SBJ: Stock Market Timing Doesn't Work, So What Does?

Industry Insight

 

This economy can make even the strong-hearted worry about their investments, so let’s revisit some basics.

First, academic studies of investors over many decades show they are pretty bad at predicting what stocks – or the overall markets – will do in the future. Only about 20% of mutual funds beat the stock market each year, about another 20% significantly lag the markets, and on average, they all lag the markets by about the amount of their expenses. (So incidentally, yes, lower expenses generally mean better performance.)

And no, you can’t simply switch to the 20% who beat the market last year, because it will be a different 20% this year.

The good news is that you don’t need someone to pick stocks or time the markets to grow your savings. The stock market has a proven record of growth and for good reason: it’s made of companies successful enough to get onto the major stock exchanges to begin with, so it’s already a “success club” of experienced and smart companies. They make hay during good times, and they try to minimize damage during poor economies like we’re in now. It’s those profit-making companies that grow your investments, not investment managers. Short-term, stock markets can be a roller coaster. Long-term, it’s a pretty good bet.

So, skip self-proclaimed investment gurus and pricey traditional mutual funds. Instead consider passively managed, broadly diversified, low-cost “index funds” – large baskets of stocks and bonds that simply mirror the overall markets. When markets are up, the funds are up.

When market values drop, the funds also drop – but downturns and recessions are only in play about 26% of the time, historically. The low cost of the funds means more money stays in your account, working for you instead of costlier fund managers.

But what if you need to raise cash during a market downturn, and all you have are stock holdings? In that case, regardless of how they’re held, you may have to sell some stocks for less than you paid. This potential for real loss is what scares some people away from stocks entirely.

But if you plan ahead for downturns by having an alternative source to raise needed cash, you can mitigate that risk.

During this current downturn, pull needed cash from nonstock holdings, such as bond funds, certificates of deposit and bank cash, so you’re not selling stocks at a reduced value.

Once the markets get back to normal, however long that takes, here’s how you can plan for the next recession.

First, understand that since 1929 the average recession took about 3.2 years for stock values to drop, hit bottom and finally recover; the 2008 recession took about five years. So if you protect five years’ of anticipated withdrawals, you can try to avoid selling low.

Every year, estimate how much you’ll need from your portfolio over the following five years. Move that amount of money into something other than stocks. Bond funds can be a good candidate for conservative growth potential without a lot of ups and downs, but you can use any easily accessible nonstock holding with low volatility. That’s your recession reserve.

When markets are down, even if only temporarily, raise cash from those nonstock holdings.

Once markets recover, rebalance to the correct recession reserve – and review the size of your recession reserve each year.

If you have a strong aversion to market volatility, you may want to protect more than five years of withdrawals, and that’s fine if you can still get enough overall growth to meet your long-term goals. Work with a professional financial planner to find the right balance – not to time the markets or pick stocks.

Diversified stock market participation can be a good long-term growth strategy for many households.

Keep your expenses low, keep the buying and selling to a minimum, and plan for inevitable downturns with your recession reserve.

CERTIFIED FINANCIAL PLANNERTM consultant Kenny Gott is President at Piatchek & Associates and author of the book "Bottom Line Financial Planning". He can be reached at kgott@pfinancial.com. 

Views and opinions here are general information only, not intended to provide specific advice or recommendations for any individual. Before investing, consult a financial professional to determine which investments may be appropriate for you. Past performance does not guarantee future results.