Tuesday, August 16, 2011

Is it time to jump back into stocks? - Reuters Blogs (blog)

Should I stay or should I go?

This compelling theme, referring to stock investing and not the great Clash song, is like a little gnat buzzing in one’s ear.

The answer depends on how well you can predict the future, your gut check for risk and history. I know that’s a weaselly response, so let me explain.

I could easily make a case for buying stocks now. There are some bargains out there and thousands of companies are profitable.

If I was a gloomy Gus or just patently realistic about Euro Zone debt travails, the moribund U.S. housing market or slack economy, I would wait. How long? Until it’s safe, whatever that means. Let’s explore both points of view.

My re-entry is largely predicated on two options: 1) gradual purchases of stocks, ETFs or mutual funds over time (also known as “dollar-cost averaging”) or 2) a lump-sum, all-in buy into stocks.

On this difficult subject, I’m guided by some excellent research by Craig Israelsen, who teaches finance at Brigham Young University and designed the versatile “7Twelve Portfolio“.

Prof. Israelsen has studied the performance of the all-in stock strategy versus gradual re-entry, which he calls “the annuity” approach through investing $10,000 a year over a three-year period in equal monthly amounts from 2008 through last year.

The nominal winner was the dollar-cost averaging investment of $277.78 per month over that period, averaging an 11.6-percent return. The lump-sum garnered a negative 0.9-percent annualized return.

Yet that’s not the whole story.

What if the period was only two years — 2009 and 2010? You’d knock out the dreadful returns of the meltdown year (2008) and you’d capture all of the rebound. Not only would you have invested at exactly the right time, if you were in Treasury bills for all of 2007 and 2008, you would have protected all of your capital.

Ahh, if we only could convert hindsight into foresight, then we’d all be billionaire geniuses. Performance always depends on the time in which you’re investing. You can hit incredible sweet spots like most of the 1990s or rough patches like the 1930s or 1970s.

Much of the mythology that stocks are always good in the long run is based on the fact that since 1926, stocks produced positive annual returns 70 percent of the time. What’s buried in that number is that the Standard & Poor’s Index had 61 positive years and 24 negative years.

The bear patches were clumped together: 1929-32; 1939-41; 1973-74; 2000-2002. Moreover, there’s a 30-percent chance of a lump sum losing money in the first year, and 15-percent chance of a multi-year loss, Israelsen has found.

Still, a 70-percent chance of making money isn’t too bad, is it? Beats the heck out of Vegas or the lottery.

Again, it’s easy to conflate these nominal returns with what investors actually do. Most people pull out of down markets when they should be re-investing and obtaining better prices. They jump back in when prices are high or near collapse. Witness the lemming-like cash flows into technology mutual funds in 1999 before the dot-com bubble burst.

Investment horizon is another part of the eternal question of choosing the right time. If you chose a lump-sum approach in 2006 and were retiring in 2009, you would have gotten creamed. So if you’re retiring soon or need funds for college bills, don’t even think about the all-in method.

Granted, if you have a long time to invest before you retire, you have a better chance of hitting a bull run than a bear patch, but it depends on what happens during the years in question. The first decade of this century was gloomy for most stock investors.

The lump-sum approach is also crippled by timing risk. Does anyone truly know the best time to get out and back in? Maybe a handful of gurus can warn of an impending crash — Prof. Nouriel Roubini comes to mind — but how many of them can accurately predict the beginning and length of the next bull run?

No doubt some investors who can’t afford to lose anything have no business in the stock market. Yet if you need the growth and dividends that healthy companies provide, “systemically investing 10 percent of your monthly income into a well-diversified portfolio,” Israelsen advises, will help you stay the course.

There’s one more constant that is common to lump-sum and gradual investments. Neither way will eliminate the uncertainty, risk or volatility of the stock market, no matter how long you invest. The psychology of investing in jittery markets will always have you on edge if you watch them every day.

Or, as my favorite musical economists Mick Jones and Joe Strummer have sung many times of market volatility: “If I go, there will be trouble, if I stay there will be double … “

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