How to minimise market timing risk for your investment strategy.

Welcome to Finance and Fury.

1. There are concerns at the moment when it comes to investing – and that is that markets are at their all-time highs – concerns aren’t that markets continue to go to new all-time highs, but that the market falls through in the short term – what goes up must come down – the major concerns are around how far this may go down
2. This episode – want to go through how to minimise timing risks – in other words, how to still invest now and if you see the market go down, minimise any loss but also take the opportunity to profit out of this situation
3. To understand this concept and market timing risks – need to understand the concept of probability – which comes back to market timing risks –
   1. I get the question a lot – Is it a good time to invest at the moment?
   2. This is at the core of timing risks – the speculation that an investor enters into when trying to buy or sell an investment based on future price predictions – fer examples – I think the market is going to go up so I go all in, but then it doesn’t – or I think the market will go down so I hold off, but then it goes up and I miss out –
   3. is now a good time to invest an important question – depends on what type of assets you are talking about and how you are going about investing – I always think that it is a great time to invest now – if you are talking about your expected position in 10 years time – it is about the time you spend in the market, not trying to time the market
      1. If you invest $100k today in an index fund, the probability that you would be in a positive position in 10 years’ time should be a sure thing, based on past performance – future performance shouldn’t be determined by past performance – but lets think about the market make up for a minute
      2. What is an index – a basket of shares – ASX300 is the top 300 companies listed on the ASX by market cap – you are buying a large chunk of companies in the large cap – but also 250 companies that may rise to be the top performers – overall, these companies should perform positively over the long term – there will be companies that do not, but the majority of the index should rise, and your position in underperforming companies should reduce as the winners take their place – it is all about probability – spreading your risk out amongst many companies to minimise the probability of loss
   4. Probability – the branch of mathematics concerning numerical descriptions – i.e. how likely an event is to occur – The probability of an event is a number between 0 and 1 – roughly speaking, 0 indicates an event that is impossible to occur, whilst 1 indicates certainty
      1. Flip a coin – you have a probability of getting heads or tails – 50/50 –
      2. Flip a coin twice – you have a 25% change of getting 2 head in a row – flip it 10 times, have a 0.1% change of getting all heads – so flip a coin 1,000 times you may see this occur
   5. Experience in the market – shows that there is always a probability of losses – but this can be minimised when investing well and implementing strategies if you are concerned about losses in the short term
4. But – it brings up an important point of probability in markets –
   1. What is the probability that you invest now and are in a positive position tomorrow, or the next month, or the following?
   2. It all depends on timing – which can really be best boiled down in probability to luck in the short term – do you finally pull the trigger today, tomorrow, or next month?
   3. A lot of people talk about luck when it comes to investments – wrong way to think about it –
      1. Luck – when investing you make your own luck – if you haven’t invested in the first place then you see the market go up – this isn’t lucky – but if you hold off investing and see the market crash – is this a turn for the better? Or a lucky situation? Technically it is – but all of these situations are viewed on a short-term time horizon –
   4. Long term – You make your own luck – you either invest for your future or you don’t – those who say that others are lucky because their made money investing are often those who have never invested
   5. In the short term – it is anyone’s guess what markets will really do – In the short term, I am talking about day to day – month to month, or even sometimes, year to year – but what about decade to decade? It becomes very hard to be unlucky with investing when your time horizon extends out to 10 years
      1. markets have a tendency to increase in value over time – the increase in value through a long term time horizon decreases the risks for short term investing
   6. But what about the short term? Here is where things get more interesting –

Lets have a look at the numbers and probability – in particular, lets look at the ASX index for investing –

1. One good illustration of this point is the holding periods that were positive – from investing from day one and waiting – for these figures we are looking at the ASX index, probabilities differ if you select one individual share, or even 5 individual shares – but for the index
   1. 1 day (the next day) – 54% that you were positive or 46% that you were negative – very close to flipping a coin
   2. 1 month – 62% chance that you were positive – so there is a higher probability that after a months’ time, you will have a positive return
      1. There is a higher probability that you are still in a positive position – but there is a 38% chance that the investment would be at a lower value
   3. 1 year – 78% – now we are getting into the positive territory that if you invested 12 months ago, you have a 22% chance of having a negative return – about 1 in 5 – so every 5 years on average you may invest and see a negative return – but looking at the longer term
   4. 3 years – 91% that you are positive – so if you invest and see the market drop day 1 after you invest, and this continues to be a market crash, you have a 9% chance that you are still at a loss – this assumes that you didn’t invest anything further at the lower points of the market to recoup your losses
   5. 5 years, 10 years – 100% – beyond 10 years – 100% – for 15, 20, 30 years
2. Out of all of these, that these probabilities don’t mention is the level of positive returns – Going long term – looking at the past 120 years – or since 1900 from the federation of Australia
   13. History of the markets – ASX in particular – average returns of around 13.2% p.a. – so if you have held investments in the index for 120 years – which in reality no individual could manage – you have 0% chance of loss – and a better compounding return rate that warren buffet
3. There have historically been periods where the market has been flat for a number of years – especially in real terms – i.e. after inflation
   1. 1914-1921 – market had a flat real return – period of 7 years
   2. 1929-1932 – flat real return of 3 years
   3. 1937-1944 and 1951-1958 both saw periods where the real returns were flat for 7 tears
   4. Largest stretch was 1970 to 1985 – 15 years without a real return – but inflation was in double digits
   5. More recently – the market was flat in real term for about 8 years, from 2009 to 2017

