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During market turbulence, it seems there are two competing narratives in the financial press and investment community. On the one hand, market timers advocate taking action to try to beat the market — making significant changes to allocations and investments in response to market conditions. We believe the evidence to be extremely strong that market timing efforts ultimately result in unsatisfactory results over long periods of time. The competing narratives seem to advocate some form of “staying the course” — that is, not to panic during downturns or euphoric during upturns, but rather stick to a long-term asset allocation.

But what does it mean exactly to “stay the course”? Investors sometimes misinterpret this to mean doing absolutely nothing. On the contrary, a turbulent market means that the disciplined long-term investor should consider taking action, but of a very different kind vs. the market timer. During a down market, a number of steps and opportunities should be considered, for example:

• Tax management, including tax loss harvesting and the rotation of investments’ asset location
• Reversals of Roth IRA conversions that qualify for a recharacterization
• Rebalancing (whether through new investments or by trading the existing portfolio) toward the long-term target allocation
• Estate planning or gifting strategies that take advantage of lower valuations
• Contributions to tax advantaged vehicles (e.g. IRAs and 529s)
• Mortgage refinances, if lower interest rates accompany the down market
• Diversification away from single stock positions, to the extent that embedded gains have been a barrier

These steps are more likely to add value, vs. trying to chase the market. And keep in mind that being in a position to take advantage of these steps requires preparation in advance, during an up market. For example, a portfolio should be well-diversified and should reflect an investor’s risk tolerance. As an extreme example, an investor that faces a severe recession holding only one stock faces the very real risk of his or her entire wealth going to zero. This particular investor is likely to be unable to “stay the course.” Conversely, an investor with a portfolio of broad asset class or index funds diversified across thousands of stocks and bonds is more likely to be able to ride out the storm, and divert his or her attention to some of the strategies discussed above.

Investors often assume that market returns are the starting point for their portfolios. They may believe that their portfolios are likely to achieve at least market returns, and will beat the market if they or their investment managers have the appropriate skill.

Several studies show, however, that investors are likely not to achieve even the market return. These studies have compared the average return of investors when factoring in the timing of their investments vs an asset class, the investors’ underlying mutual funds, or a market index. Consistently, the data show erosion of investor returns due to mistiming.

• A 2010 Morningstar study showed that the average investor had a return that was 1.5% lower than the mutual funds in which they invested, for the ten years ending 12/31/09.
• Research firm DALBAR publishes an annual Quantitative Analysis of Investor Behavior that has consistently shown underperformance by the average investor vs. the S&P 500. Most recently, DALBAR shows an underperformance of 7.85% in 2011.
• An academic study by the NYU-Polytechnic Institute showed that investors lost 1.0% of return vs. the S&P 500 due to timing, for the fifteen years ending 12/31/10.

The time periods, methodology, and exact results of these studies vary, but they all point to the detriment of market timing. Many investors become risk-averse during down markets, and may flee from equity funds in favor of safer bond funds — and in so doing fail to participate in a market recovery. Conversely, those investors may seek risk during bull markets, and may make investments based on their strong prior performance. When market conditions reverse, they may be caught with excess risk, and more losses than they can handle, repeating the cycle.

These studies show that even achieving market returns may be considered a victory (when compared to the average investor), and that investment discipline sustained across up and down markets is critical to long-term success.

Investors have opportunities to deploy capital internationally. Companies worldwide compete with each other for that capital, and investors compete with each other to find the most attractive risk-adjusted returns. In this way, capital is allocated to different countries. Their relative market size can help indicate where investors have found attractive investment opportunity.

Over half of the worldwide investment opportunity exists outside of the United States. The United States, as of December 31, 2011, accounted for only 44% of the worldwide market capitalization. While some degree of bias to their home country is warranted, investors that focus only domestically fail to participate fully in global markets.

Many investors assume (consciously or subconsciously) that stocks will perform better when buying them in a strong economy and selling them in a weak economy. When stocks have been rising for some time, they may feel that ”it’s safe now,” and that the market will continue to rise. Similarly, they may feel that in a weak economy, they want to “wait it out” when it comes to the stock markets. However, in reality, stock markets may present lower long-term returns if bought in an economy that has been strong for some time, and higher returns if bought during a weak economy. In this sense, investors risk being late to the party if their stock allocation mirrors the economic cycle.

