By Karl Steiner, Mindfully Investing
My view of “market timing” is a bit different than most people’s. While market timing is often poorly defined, to start today’s post, I’ll define it as buying and selling assets over time based on anything from strict rules to vague feelings.
Most stuff you’ll see about market timing falls into one of two camps. The first camp maintains that market timing is entirely possible, and many of those campers are more than willing to sell you a “great system” for timing the market¹. The second camp maintains that successful market timing is nearly impossible with any regularity. These campers will tell you that investing is all about “time in the market, not timing the market”.
Mindfully Investing camps elsewhere, based on a critical distinction between “short-term” and “long-term” timing. Short-term timing involves buying and selling on timescales ranging from daily to annually. Long-term timing is about making one or two key decisions over many years of investing. My view is that short-term timing is mathematically impossible, and long-term timing is entirely feasible if it’s executed carefully.
Although it’s rarely stated, most of the time people address this topic they are talking about short-term timing, where routine market gyrations and economic indicators are used to jump in and out of markets, funds, individual stocks, or other assets. But my main concern in past posts, and today’s post, is the much less discussed topic of long-term timing.
One Type of Long-Term Timing
Specifically, in Article 8.3 of Mindfully Investing I’ve advocated that “older” investors who are nearing retirement or recently retired should hold a predefined amount of cash, usually 20% or less of a portfolio, to invest in the event of a market crash.² This procedure is intended to manage so-called sequence-of-return risk, where portfolio losses early in retirement can severely reduce the number of years your portfolio lasts. That’s because most retirees are routinely divesting small amounts to fund retirement expenses and don’t have any new income to replace those investments. You can learn more about sequence-of-return risk from this post.
Basically, this type of long-term timing boils down to a once-in-a-lifetime decision. Under this procedure, there is only one event (a large market crash) that would trigger using the cash reserve to buy additional stocks, and only if the crash occurs in the first several years after retirement, for reasons I describe more in Article 8.4 of Mindfully Investing.
For this procedure to work, we also need a definition of a large market crash. Based on the magnitude and length of past market crashes, I came up with a rule that a 35% or greater decline in the S&P 500 triggers investing cash reserves in stocks. History has shown that when the stock market (S&P 500) has declined by less than 35%, it usually started to recover in less than 2 years. In contrast, more severe declines took 5 to 15 years to fully recover. Because the future is unpredictable, the 35% threshold is admittedly, somewhat of a simplification.
I use this long-term timing procedure to manage the sequence-of-return-risk in my own investing plan. And it turns out that the market decline earlier this year required me to put this theory into practice. So, I thought I’d review my real-life example of implementing long-term timing and describe how it’s working out so far.
My Own Plan
I fully retired in 2017. At that time, I set up our investment portfolio as follows:
- 80% low-cost stock index funds (diversified by geography and sector, and to a lesser extent by size).
- 20% cash held in a high-yield online savings account.
This does not include our home, which is paid off, as an investment. This also does not include two rental properties we owned at the time, because the plan was to sell the rentals (which we did) and plow the proceeds into stocks and cash at the same 80/20 ratio.
Since late 2017 we’ve been funding our retirement by slowly depleting the cash account. All the stocks have been left untouched to grow and all dividends have been reinvested in the same stock funds. The cash account now stands at about 14% of the total portfolio, which again, is roughly consistent with the original drawdown plan. So, earlier this year when the stock market started to tank, we had a bit more than 14% of our total nest egg that I could have used to buy stocks.
The Face-Off with Reality
Consistent with mindful investing principles, I don’t pay a lot of attention to daily stock market gyrations. By the same token, I try not to expressly avoid market news either, because mindfulness is about being aware without being reactive.
I’m not sure exactly when, but I woke up one morning in March this year and thought to myself, “Hey, this coronavirus thing is really starting to make the stock market tumble.” So, I looked at some S&P 500 stock charts and realized that the market had gone down by nearly 30% from its February 19th peak. Alarm bells went off in my head. I knew my threshold to start buying stocks (a lot of stocks) was 35%, so I needed to start paying more attention.
The first thing I did was review my plan. Frankly, I couldn’t remember whether I was supposed to measure the 35% starting from the calendar year or the market’s last peak. I also wasn’t sure whether my rule was based solely on the S&P 500 or some other indices as well. This is where having a written investing plan is invaluable. All I had to do was review my past articles (particularly the ones I linked to above) to recall that my threshold was based solely on the S&P 500’s decline from the last market peak.
I won’t lie. There was some doubt in my mind whether I should actually stick to this “silly rule” or rely more on my intuition about the specifics of this crash. But then I paused and remembered, the whole point about having a plan is that you have to stick to it. The rules you’ve adopted may be over-simplified or even relatively arbitrary. But if you don’t stick to those rules, you’re essentially making it up as you go along, which leaves you prey to a litany of behavioral biases and potentially counterproductive emotional reactions.
So, I continued to watch the market decline for the next few days. Here’s a chart of percent change in the S&P 500 since its peak on February 19. (Click on the image to enlarge the view.)
Incredibly, on March 23 the market bottomed at -33.92% from its prior peak, which is about 1% shy of my -35% threshold to start buying stocks. The next day the market started to recover, and just three days later, it had shot back up by nearly 10%! To again be perfectly honest, I only became aware of this dramatic rebound after the fact, partly because I was distracted by events surrounding my birthday on March 21.
I came within a hair’s breadth of going all-in and investing hundreds of thousands of saved dollars in stock funds. Would I have actually pulled the trigger? I guess I can’t say for sure, but I’m pretty confident I would have swallowed hard and followed my plan.
When I devised my investing plan, I would have never guessed that a few years later a global pandemic could force me to roll the dice with the market’s next move. But back in March, I found myself at the head of the metaphorical craps table. And I may wind up at the craps table again in just another month or two because all evidence suggests that COVID is coming back with a vengeance this fall and winter.
Market timing is always a gamble. In this case, buying a bunch of stocks after a 35% market drop could turn out badly for me. What if later this year the market continues to drop to -70 or -80%, as some are predicting? If that happens, my 35% rule may cause me to buy stocks way too early, and my portfolio and retirement would suffer severe consequences. But in such a huge crash, the nuances of my plan will probably be mostly inconsequential. Almost no reasonable investing plan would be able to withstand that kind of market carnage.
Conclusions
Long-term market timing is about transforming risk. In my case, I’m accepting the additional risk of gambling with market timing so that I can hopefully reduce my sequence-of-return risk.
I’ve never considered any other long-term market timing decisions, but you or I could undoubtedly devise some new ones that aim to transform other perennial investing risks. Given that we know frequent market timing is bound to fail, to be successful, long-term market timing must involve decision points that occur perhaps one or two times in an investing lifetime and that transform or explicitly trade one specific risk for another. And as my example has shown, to avoid second-guessing, successful long-term timing involves ironclad rules that we have the nerve to follow when and if that fateful day arrives.
Originally published by Mindfully Investing, 11/4/20
1 – I’m not going to provide a link to an example of this notion, because I don’t want to lead anyone down this path. But if you Google it yourself, I’m sure you’ll be inundated with examples.
2 – I’ve seen some confusion over this cash reserve idea. Many people point out that maintaining a cash reserve simply drags down a portfolio’s long-term return, which in most cases is true. But with this procedure, the cash reserve is only temporarily and partially sustained such that it’s fully exhausted after a period of about 5 to 8 years.