But markets have changed over time – what drives markets is different –

1. Looking back – the periods of time that markets have underperformed, or been flat long term follow economic recessions/depressions – why? Markets were behaving rationally for their time – differences to today
   1. no endless liquidity injections – money was relatively finite before endless liquidity from CBs –
2. Looking at the market since 1970s- when fiat came into existence
   1. bull markets and bear markets –
      130. Average bull market – 46 months – return of 130.1%
      131. Average bear market – 13 months – return of -35.8%
   2. So your probability of losses are still smaller than the gains from investing when viewed in the long term
      1. But capital preservation is important – lose 50% of your investment, have to make 100% on the positive to get back to your original position

There is no way to completely remove risk from investing – even cash technically has a risk to it – counter party risks of the banks – But there are Strategies to reducing timing risks – volatility –

1. The first and easiest is behavioural – if you own investments – and the market go down – don’t sell
   1. This one is very simple – but effective – if you buy investments and the market declines – don’t sell
      1. This can be very hard – humans are risk adverse by nature – we have myopic risk aversion
      2. But if you remember that if you hold long term, you should be at least back to your original position in 5 years at the very worst case

• Often the feelings of wanting to sell occur right around the bottom of the market – you see a major loss and worry about markets going down further? Guess what? Most people who have funds invested feel this same way – some feel it at 10% loss, some at 20%, some at 50% – but at some point those who feel the fear start to be outweighed by those who get greedy and the markets recover
  1. Timing risk comes from trying to guess what the market will do in the short term

1. The worst thing to do is sell – because how do you know when to get back in? The hardest part of selling is then getting the guts to then put your own money back into an investment that has caused you loss – which financially has hurt you – this financial hurt can linger worse than a physical pain – cut yourself, it will heal in a week or so, but the painful feelings of financial loss can linger far beyond this point – this affects your future behaviours – you would be less likely to invest again – past experiences affect future decisions – heuristics of human beings – one bad experience can ingrain a bias to avoid repeating this – hence you don’t ever actually want to invest again – so you never do and you miss the rebounds in the market and the long term performance this can provide

1. Remedy to this is to Buy more – when markets go down, buying more can help avoid long term losses – but it takes some guts to put money into investments that appear to be declining in value – but if the only reason that they are going down is that everyone is selling, which has nothing to do with the underlying performance of the investments – then investing is basically picking up a bargain
   1. but sometimes you don’t have any capital left, to avoid this, another strategy can work
2. DCA – dollar cost averaging is about breaking up timing risks – done full episodes on this strategy – last one was about 5 months ago
   1. Check out the episode “Dollar cost averaging – how and when can this best be used for investment purposes”
   2. But in summary – if you have $100k to invest now, and are worried about short term capital losses, then you can invest $40k now and the remainder over a number of months – $20k over 3 months, $15k over 4 months, or $12k over 5 months, or even invest $20k over 5 months – no one right way about it, depends on individual preference and investments being selected
   3. What is important is that the probabilities are being averaged – DCA – stands for cost averaging, costs are the prices of the market – buying the average price of the market over the time period you are investing – which comes back to probability
3. ABI – Always be investing – done through Monthly investments
   1. If you don’t need the funds for years then market declines can provide an opportunity – shouldn’t be viewed as a painful experience, if you know markets will recover at some point – instead view it as an opportunity
   2. Deploying spare cashflow – keep investing in down markets, if you can afford to invest more, then do it
4. Diversification – process of spreading your risk out – many people think this refers to buying say an index – of having 300 shares on the ASX – or a few thousand international shares – this is a method of diversification, but it doesn’t save you from a systemic market collapse – where all markets are crashing – real diversification comes through investing in asset classes which can preserve capital, or even gain in value when another is declining
   1. Strategy: Initially – invest in other asset classes – and rebalance over time –
      1. Diversification helps to minimise downturns in the short term through being in uncorrelated assets, or assets that have low levels of correlations
   2. Investing between asset classes – bonds, credit, alternatives, gold, etc. – but many people don’t want to own these investments long term
      1. Bonds – a lot of people I speak to don’t want to be in bonds if they have a 30+ investment time horizon, and I completely understand this – personally I don’t hold defensive investments like bonds –
      2. But they can provide a capital hedge against going fully into the share market – and aim is to get a better return than cash
   3. What you can do, is if markets decline then use your defensive funds to rebalance into the undervalued assets
   4. If shares go down, and bonds and gold go up, use those assets to buy back into shares – buying more of the assets

Summary –

1. Markets rise and fall – long term – you aim to get positive returns
2. Short term – i.e. 1 year, it is anyone’s guess

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