When the economy is strong, more investors buy stocks. This increases their valuation, which in turn lowers expected returns. During a recession, on the other hand,  investor demand for stocks drops, and their valuations decline. This increases expected returns.

Investors should not, however, attempt market timing. The strength/weakness of the economy is generally not known until after the fact, at which point stock prices adjust extremely quickly to incorporate publicly available information. Disciplined long-term investors that balance their portfolios according to an acceptable level of risk are most likely to ride out multiple business cycles.

Ask ten financial advisors (or software programs) to provide the probability of success of a given financial plan, and you’re likely to get ten different answers. This is because any financial plan requires the use of Monte Carlo simulations to project portfolio behavior decades into the future. Although the purpose of the Monte Carlo calculation is to take into account chance and variability, it cannot predict the future. The practitioner provides inputs relating to future capital markets performance and standard deviation. Based on these inputs, the Monte Carlo simulation will try to provide a range of outcomes. But if practitioner A places a lower expected capital markets return vs. practitioner B, that difference will manifest itself in the calculated probability of success. Since no one knows how capital markets will perform decades into the future, there will likely be no consensus view. Hence, Monte Carlo results should never be relied upon as a guarantee of a financial plan.

One reason Monte Carlo simulations are used is that it provides a framework to assess tradeoffs between various financial goals. They can quantitatively assess different financial planning priorities, and their costs. Furthermore, even under moderately optimistic assumptions, they can help illustrate the finite nature of a portfolio and the importance of saving. People are often surprised at how little they can withdraw from a portfolio each year without running a high risk that it will deplete entirely during their lifetimes.

If you hold equity in a company and are expecting a future rise in valuation and a significant liquidity event, consider whether your potential proceeds could outpace your lifetime spending. If so, you may have opportunities to mitigate tax — opportunities that could be very significant, yet may decrease over time. Assets you want to transfer to future heirs will likely ultimately face a transfer tax, whether gift or estate taxes. Those total transfer taxes may be lower if you make a transfer that is ultimately rooted in today’s fair market value, ahead of a future valuation increase. Furthermore, certain types of holding entities and trusts can further enhance the tax efficiency of your wealth transfer.

A number of risks are involved, so you should consult with your tax, financial, and legal advisors. But begin the process of estate planning early if you are in this fortunate situation.

As discussed in the prior post, three factors (market, size, and value) can explain the relative risk and return among portfolios. However, to capture the performance premium offered by these three factors, an investor must be willing to weather what can be long periods of temporary underperformance.

For example, from July 1926 to December 2011, value stocks outperformed the S&P 500 in 87% of rolling 30-year periods, but only 58% of rolling 1-year periods. During the same time period, small stocks outperformed the S&P 500 in 92% of rolling 30-year periods, but only 54% of rolling 1-year periods. And the S&P 500 outperformed 1-month T-bills in 100% of rolling 30-year periods, but only 68% of 1-year periods.

This means that in any single year, an investor has only slightly better than even odds that value and size tilts will outperform the S&P 500 — it is only over very long time periods (possibly decades) that the expected outperformance reliably rewards the investor for taking greater risk.

Again, a long-term perspective is critical to asset class investing.

Many economists believe that differences in portfolio performance is determined by each portfolio’s relative exposure to the equity market, small cap stocks, and value stocks. Consistent with an efficient markets framework, small cap and value stocks outperform the broader equity market because they represent greater risk.

Investors seeking higher long term return may increase their overall exposure to the market, size, and value factors. Since risk and return are inextricably linked, portfolios with higher expected return could face greater percentage decreases in down markets.

Whenever the stock markets persistently disappoint, it can be tempting for some to avoid stocks in favor of bonds or cash. It is important to remember that stocks outperform safer asset classes, but only over very long time periods.

For a period of over fifteen years (1965-1981), the annualized compound return of the S&P 500 was 6.33%, lower than the 6.66% return of one-month T-bills. During this time, the famous 1979 BusinessWeek cover story, “The Death of Equities” summarized the sentiment of the times: “the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.” However, the market had a very strong recovery in years following the article. The compound annualized returns for the S&P 500 from 1982-2011 was 10.98%, handily beating the 4.65% return of one-month T-bills.

The market ultimately rewards investors for taking risk, but long-term discipline is required to achieve that reward.