Why investors have time on their side

Managing risk is all about faith in the market and hanging in for the long term, writes Dale Gillham.

I have read with interest the articles and comments over the past two years of those who espouse ‘time in the market’, encouraging investors not to panic, to leave their money with the professionals and to accept the inevitable negative returns until the market recovers.

Every time the debate about ‘time in the market’ versus ‘timing the market’ arises, those who advocate the former attempt to discredit supporters of the latter by pointing to the small number of times the forecaster was inaccurate.

Each week I predict where the Australian market will be in the short, medium and long term, which is covered in local and national publications and on radio around Australia.

Just because a prediction does not unfold once or twice does not mean that market timing is not an effective strategy.

I will be the first to acknowledge that although market timing forecasts have an incredibly high reliability, they don’t work 100 per cent of the time. That said, having the knowledge will allow decisions to be made in preparation for the market’s next move.

So what is market timing? Managing risk; no more, no less. If the risk of holding an asset becomes too high, it should be liquidated.

Just as importantly, if the risk of holding an asset decreases, it should be held, provided it supports the investor’s objectives.

I could quote past articles of those who push the time in the market theory to argue my point, but it would be fruitless.

Many in the financial industry are used to receiving commissions from product providers rather than focusing on the best outcomes for the investor.

In the past nine months, we have received numerous emails from clients praising our efforts in managing the risk on their portfolio during 2008 and early 2009.

One client summed it up very nicely when he stated: “It’s not the 15 per cent stop loss that we should worry about, but the protection of the other 85 per cent of capital.” This shows that investors understand the importance of risk management.

The industry promotes the idea that individuals should leave their funds fully invested for at least five years. But without knowledge of market timing, the end of this period could coincide with the bottom of the market, which was the case in recent times.

Many hardworking Australians, who intended to retire between 2008 and 2010, are faced with putting off retirement until the market recovers. If market timing was used to protect the clients’ investments, they would have achieved their goal.

It will be up to the investor to vote on what is best for them, which they are doing in droves. As an industry, we need to look at why there is a continued increase in the number of people setting up self-managed superannuation funds and why a significant proportion of Australians choose not to use financial planners.

The answer is quite simple: they do not believe the industry adds value to what they could do themselves.

Studies show over a 10-year period, managed funds average around 7.5 per cent per annum, while the All Ordinaries Index averages much higher returns.

The ASX 2008 share ownership study shows in the last 10 years, the total share ownership for Australians has decreased, but direct share ownership has increased as investors prefer to do it themselves.

I believe financial planners need to be more proactive in managing portfolios and, if necessary, move clients’ funds to safer or more appropriate asset classes when the risk becomes too great.

Some members of the financial industry believe timing the market provides investors with a false sense of security.

I am sure my clients, who were out of the market when it fell significantly, would argue otherwise. They did not suffer losses of between 20 to 70 per cent like most investors subjected to the buy-and-hold strategy. If an investment falls by 50 per cent, it needs to recover 100 per cent just to break even.

How many financial planners are aware that the average market recovery is around 30 per cent in the first year following a bear market, which means it will take over three years for investors to get back to square one?

I believe many investors would much rather recover 15 per cent using a stop loss than be faced with the significant losses experienced during 2008 and early 2009.

Investors who were told to buy and hold both the Telstra 1 and 2 floats, only to watch the stock fall 60 per cent over the last 10 years, would certainly be questioning being told not to worry. But it is a good share and will come back.

A similar fate hit AMP, which has fallen 61.66 per cent over 10 years, or NAB, which fell 25.33 per cent from 1999 to March 2009.

While this is true, the question that many investors have been asking is, when? All of these shares rose between 40 and 280 per cent at least once during the last 10 years to March 30, 2009.

But in the majority of cases, investors who were told to buy and hold would have ridden the waves as the stock unfolded without the opportunity to lock in profit as the stock fell away.

To assume that time in the market is the only way to invest means investors will need to accept below-average returns despite paying management fees to achieve otherwise.

Clients are demanding more, and rightly so, by attempting to manage their own direct investments.

The downside is that many are doing this with little or no knowledge. This is why there is a huge opportunity for financial planners to learn how to better manage client portfolios by understanding the benefits of timing the market.

While no one can accurately predict the share market 100 per cent of the time, to ignore the fact that all share markets suffer falls of 20 per cent or more every four to five years is like sticking your head in the sand when a tsunami is coming.

Every fourth or fifth financial downturn historically results in a fall of about 50 per cent or more.

The global financial crisis has been a financial tsunami that many failed to see or admit was coming, even though the warning signs were there. The unfortunate outcome of this downturn is that any investor subjected to the buy-and-hold mentality has suffered the most.

Dale Gillham is chief analyst at Wealth Within.