Introduction
In the world of investing, there is a long-standing debate between two strategies: timing the market and time in the market. Countless investors grapple with this dilemma. The conventional wisdom often echoes the importance of holding investments for the long term and riding out market downturns. However, recent research challenges this axiom, suggesting that time may not necessarily decrease investment risk. In this article, we will delve into the intricacies of these strategies and explore the potential risks and rewards associated with each approach. The issue is compounded however by the failure in managing expectations, modelling, risk management, strategies, and the failure of advice to adequately personalise product to client needs from a benchmark perspective. All of this is leading to reduced value in advice.
The allure of market timing
Market timing involves attempting to predict future market price movements and making buying or selling decisions accordingly. The goal is to buy low and sell high, capitalising on short-term market fluctuations. This strategy can be enticing, especially for experienced investors who believe they have a deep understanding of market dynamics. However, the reality is that consistently timing the market is notoriously difficult, even for the most seasoned professionals.
A study conducted on day traders found that over 70% of investors lose money in their first year of implementing market timing strategies. The few success stories of individuals who timed the market correctly are often celebrated, but these instances are rare and seldom repeated. Warren Buffett, one of the most successful investors of our time, famously stated, “The only value of stock forecasters is to make fortune-tellers look good.”
The case for time in the market
On the other hand, time in the market refers to a passive investment strategy where an investor holds a position for an extended period, usually several years or more. This approach focuses on the fundamentals of the asset itself and the belief that over the long term, the market will generally trend upward. Proponents of this strategy argue that patience and discipline are key to achieving significant portfolio gains.
Historical data supports the notion that the stock market has delivered impressive returns over the long term. The S&P 500 index, for example, has returned an average of 10% annually over the past century. By adopting a buy-and-hold approach, investors can potentially benefit from the power of compounding returns and mitigate the impact of short-term market volatility.
However, it is crucial to acknowledge that time in the market is not without its risks. A recent US study, based on 100,000 simulations using the Black-Scholes pricing model, sheds light on the potential downsides of this strategy. The study found that while the chances of losing money decrease with longer investment horizons, the worst-case scenario (i.e., the biggest loss) becomes progressively worse.
To illustrate this point, consider a hypothetical “risky” asset with a 10% annualised return and a 20% annualised volatility. The study’s simulations showed that over a 20-year investment horizon, the chances of generating a positive return increased significantly compared to shorter time frames. However, if an investor were to experience an unfortunate sequence of returns, the magnitude of the potential loss could be devastating.
Balancing risk and return
As investors, it is crucial to understand and manage the inherent risks associated with any investment strategy. Roger Ibbotson, a renowned finance professor, emphasises that the value derived from investment management comes from various components, not just asset allocation. This of course has huge ramifications for those that outsource their investment decision making, particularly when many of these Firms attest to the discredited view of Brinson around the value found in the asset allocation decision alone. Advisors must be well-versed in all aspects of risk management to effectively guide their clients.
One of the challenges in the investment industry is the lack of proper risk disclosure and discussion. Linear retirement modelling and simple asset allocation based on risk profiles often fail to convey the true risks involved in portfolio recommendations. It also illustrates a failed product research process that revolves around historical returns and recency bias. Access to accurate data and risk assessment tools is essential for advisors to communicate the potential downsides to their clients effectively.
Modelling is an essential tool in the investment management and advice process, enabling advisers and clients to make informed decisions based on data-driven insights. Modelling plays a critical role in helping manage expectations between advisers and clients.
Linear deterministic models
Linear deterministic models are a type of financial model that assumes a linear relationship between variables and a fixed outcome. These models are often used to forecast future cash flows, investment returns, or other financial metrics. The primary advantage of linear deterministic models is their simplicity, as they require minimal data and computational resources. However, linear deterministic models also have significant limitations. They do not account for uncertainty or randomness in the financial markets, which can lead to inaccurate predictions and overconfidence in investment decisions. Additionally, linear deterministic models are sensitive to the assumptions used, meaning that small changes in input variables can result in significant changes in output. Despite these limitations, linear deterministic models can still be useful in certain situations. For example, they can be used to create a baseline scenario for investment planning, which can then be supplemented with more sophisticated models that account for uncertainty.
This approach is most used in Australia and the methodology along with the capital markets assumptions used are truly inadequate. Justification for using this approach stems from a view that it’s all “garbage” anyway to consumers aren’t interested. These arguments, like many in Australian advice have their beginnings in vertical integration and are championed by product creators who are not interested in critical assessment of a product.
Constrained Monte Carlo modelling using an upside and downside view
Constrained Monte Carlo modelling is a more advanced modelling technique that accounts for uncertainty. This approach involves simulating thousands of potential scenarios based on historical data (although synthetic and / or forecasted data can be used) and statistical distributions, allowing advisers and clients to better understand the range of possible outcomes. One way to implement constrained Monte Carlo modeling is by using an upside and downside view. This approach involves recognising that besides focusing on downside risk we need to be prepared to talk to the possible best-case outcomes. By considering both scenarios, advisers and clients can better understand the potential risks and rewards of an investment strategy for a given risk profile. Stress test outcomes are also another way to manage expectations. The upside view is typically based on optimistic assumptions about market conditions, such as high economic growth and low interest rates. In contrast, the downside view is based on pessimistic assumptions, such as a recession or a market crash. By simulating both scenarios, advisers and clients can better understand the potential impact of market volatility on their investment portfolios. Constrained Monte Carlo modelling using an upside and downside view can be particularly useful in managing expectations between advisers and clients. By presenting both the best-case and worst-case scenarios, advisers can help clients understand the potential risks and rewards of an investment strategy. This can lead to more informed decision-making and a better alignment of expectations between advisers and clients.
