INVESTMENT STRATEGY: INDICES UP VS. DOWN MARKETS

27 Jan INVESTMENT STRATEGY: INDICES UP VS. DOWN MARKETS

In addition to Target Dated Funds, many investors buy passive index funds for their 401k, 403b and IRA retirement plans.  They do this systematically out of every paycheck.  They have recently seen the three major indices fall by over 10 percent, leaving many to wonder what they should do during this market correction.

“Which index will lose the least on the way down should the trend down continue? And which indices will rally first if the trend reverses?”

Advisors answer these types of questions constantly. And the answer is always, “It depends.”

It depends on two things. First, the type of investor you are, and second, the investment strategy you follow.  While this may be obvious, if you have an investment strategy you follow then you aren’t asking these questions because you know what to do and you know what type of investor you are.

For people in this category the question is moot, and the real question needs to rephrased as follows:

“I have lost a lot of money in the stock market recently. I have no investment strategy. I don’t know what type of investor I am and I have no idea what to do.  How should someone that has no idea what to do act in this type of environment?”

There are two schools of thought on this matter.

Some people believe the best offense is a good defense and they sell everything and then try to regroup.  They tell themselves they will get back into the stock market “when things are better” but unfortunately they have no way of knowing when “things are better” and by selling without a re-entry plan they seldom win the stock market game.

Some people believe in the Foghorn Leghorn approach to investing, ask them what they are doing and they tell you, “I say, I say, I say, I am a buy-and-hold investor and I’m just going to hold on for the ride and keep adding to my positions.  I’m not retiring anytime soon so what does it matter to me.”  Foghorn Leghorns are blustery when markets are only down 10 percent but when markets are down an additional 30 to 40 percent from here they turn into Chicken Little and sell at even lower prices.  The reason this happens to them is because they also had no idea what to do in this type of environment but somewhere along the way bought into a strategy that said you should buy and hold.

So what should you do?  You should first identify the type of investor you are.  You do this by determining your objective.  There are only two types of objectives in our opinion, those looking to create wealth and those looking to preserve it and you should identify yourself as one of these.  This simple act of self-identification is the first step required to know how to behave in this type of market and based on the type you are, your actions should be different.

What Should the Wealth Creator Do?

The point of wealth creation is to convert your capital to income at some future time.  In order to do this you need to create sufficient capital so that the profits from your capital can generate the required income.  Studies differ as to how much capital is required but the number we use is 8 times your salary.  If you have saved eight times your salary then you probably have sufficient capital to identify yourself as a wealth preserver instead of a wealth creator.

Think of it like a magic switch though it is not so black and white.  What is black and white however is a hypothetical person that makes $50,000 per year and has $10,000 in their retirement plan or 0.2 times salary asking what to do in this type of market environment.  This person should maintain a 100 percent allocation to stock indices and if they don’t have this level of allocation because they are “conservative,” they need to educate themselves as to why being “conservative” could cause them to work decades longer than with a total allocation to stocks.  Our firm has published a white paper that speaks directly to this topic and does a monthly analysis starting in 1900 through 2015 to show you why it is so important to know how stock indices behave.  For a free copy click here.

What Should the Wealth Preserver Do?

The wealth preserver has accumulated at least eight times their salary.  These investors have two decisions to make.  The first is what to do with current and future contributions and the second is what to do with the capital they have accumulated and probably want to preserve.  In all cases, current and future contributions should be 100 percent allocated to the stock market.  But what about your capital?  There are two schools of thought here.  If you read our study on wealth creation, you will understand we do not espouse low risk investments while on your wealth creation journey.

However, we have seen that for almost everyone, as a person’s capital increases, they become increasingly risk averse as their capital approaches an amount that lets them retire.  They do not want to go backwards and when they reach this point, which we call the wealth inflection point, they almost universally take some risk off the table by reducing their exposure to stocks.  If you have sufficient capital to retire and don’t know what to do, we advise you immediately take some risk off the table and sell some stocks.  We then advise you hire a competent registered investment advisor to assist you with your money.  If you have sufficient capital and know what to do, do it.  Don’t second-guess yourself.

This brings us to answer the technical question, which indices do better in down markets vs. up markets.  We are fortunate to have witnessed a recent laboratory experiment that answers this question.  It goes by various names.  I will simply call it the bear market in stocks that started in late October 2007 and ended March 9, 2009.  If you owned major stock indices in October of 2007 and held them through March 9, 2009, you would see they all went down in excess of 50 percent.  Therefore, based on recent experience and historical evidence as well, the answer is clear, in a continuation of this recent decline of 10 percent all major indices will fall.  We urge you to read A Practical Tale for a more detailed understanding.

So which indices do better in an up market?

The answer is also very clear, those indices with the highest relative strength.  Unfortunately, major indices seldom diverge sufficiently to measure relative strength with any accuracy and very few employer sponsored retirement plans include focused investment choices, so your guess is as good as anyone’s as to which recover the fastest.  If you are fortunate enough to have the opportunity to have focused investments in your retirement plan, then studies on momentum investing or relative strength investing point to buying the investments that have performed the best.  They are typically the first to recover.

This brings us to a problem: Unless you have a consistent and tested methodology to measure which investments are performing the best and the ability to execute based on this approach, we advise you to avoid this type of adventure.

Carl Sera is a Registered Investment Advisor Representative of Sera Capital in Annapolis, Md.

Carl Sera
cesera@seracapital.com

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