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Should I be changing my portfolio considering the news?

March 13, 2022

After touching record highs in early January, many world markets have pulled back from their highs, and investors have been confronted with worrisome headlines in the financial press regarding record inflation and more recently the Russian invasion of the Ukraine.

Is rising inflation and Russia’s invasion a negative for equity investors? Do large losses in a handful of popular stocks signal a downturn ahead for the broad market?

Invariably, the question behind the question is, “Should I be doing something different in my portfolio?” This is just another version of the market timing question dressed in different clothes. Should I sell stocks and wait for a more favourable outlook to buy them back? More precisely, can we find clear trading rules that will tell us when to buy or hold stocks, when to sell, when to admit our mistakes, and so on?

The lure of successful trading strategies is seductive. If only we could find them, our portfolios would do so much better.

Motivated by the substantial payoff associated with successful timing, researchers over the years have examined a wide range of strategies based on analysis of earnings, dividends, interest rates, economic growth, investor sentiment, stock price patterns, and so on.

One colourful example, known as the Hindenburg Omen, had a brief moment of fame in 2010. Developed by a blind mathematician and former physics teacher, this stock market indicator took its name from the German airship disaster of 1937. The Omen signalled a decline only when multiple measures of 52-week high/low prices and moving averages all turned negative. This indicator had correctly foreshadowed major downturns in 1987 and 2008. When it flashed a “sell” signal on Thursday, August 12, 2010, internet chat rooms and Wall Street trading desks were buzzing the next day, Friday the 13th, with talk of a looming crash, according to the Wall Street Journal. But no crash occurred, and the S&P 500 had its highest September return since 1939.

The money management industry is highly competitive, with more stock mutual funds and ETFs available in the US than listed stocks. If someone could develop a profitable timing strategy, we would expect to see some funds employing it with successful results. But a recent Morningstar report suggests investors should be wary of those claiming to do so.

The report examined the results of two types of funds, each holding a mix of stocks and bonds:

As a group, funds that sought to enhance results by opportunistically shifting assets between stocks and fixed income underperformed funds that simply held a relatively static mix (see table below). Morningstar further pointed out that if the performance of non-surviving tactical funds were included, the numbers would be even worse. Its conclusion: “The failure of tactical asset allocation funds suggests investors should not only stay away from funds that follow tactical strategies, but they should also avoid making short-term shifts between asset classes in their own portfolios.”

Scare Tactics

We should not be surprised by these results. Successful timing requires two correct decisions: when to reduce the allocation to stocks and when to increase it again. Watching a portfolio shrink in value during a market downturn can be discomforting. But investors seeking to avoid the pain by temporarily shifting away from their long-term strategy may wind up trading one source of anguish for another. The initial upsurge in prices from their lows often takes many investors by surprise, and they find it extraordinarily difficult to buy stocks that were available at sharply lower prices a few weeks earlier. The opportunity cost can be substantial: Over a thirty-year period ending in 2020, the American S&P 500 index would have returned on average 10.2% pa.  But during this thirty-year period, missing the best 15 days would have shaved the return down to 6.5% an alarming 36% reduction.

Add to this the likelihood of increased transaction costs and the potential tax consequences of a short-term trading strategy, and the odds of adding value through market timing grow even slimmer.

As a thoughtful financial planner once observed, “A portfolio is like a bar of soap. The more you handle it, the less you have.”