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Printable version  |
Timing Doesn't Count; The Amount
Of Time in the Market Does |
The world's markets went through an incredibly difficult first quarter in 2008. The value of many stock investors' portfolios has eroded and price declines tend to create panic, which can worsen as daily reports detail the worsening tumult.
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What's Your Risk Tolerance? |
Risk tolerance can be determined once you determine your reasons for investing, goals, time frame and the amount you are willing and can afford to invest.
Understanding risk tolerance allows you to choose investments you'll be comfortable with. If you want little or no risk, your investments likely will be comprised of vehicles like savings accounts, money market funds, U.S. Treasury Securities and Savings Bonds.
On the other hand, if you can accept a higher degree of risk, you will add mutual funds and individual stocks. Over a long time, even with periods of low or negative returns, stocks typically outperform other investments.
Risk tolerance and age often go hand in hand. Younger investors with a longer time horizon can generally tolerate more risk and weight their portfolios more heavily with equities. As they approach retirement, they may become more dependent on income from investments and opt for bonds.
However, retirement isn't the end of the investment horizon. You may live another 20, 30 or more years.
Risk tolerance is very personal. Some investors in their 60s concentrate their holdings in stocks because they have few financial responsibilities and can live with market volatility. In contrast, some investors in their 40s aren't comfortable with the stock market ups and downs. Your financial adviser can help determine how much risk you should take to get desired returns. |
The worse the losses, the greater the temptation to start using market timing strategies to jump in and out of the market in the hopes of avoiding downturns and salvaging portfolio profits.
It's rare for any one investor to be able to perfectly time the markets and every event that can move them. Nobel Laureate, William Sharpe, using historical market data over a 38 year period, found that in order to be better off than being fully invested in equities for the period, the market timer would need to be able to predict the market with at least 83 percent accuracy.
In the first quarter, market timers would have had to anticipate widely fluctuating economic data, corporate meltdowns, central bank rate changes and government regulators coming up with plans to tighten market and investment vehicle oversight.
Still, as you watch the paper value of your portfolio decline, you may find it tempting to try your hand at investment strategies aimed at beating the market. But before abandoning a classic long-term portfolio strategy, keep this fact in mind: market timing can hurt your long-term financial health and produce lower returns.
Market timing normally requires being out of the market for some period of time. And you may have seen the data showing that being out of the market for even a short period of time -- say 10 days or 40 days, can lead to missing out on the markets' best days. That can significantly hurt returns.
Here's an example of how market timing can damage your returns:
Suppose you invested $10,000 in the S&P 500 index at the end of 1996. With a buy and hold, fully invested investment policy, ten years later your money would have more than doubled and you'd have an average 8.42 percent annual return.
However, if you had been market timing and missed the 10 or 20 best days during that decade, your portfolio would show much lower average annual returns as this table illustrates. (Keep in mind that this chart is for illustrative purposes only and past performance does not guarantee future results.)
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Average
Annual Return |
Dollar
Growth |
| Fully Invested |
8.42% |
$22,440 |
| Missed 10 best days |
3.41% |
$13,980 |
| Missed 20 best days |
-0.38% |
$9,629 |
Moral: It's not timing the market that's key, it's the amount of time you're in the market.
Don't Forget the Tax Implications
Of course, taxes are another important consideration.
Suppose you want to try to lock in some profits by selling shares when they are at or near their historical highs and you react to warnings of an impending correction. The decline in the stock's price that you avoid by selling high could be offset by capital gains taxes.
However, rates are currently low, with the top tax rate on both qualified dividends and long term capital gains just 15 percent. With both rates set to expire on December 31, 2010, and a new president being elected this year, the prospect for future rates being this low is uncertain.
By and large, investment professionals note that over the long haul, investors with a sound strategy make money during the good times and hold onto their cash through the hard times. The question remains, which sound strategy do you use? There are several out there and although investment professionals may disagree about which method is the best, most agree that once you pick a strategy, you should stick with it though bull and bear markets.
When choosing an investment strategy, it is important to consider a variety of factors including your investment time horizon, goals, return expectations and risk tolerance. (See right-hand box for a look at gauging risk tolerance.)
Here are three long-term investment strategies to consider:
1. Buy and hold - This is the most conservative and possibly the most efficient strategy. You simply choose a selection of stable or blue chip stocks, and mutual funds, and hold them for many years.
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"The key to making money in stocks is not to get scared out of them."
-- Peter Lynch, Former Fidelity Magellan Fund manager and author of investing books | Long-term investors don't worry about market fluctuations, reckoning their holding will have time to recover from a down market. In addition, you save on transaction costs.
2. Asset allocation - With this strategy, you diversify your portfolio into asset classes such as stocks, bonds and cash. This is intended to reduce the exposure to any single asset and smooth out your portfolio's performance since the different classes don't usually move in tandem. The mix you choose depends on your investment goals and risk tolerance. Generally, the greater your desire for growth and protection from inflation, the larger your risk from exposure to equities. With asset allocation, however, you aren't stuck with the same mix. Depending on changing economic and market outlooks, you can shift the weighting of your portfolio to take advantage of opportunities. However, this is not the same as market timing as you don't drop one asset class in favor of another.
3. Dollar-cost averaging - This method completely ignores market fluctuations. You simply deposit a set amount of money each month into an account and the money is used to buy as many shares as possible. When the market is high, you buy fewer shares, and when it is low, you buy more. The advantage is that over time, your per-share price averages out to the middle range of the stock's pricing.
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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.
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