High Risk and Low Return?
With the market pressing forward toward record-setting gains, I continue to see clients that don’t believe that this market rally is for real. In the face of economic challenges, employment declines, widespread de-leveraging and an increasing tax load the market has continued to climb. In part the question is an attempt by some investors to pick a market top and make an investment decision based on a view of a short term market reversal.
One of the key challenges to a market rally in the face of poor economic data is that investment managers are evaluated based on relative performance rather than absolute performance. This causes a crowding effect that magnifies, in the short term, any market move of significance as investors “chase” the prevailing market direction.
While Wall Street economists and strategists continue to try to predict market tops and market bottoms, investors who follow such advice tend to suffer consequences in high risk and low real dollar performance.
Wall Street economists and TV pundits make a name for themselves by being the first to forecast unpredictable market events like tops and bottoms. In doing this they are forced to evaluate incomplete data and pick a point in time without good basis or conclusive reasoning.
The risk for them is low because when they are wrong, as anyone who has followed the advice knows, they can then identify the new data that was previously unknown and a new thesis will make sense. If they are mysteriously correct, they will broadcast their “correctness” for the duration of their career as the one professional that saw “it” before anyone else.
For investors, this type of investing game is dangerous with real dollar consequences. Investors that pick market bottoms and market tops are difficult to find because they disappear so quickly. These types of investors take the most amount of risk for the least amount of risk adjusted return—the odds are not with them.
For example, throughout 2008, month after month, economists were calling the bottom in the stock market and encouraging investors to buy more stocks. They gave several reasons that were well thought out and suggested that we had seen the worst.
By September, investors that had listened to this advice had tried and failed several times with the thought that this time they should be right. As investors added to stock positions, the losses grew and by the end of the year most bottom-picking investors decided they weren’t very good at picking market bottoms.
An investor who attempts to pick market bottoms or market tops inevitably takes more risk in a portfolio than one who follows a defined trend over time in a methodical, well-founded discipline. In other words, those who saw the market decline begin to define itself in late 2007 would have determined to reduce stock exposure until a clearly defined uptrend had established itself.
While Wall Street will always encourage an investor to trade to earn a commission, truly disciplined investors will not take the risk of picking market tops or market bottoms. After all, timing a market move is a risk that in the long run doesn’t compensate an investor very well.
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