Constraining a Monte Carlo simulation can be achieved in many ways beyond changing assumptions. Using assorted risk metrics as a constraint the advisor and client can enjoy the benefit of only considering more probable outcomes.
Strategy considerations
Often people talk to annuities as a solution for this risk however annuities are typically funded at a single point in time, which means that if the market experiences a downturn shortly after the annuity is purchased, the client’s retirement income could be significantly reduced. This risk is particularly high during the last 10 years of an investor’s accumulation phase and the first 10 years in retirement, as the sequence of returns during this period has a significant impact on the sustainability of the retirement income.
The debate between time in the market, timing the market, and sequencing risk is a complex one, and the structure of a portfolio made up of various investment options can add to this complexity. In the case of pooled investment vehicles, each with its own benchmark and investment objectives, changes over time can indeed defeat the concept of buy and hold. This is because the investment objectives and benchmarks of the underlying investments may no longer align with the original investment goals of the portfolio, potentially leading to suboptimal performance.
Moreover, the portfolio itself may have a growth and defensive asset exposure that matches the risk profile of the client, but the benchmarks and investment objectives of the products may not. This can create a mismatch between the client’s risk tolerance and the actual risk exposure of the portfolio, leading to potential losses during market downturns. This is particularly relevant in the context of sequencing risk, which refers to the risk that the order of investment returns can significantly impact the long-term sustainability of a portfolio, especially during the early years of retirement. To address these challenges, it is crucial for investors and financial advisers to regularly review and reassess the investment objectives and benchmarks of the underlying investments in the portfolio. This can help ensure that the portfolio remains aligned with the client’s risk tolerance and investment goals, even as market conditions and investment objectives change over time.
Assigning a strategic benchmark to a client’s portfolio makes a great deal of sense in managing this risk. Strategic benchmarks are essential tools for driving performance, growth and managing expectations. They provide a clear frame of reference for evaluating performance and guiding decision-making. In the context of portfolio management, strategic benchmarks are used to measure the performance of an investment portfolio against a standard or reference point. This enables investors and managers to make informed decisions, identify areas of strength and weakness, and foster accountability. There are various types of strategic benchmarks, including market benchmarks, custom benchmarks, absolute return benchmarks, peer group benchmarks, and risk-adjusted benchmarks. Each has its unique benefits and limitations, and the selection of the appropriate benchmark depends on various factors such as alignment with investment objectives, time horizon, risk tolerance, and asset allocation.
For example, a market benchmark such as the S&P 500 index can be used to measure the performance of a portfolio that invests in large-cap U.S. equities. This type of benchmark provides a broad representation of the market and enables investors to compare the performance of their portfolio against the overall market. However, it may not be suitable for portfolios that invest in other asset classes or have different investment objectives.
Custom benchmarks, on the other hand, are tailored to the specific needs of the portfolio. They can be created by combining different indices or by using factors that are relevant to the portfolio’s investment strategy. For example, a custom benchmark can be created for a portfolio that invests in small-cap stocks by using the Russell 2000 Index as a starting point and adjusting based on the portfolio’s specific characteristics.
Absolute return benchmarks measure the performance of a portfolio against a fixed target return, such as inflation plus 3%. This type of benchmark is useful for portfolios that have specific return targets or that invest in alternative asset classes that are not well represented by traditional market indices.
Peer group benchmarks compare the performance of a portfolio against a group of similar portfolios. This type of benchmark enables investors to compare the performance of their portfolio against other portfolios with similar investment objectives and strategies.
Risk-adjusted benchmarks consider the level of risk taken to achieve a certain level of return. This type of benchmark is useful for investors who are concerned about the risk-return trade-off and want to ensure that their portfolio is aligned with their risk tolerance.
In addition to selecting the appropriate benchmark, it is important to implement best practises such as regular benchmark review and updates, incorporating multiple benchmarks, aligning benchmarks with stakeholder expectations, and balancing benchmarking with innovation. Regular benchmark review and updates ensure that the benchmark remains relevant and aligned with the investment objectives. Incorporating multiple benchmarks can provide a more comprehensive view of the portfolio’s performance and help identify areas for improvement. Aligning benchmarks with stakeholder expectations ensures that the benchmark is meaningful and relevant to the stakeholders. Balancing benchmarking with innovation allows for flexibility and adaptability in response to changing market conditions and investment opportunities. Whilst still maintaining exposure to the market.
The value of custom and direct indexing can be seen in this space as it is the only option that reflects the personalisation that is required for advice to truly meet its fiduciary duties. Other solutions are too broad.
Conclusion
The debate between timing the market and time in the market is likely to persist, as investors continue to seek the most effective strategies for long-term wealth creation. While the allure of market timing may be tempting, the evidence suggests that it is a challenging and often unsuccessful endeavour. On the other hand, adopting a long-term investment approach, while not without risks, has historically proven to be a more reliable path to financial success.
At this point I could say that diversification (fails due to correlation problems in reality), bucket strategy (simplistic personalisation attempt that fails to solve all the issues) and dynamic withdrawal strategies (the horse has already bolted). Tontines, longevity insurance and flexible annuities are all other products but again they all help but none address the personalisation issue and have unique issues in themselves.
Advice does not consider risk properly nor does a statement of advice articulate an investment policy statement both are aspects missing that will help manage the issues outlined.
Ultimately, the key to successful long-term investing lies in understanding the trade-offs between risk and return, maintaining a long-term perspective, and having the patience to weather short-term market fluctuations. By embracing these principles and working with trusted professionals, investors can position themselves for financial success and achieve their long-term investment objectives.
The original article by Ben Walsh, Adviser Voice can be viewed here: https://www.adviservoice.com.au/2024/08/perspective-on-long-term-investing-questioning-the-time-in-the-market-axiom/
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