The Growth / Timing Myth
There is a lot of misinformation out there regarding retirement plan management. Financial Planners routinely explain that you should invest for growth and not worry about market volatility because you won’t need the money for such a long time, making good timing irrelevant. Like most investment advice, this is partially true, but mostly it will fail. I get these questions all the time and thought it would be appropriate to try to address this confusing topic as maybe some of you have the same questions, but have never asked an educated, unbiased logical adviser.
The erroneous reasoning goes something like this: “Usually three to five years is plenty of time and throughout history any ten year period shows profit in the stock market, including the Great Depression, so if you have more than a few years until retirement, you should be invested into growth stocks or growth stock funds”. This is absolutely false.
I too was taught about the “Ten year rule”, but questioned its accuracy. I performed my own research. I personally put the history of the Dow Jones industrial average for the past 100 years on my computer to the test. To my non-surprise, I found several periods which were unprofitable from date A to date B twenty years later. Now, admittedly, these points in time were at the peak of one very strong market to the next point when it finally grew to a higher value. Certainly along the way there were opportunities for profit, but money left sitting from that peak to the next was absolutely stagnant for over twenty years.
How does this affect you? Well, if you have a plan to be fully invested into the stock market, or even partially, that portion will incur serious long-term stagnation at some points because they always do. Retirement plans are a long time in developing, so you will have money in at a dangerous peak at some point in time.
What to do? A retirement plan should be invested as though it is two separate portfolios: one to with the purpose of accumulation; the second as preservation.
MYTH: “Dollar Cost Averaging will solve all issues of volatility if allowed enough time as you are investing every week into a fund that will buy more when the shares are down and less when the shares are up.” Wrong.
First, DCA is a fine method to accumulate retirement assets, and I do recommend it, but only for the part of the plan that is its accumulation stage – that isn’t all of it. Most retirement investment is money taken out every paycheck and invested into our fund choices at whatever price it is at the time. This takes advantage of price swings by automatically purchasing more shares when prices are low and fewer when they are high so mathematically more shares are always bought at a lower cost than a higher one. In fact, I suggest an even more volatile fund for DCA because if price fluctuation enhances the chances of profit, then even greater price movement will further increase that mathematical potential.
A problem arises later. When we accumulate a lump sum worth protecting at some point over time, that money is also at the mercy of price volatility. Sure, if the price falls, we will again buy more shares, but every share we already purchased sitting in our portfolio also falls, not a happy thought.
Lets use an extreme example to illustrate this. Assume you have been in a plan for some years and accumulated $500,000 with good growth stock funds. You place $1,000 each month into it and the price has risen to $50 share because the market has been so good. You are now buying 20 shares with your monthly investment. Suddenly the price falls over a few month period to $25 a share.
The good news is that you will now be able to buy 40 shares with your $1,000, and when it comes back eventually, you will have more shares. The bad news is your nest egg is now worth only half if its previous $500,000, and it will take a very long time to recover that loss.
A retirement plan should be considered 2 separate plans, not one. The first is your accumulation portion, the second is your lump sum meant to be preserved, handled separately, differently.
AVOID VERY BAD TIMING
Most advisors say you should never try to “time the market” because it is too hard and you could miss opportunities while you sit out, so just stay in forever, eventually you will win. Ludicrous.
The most important aspect of timing is to avoid the temptation of hitting the market at the bottom with all of your money. Sure, that would be great timing, but it is impossible. If you did it once, you were lucky, not good. I agree, don’t try this definition of market timing in your portfolio, it is too hard.
It is critically important to avoid very bad timing. – and it isn’t all that hard. You wouldn’t put all of your money into the stock market when you think it is likely peaking, yet you do it with your retirement. Why? Well, your accumulated balance can be converted to cash if you choose. They all have money market accounts as an investment option. If you don’t move some of it somewhere when you believe the market appears to be peaking, you have made the decision to leave it at the mercy of obviously terribly bad timing. It is the same thing as taking cash and plunking it down at that time.
How do we know when it is peaking? Well, there is no certainty, but price / earnings ratios are a good clue. An average P:E ratio is about 14 – 18:1. That means that company stock is selling for 14 to 18 times the earnings of the company. Some say the average is increasing to 20 or a little more, a slight disagreement, not important to our strategy. So if a company is earning $1 a share, and share price is $20, then it has a 20:1 P:E ratio. Investors have decided that it is worth $20 to own that company earning $1 a share.
If that company were selling for $40 instead of $20, while earning the same amount of money, clearly there is more risk. Maybe there is a reason investors are willing to take that risk for that particular company, but generally, and on average, (depending on industry (Utilities are usually lower for example) a Safe P:E ratio is around 16. They have been well over 40 and less than 10. What do you suppose happened when the P:E ratios were less than 10? Right, a huge bull market followed. What happened when they were over 40? Right again, a recession. It was inevitable.What do we do when these P:E ratios increase to 30:1 or higher – even over 40:1? Ask yourself this simple question: “If I had this lump sum in cash to place directly into the market right now, would I?” You must ask this question, because that mutual fund is not “paper profit”, it is real money. Those who say it was only paper do so largely to justify their mistakes to themselves and their clients. It is only paper when it has disappeared, but at one time it was real money.
WHERE DO I PUT IT IF I MOVE?
Another impractical argument is: “Well, if it isn’t in the market, where will you put it? You may as well leave it where it is.” First of all, if you agree with me that retirement plans by the nature of their duration often subject themselves to extremely bad timing, and that it could be very many years until recovery from that, then leaving it to decay or stagnate is not an option. The choices depend on your personal investment style.
Sometimes, we might select an unpopular sector. An sector is considered out of favor with investors when the P:E ratio is average or low for the industry or region when the rest of the market has been booming. Maybe its health care, or banking, maybe transportation or utilities, but it should be a large sector that is currently not as popular as the market in general. Those jumping out in fear will likely seek it out because of its higher earnings, as they return to investment basics again. As investors demand for the sector increases, so does the price of the stock.
Remember the tech collapse? Investors were grossly overpaying for shares of these unprofitable and undercapitalized companies because they were projected to earn X amount of dollars in five years. A lot can happen before that long-term income projection materializes into anything tangible – many crashed and burned in the middle of glowing “projections”. Investors again saw the light and returned to basics. What is it earning now compared to its price? Sure there are other factors that affect the future of a stock price, but P:E ratio is the primary factor I use.
If you don’t know where to go, don’t just stay put when you know that the risk of loss far exceeds the potential for gain over the next couple of years. Just move the lump sum (or part of it) into the money market and wait until you decide, while continuing to invest periodically into the volatile accumulation fund(s).
(When actually into retirement, investing is different. Again we have two primary areas to consider, but one is now current income, the other is still growth & preservation. )This article would be too long to explain that in detail now - so there is another addressing retirment strategies).
I hope that this writing will help you a little in understanding how to manage your money and avoid the common mistakes the neophyte “Financial Planners” tend to make over and over again. As you know, I offer this service as well as taxes, to my tax clients only. I find that most prefer to do it themselves, but if you want my specific help in this area, please don’t hesitate to contact me. We sell no investments so you don’t have to worry about that conflict.
As always, call or e-mail if you have any questions,
Christopher M. Barra, M. S.