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PATH FINANCIAL LLC
Registered Investment Advisor
1990 Main Street #750
Sarasota, FL 34236
941-350-7904
Raul Elizalde - Friday, August 19 2011
We hear often that when markets go into a panic, opportunities arise for the cool-headed investor. Warren Buffett, no less, proclaims that he wants to be brave when others are fearful and fearful when others are brave. Is he right?
It would seem obvious that the best way to make money is to buy low and sell high. The problem is that “low” is only revealed after the fact. Knowing whether the market is close to bottoming out is a problem that has never been resolved.
On the back of a sharp deceleration of the US economy and ongoing problems in Europe that we reported frequently in the past, the S&P 500 fell more than 13% this August. Market commentators are telling hapless investors to “stay calm” and to throw some more money into the mayhem. The advice usually adds that companies with a history of dividend payments and lots of cash are a good buy when the market tanks.
But a look at similar dips in the past does not offer great comfort to the regular individual investor.
We ran the numbers on the S&P500 since the 1970s on a hypothetical investor who buys the S&P 500 when it falls 13% during a month. This is what we found out:
Average Result |
Probability of Gaining |
|
| End of Month | 1.5% |
67% |
| End of Three Months | -1.2% |
33% |
| End of Twelve Months | 12.9% |
67% |
At first glance, it seems that only quick traders and long-term investors would fare well by buying against the sentiment. Medium-term market participants – the most common type – may well end up losing heart at the end of three months, throw in the towel, and book a loss.
A closer examination shows that much of the long-term gain is skewed by the 2008 market. The S&P 500 fell more than 13% three months in a row, so an investor would have had to buy consecutively for three months and book three quarterly losses before having an average 6% gain a year later. Whether an investor can really be so cool-headed for such a modest profit is anybody’s guess.
It all boils down to each investor’s style. Without a strong plan, extreme market events may seem to offer opportunities. Under that light, the current market rout would appear to be a good time to buy. Yet, the current upheaval is too uncommon and its outcome too uncertain to be part of a successful market strategy.
Instead, we have long advocated a systematic approach to identify steady trends when investing does not depend on things turning around. That means buying into markets that have enduring strength while exiting markets that are mired in self-feeding weakness. In our view, it is better to go with the market flow than to struggle against it.
See what would have happened to an investor who bought the S&P 500 after it gained 11.4% during a given month (we chose this number to have the same number of observations as for the previous graph).
Average Result |
Probability of Gaining |
|
| End of Month | 0.3% |
56% |
| End of Three Months | 4.2% |
67% |
| End of Twelve Months | 13.9% |
78% |
In the earlier example the quick trader that bought into weakness would be slightly better off than a quick trader that buys into strength. But for the vast majority of investors who have a horizon longer than a few weeks, it would be far better to buy into up markets. Buy high, sell higher beats buy low, sell high.
Sophisticated statistical analysis can show that markets tend to trend more than if they were strictly random. This leads to our conclusion: momentum investing is more successful than a contrarian approach. But nobody needs an advanced degree in statistics to appreciate the dangers of trying to catch a falling knife. It would certainly be impressive if you pull it off, but chances are you will get hurt.
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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.
Raul Elizalde | raul@pathfinancial.net | 941-350-7904
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