To Bail or Not to Bail

June 1st, 2010

That is the question. Whether ‘tis nobler in the mind to endure the slings and arrows of outrageous equity markets, or to take rise against a sea of portfolio fluctuations – and, by opposing, end them.

Shakespeare’s portfolio decisions are not recorded. Nonetheless, his protagonist in Hamlet displays a psychology remarkably like that of non-professional equity investors. They can’t make up their mind, either. On the one hand, they can still feel the terrifying sensation of the equity downdraft in late 2008 and early 2009. On the other hand, they are obsessed with “getting back” what they lost – and how can they do that if they aren’t in the market?

In this connection, a new study by T. Rowe Price offers some keen insights and useful distinctions on whether it makes sense to desert the equity markets when the going gets rough.

The T. Rowe Price Study

T. Rowe Price analysts tell a tale of two investors – no, call it a tale of “two gentlemen of Wall Street,” to preserve the Shakespearian metaphor. Both of these investors begin with an equity portfolio of $10,000 as of late 2006. The study follows their investment decisions for the next 3+ years, culminating in 2010.

Investor #1 maintained this equity allocation until September, 2008 – at which point he or she bailed out and converted the $10,000 to cash. Investor #1 stayed liquid until February, 2010.

Investor #2 maintained a steady program of augmenting equity holdings with $100 per month in new investment. This program stayed in place through the ups and downs of the stock market, all the way to February, 2010.

The results of this experiment are both intriguing and instructive. As of February, 2010, Investor #2 had the larger portfolio. His lead was substantial but not overwhelming. But as of February, 2009, Investor #1 was solidly ahead.

What, if anything, can we learn from this experiment?

As You Like It

The first conclusion is that the final result is not surprising. The general public thinks that falling markets mean losses and that money is made only when market values rise. This is only partly true. When markets rise or fall, you make or lose money on shares that you own. But the money you make depends on the price you pay for the shares – the lower the purchase-price, the better it is for you. Falling markets are a buying opportunity.

Consider an investor who is 25 years old. He is just starting his investment program. He has acquired relatively few shares so far – so the falling price doesn’t knock very many dollars off his wealth. But it does enable him to keep buying more shares. If he invests a fixed amount of money, that means he must buy more shares when the price is low, in order to meet his dollar investment quota.

Ever since Adam Smith, economists have taught would-be investors to “buy low, sell high.” A falling market is a golden opportunity to buy low. How do you arrange to sell high?

The answer is: Simply by holding on to the shares you buy for as long as possible. The general public believes that when they buy stocks, they are buying brilliant management, exciting products, and revolutionary methods of production. Whey they are really buying, however, is increases in productivity from year to year, averaging 1-3%. If there is anything certain in life, it is that production gets more efficient from year to year. Over a long investing career, those increases mount up. They are passed through to shareholders in dividends and share-price growth. Eventually, they are passed on to consumers as well.

The source of true investor gains is hidden from the general public by the up-and-down fluctuations in share prices. These fluctuations are driven by transitory factors such as changes in interest rates and government policies toward business. But the undeniable truth is that the best thing that could happen to a young investor is a long period of low share prices. This enables the investor to accumulate as many shares as possible. When share prices eventually rise, the investor’s portfolio value goes through the roof.

Dollar-Cost Averaging

Continuous, level investment in stocks over time is a form of diversification – but across time. (It also makes sense to diversify among different companies at any one point in time.) When prices fall, the investor is accumulating a larger number of shares. When prices rise, the value of each share rises, and the more shares accumulated during the low-price time period, the larger is the total increase in portfolio value. Arithmetic guarantees that the average cost of the shares is lowered by this strategy of fixed, regular investment, which has been dubbed “dollar-cost averaging.” This accounting-oriented focus obscures the real economic basis of the strategy, which is independent of accounting or even the existence of money.

The Investment Life Cycle

Over time, the character of the investing process changes gradually. The total portfolio value rises, so that price declines affect a larger number of shares and magnify total-dollar losses in wealth. On the other hand, increases in earning power enable the investor to invest larger amounts of money each month. And productivity continues to increase inexorably.

At all stages, the investor should calibrate his level of equity investment with his personal risk-tolerance. He should periodically rebalance his portfolio in line with that calibration. But regardless of the amount of equity investment chosen, the investor shouldn’t change it just because of market fluctuations. Jumping in and out of the market is a tacit claim that the investor can predict changes in the markets. There is no evidence to suggest that even professionals can do this consistently. Neophytes and non-professionals certainly can’t.

Eventually, the investor will reach a point when his portfolio is large and his monthly investments are a small fraction of that portfolio. That is the point when equity holdings  should be reduced and replaced by fixed-income investments. The investor should make a decision on how best to assure a future flow of income throughout retirement. Annuities, bonds, and real estate should play a role in seeing the investor through old age.

Until that point is approached, the investor should be unfazed by equity-market swings – even large ones. Declines in market prices should be embraced as buying opportunities. The time to worry about losses in portfolio value is when the portfolio is large and there is less time to gain from buying cheaply.

Brush Up Your Shakespeare, But Quote Him Carefully

The investor should take his cue from Shakespeare – not from Hamlet, but from Julius Caesar. “There is a tide in the affairs of men that, taken at the flood, leads on to fortune.” Price declines in equity markets are one such tide.

Category: Annuities, Contingency Planning, Economic Analysis, Economic News, Investment Strategy, Retirement Planning, Risk | Tags: , , , ,

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