Taking action: Implementing your written investment plan. BITING THE BULLET part 5

11 Jan
2012

Dollar cost averaging versus lump sum investing: Once money managers have been selected, either in the form of mu­tual fund managers or professional managers to whom you give discretionary power to make the day to day decisions in your in­vestment accounts, the final decisions to be made are about the timing of the actual placement of cash into the fund or man­aged account.

Two options you need to choose between are ‘dollar cost- averaging’ and ‘lump sum investing’. When cost and perform­ance of these approaches are evaluated, neither has been shown to be consistently preferable over the other.

‘Dollar cost averaging’ is the process of making multiple de­posits of equal size at regular intervals over a specified period of time. This results in acquiring a particular type of asset slowly, which can decrease the risks of a sudden market downturn. Dol­lar cost averaging can be particularly useful when markets are unstable.

For the individual investor, cost averaging strategies are sometimes more feasible for purchasing mutual funds than for placement of money in separately managed accounts. As dis­cussed previously in this article, in order to access the services of separate account managers, it is not unusual to have to meet a minimum initial account size requirement of $100 thousand to $1 million per mandate or manager.

‘Lump sum investing’ is exactly what you would expect – investing all the money intended, as specified in the asset allo­cation determined in the second step of the IMC process, over days or weeks. Some believe that this approach is preferable to dollar cost averaging, which is seen by proponents of lump sum investing as attempts at market timing; they argue that short – term market fluctuations have a negligible effect on the portfo­lio’s performance over the long term. As well, advocates of lump sum investing suggest that delays in getting into the mar­ket expose the investor to the risk of lost opportunity. Market timing versus strategic asset allocation: Fiduciaries, individual investors and investment consultants usually have quite different opinions on most investment management sub­jects. However, the subject of market timing is not one those subjects.

‘Market timing decisions’ involve moving funds in or out of the stock markets in an attempt to enhance returns. The com­pelling lure of buying low and selling high is often so attractive to inexperienced investors that they often fall victim to market timing attempts, despite evidence that clearly shows this ap­proach as an ineffective way to increase returns consistently. “Though attempts at market timing exist, the overwhelming consensus is that market timing is a fool’s game since it is statis­tically improbable that some system or someone can consis­tently time when to be in or out of the market”.

To add value to a portfolio, a market timing strategist must successfully perform each of the following seven functions: identify where current economy is positioned in the context of a full market cycle; identify the factors that will affect the value of securities within each asset class – stocks, bonds and treasury bills; identify which asset classes will realize the best advantage from anticipated economic and political changes; weigh the ex­posure to each asset class; make appropriate decisions to realize capital gains by selling assets that have appreciated while fac­toring in the tax consequences; redeploy the liquidated assets to exploit upcoming economic changes; and minimize perform­ance erosion by controlling transaction costs.

It is hard to imagine a more daunting task in this world of constant change than to succeed consistently in the practice of each of the above points.

‘True market timing’ involves total or large scale shifts in the portfolio’s allocation among stocks, bonds and cash. When the market timer is bullish, 100% of the portfolio is invested in stocks. Conversely, when the timer anticipates a market correc­tion, 100% of the portfolio is invested in cash.

In a study supporting asset allocation instead of market tim­ing, Brinson et al examined the 10-year performance of 91 large American pension plans. The results show that, on aver­age, market timing actually cost the pension plans 0.66% or 66 basis points of annual average return over a decade. The most fortunate pension plan added just 25 basis points from market timing, and the most hapless plan forfeited 268 basis points an­nually over a decade. Do not forget that these costs were in­curred in nontaxable pension portfolios. If we include the impact of capital gains tax as entire portfolios are sold and then rebought, the results would be even more unappealing. Beat the drug companies and buy cialis professional

Figure 3 shows that consistent participation in the S&P 500 index over a five-year period was remarkably more rewarding than taking the risk of missing just the 30 ‘best days’ during that same time frame. Over a longer time frame of the past century, the S&P 500 has risen approximately 70% of the time. This suggests that by pulling out of the market and remaining in a cash position, aspiring market timers stand to be wrong seven times out of 10. “It doesn’t help the long-term investors to be pulled out of the market before a crash, only to miss the inevita­ble bull market that follows”.

Figure 3) The risks of market timing

Figure 3) The risks of market timing

A more favourable alternative to market timing is strategic asset allocation. In step 2 of the IMC process, a specific plan is calculated for allocating investments among stocks, bonds and cash for a particular investor and represents the optimal portfo­lio for that investor. The optimal portfolio is one that provides the highest return with the least amount of investment risk that is consistent with your risk tolerance.

Practising strategic asset allocation instead of market timing allows you to stay within your own specific risk/return parame­ters. This is done by rebalancing the portfolio as necessary when changes in market values result in as little as plus or minus 5% variation in the asset class allocations. Significant variation from the initial asset allocation plan can markedly affect the re­turns and the amount of risk contained within the portfolio.

Although there may have been a time when it was possible to have an advantage of more or faster information with which to time buying or selling, it is rare today. Technology and the speed with which information travels have been referred to as the ‘great equalizers’ of the 20th century. Effective market tim­ing will continue to become even more difficult.

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