By Robert Michaud, Chief Investment Officer at New Frontier Advisors
Most investors have heard the contradicting clichés “never try to time the markets” and “buy low and sell high.” Both weigh heavily on the consciousness of investors and advisors, particularly during these times when equity markets have risen substantially. Should a long-term investor scale back or even eliminate equity exposure for periods following new market highs? Or should they, on the contrary, continue apace with regular contributions to an equity-rich retirement account?
As researchers and investment managers, we did a quick calculation to see if it makes sense for a holder of a long-term equity portfolio to act on either of those persuasive maxims.
To begin, we looked at the Dow Jones Index from 1/31/1900 to 7/31/2017[i], and considered all of the many market highs and lows. There were over 1400 months in the sampled timeframe. We looked at the last day of each month to determine if markets were at their all-time highs (the highest the market had been up until that point), 12-month highs, both, or neither. We chose a monthly rather than daily analysis to avoid excessive data noise, and required at least 12 months of previous data to be available before deeming a given point to be a market high. Out of the 1400+ monthly data points examined, 210 of them were counted as all-time highs, and 396 were 12-month highs. Now comes the fun part.
We wanted to see what would happen if we had invested immediately after each market high and held on to those positions for one, five, or ten years. So what did we find?
| Annualized Price Return and Standard Deviation, 1900 to May 2017 | |||
| Price Return | 6.66% | ||
| Standard Deviation | 18.28% | ||
| Average Annualized Price Returns and Standard Deviations, Starting at a New All-Time High | |||
| 1 year | 5 years | 10 years | |
| Avg. Price Return | 7.75% | 6.81% | 8.43% |
| Avg. Standard Deviation | 15.07% | 18.48% | 18.16% |
| Average Annualized Price Returns and Standard Deviations, Starting at a 12-Month High | |||
| 1 year | 5 years | 10 years | |
| Avg. Price Return | 8.24% | 6.90% | 8.41% |
| Avg. Standard Deviation | 14.20% | 17.15% | 17.40% |
We found that when investing in the Dow Jones Index at all-time highs and holding on for one, five, or ten years, on average the investor would have experienced an annualized rate of return (not including dividends) ranging from 6.81% to 8.43%. Using 12-month highs instead, the numbers range from 6.9% to 8.41%. The highest return on the chart (8.43%) corresponds to the average result of buying at an all-time high and remaining invested for another 10 years, with the resulting price returns annualized. We can compare that range of returns to the average annualized price return on Dow Jones equities over the entire period since 1900: 6.66%. So history suggests that buying at the high points and holding would have provided more than the average market return. And the standard deviations suggest that the risk (or magnitude of typical deviations from the average) associated with price return did not significantly exceed the market’s long-term average risk when buying at the high points and holding. (Dividends are relatively stable and don’t contribute much additional standard deviation to total return.) On the face of it, this analysis suggests that selling or even slowing contributions upon hitting market highs would not have served a long-term investor well on average during the past 116+ years.
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That said, an historical study such as this only provides some understanding of the possibilities and expectations of the future. Investors are generally better served by understanding their investment goals and risk tolerance and investing accordingly rather than simply following the highest expected return strategy, particularly one based on historical analysis. Any thoughtful investment plan involves rebalancing one’s account back towards risk-appropriate allocations whenever one asset class has appreciated too much relative to another. Often, risk targets change as the investor’s circumstances change, which can make a direct comparison to any historical results difficult. Nonetheless, our look back shows that investors shouldn’t necessarily shy away from investing at market highs. Our study reveals that as investment adages go, “don’t try to time the markets” is a better guiding principle than “buy low sell high.” As a corollary, we would add this specific recommendation: stay fully invested even at market highs.
Robert Michaud is the Chief Investment Officer at New Frontier and is the co-holder of four U.S. patents in portfolio optimization and asset management. He holds a Masters in Mathematics from Boston University and pursued a Ph.D. in finance from the Anderson School of Management at the University of California, Los Angeles before joining New Frontier. His research interests include portfolio theory, risk models, empirical asset pricing, and international finance. He is co-author of Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, (2nd ed. Oxford University Press, 2008) and research articles in refereed journals.
New Frontier Advisors is a research and investment advisory firm. We do not subscribe to any one method of investing; rather we focus on defining strategies that reduce risk and deliver solid returns across uncertain future market conditions.
[i]http://us.spindices.com/indices/equity/dow-jones-industrial-average