more than most individual investors are willing to commit.
Finally, on the opposite end of this continuum lie those who actively "time" the market, attempting to capitalize on short-term swings in markets and indices through aggressive trading in stocks, options, futures contracts and commodities. True market timers often try to play both sides of the market to their advantage... to make money in falling markets by "shorting" stocks, as well as by "going long" or using "leverage" in rising markets. Professional traders often use a variety of sophisticated technical tools to guide their decisions and, for them, trading is a full-time job. Amateurs who engage in this type of trading are, unfortunately, too often on a collision course with reality.
The key to investment success lies in understanding your capabilities and establishing a discipline over how you manage your investments. If you don't have the time, training, experience, and discipline to make the judgments necessary to adjust portfolio allocations, then you probably shouldn't try. Find a comfortable stock commitment level based on your goals and risk tolerance and stick to it. Just recognize that your portfolio will decline from time to time... sometimes significantly. If you have anticipated periodic market declines and incorporated their effect into investment return assumptions in your financial plan, you'll still be OK.
If you do think you have what it takes to "time" the market, try it first with a relatively small part of your portfolio. Formalize your efforts by writing down the rules and protocol you will follow to make adjustments in the future, and then stick to them. After a complete market cycle (usually five to seven years), assess your performance. If you haven't outperformed a "buy and hold" approach then you have to ask yourself why you bothered, because a disciplined approach to active asset allocation takes a lot of time and effort. If it doesn't produce superior results, your life would have benefited more by spending that time and effort elsewhere.