Happy New Year.  An investment toast...May 2009 be filled with prudence, patience, and planning.  May your decisions be void of both greed and fear.  May your assets be diversified, your wealth increase, and may the riches of your life be found outside of your portfolio.

In times like these it pays to listen to

the "old hands" - successful investors who have weathered many previous downturns and who have spent their lifetimes studying the investment markets.  Their advice is pretty similar: sit tight, maintain a diversified portfolio, and, if you have cash to spare, invest more for future gains.

"The probabilities for stock market investing right now are very compelling," John Bogle, the founder of the mutual fund company Vanguard, told The New York Times recently.  Bogle, 79, helped to invent the first retail stock index mutual fund, now the Vanguard 500 Fund.  He believes that stock valuations are reasonable and that returns over the next decade may average 9 percent annually.  He cautions against trying to time the market and move in and out of stocks, calling it a fool's errand.  He counsels holding a portfolio of stocks and bonds, and keeping it to a fixed balance.  Most of all, he says investors should avoid looking at the markets and their portfolios daily.  "If you were to put your money away and not look at it for many years, until you were ready for retirement, when you finally looked at it, you'd probably faint with amazement at how much money is in there," he said.

 

Warren Buffett 

At last count investor Warren Buffett was America's richest man.  He built his fortunes by investing widely and cannily in stocks and companies for over 50 years.  Buffett wrote an editorial in the Times on Oct. 17. The headline was simple: "Buy American. I Am."  Buffett said he was moving all of his personal wealth not already invested in his flagship Berkshire Hathaway from bonds to U.S. stocks.  "Equities will almost certainly outperform cash over the next decade, probably by a substantial degree," he said.  He criticized those who have moved to cash with the idea of getting back into stocks at an appropriate time. "In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: 'I skate to where the puck is going to be, not to where it has been,'" he wrote.

 

Burton Malkiel, economics professor at Princeton whose theories led to the creation of index funds, says "a century of investment experience" shows that investors who sell stocks now "are almost always making the wrong decision."  In a recent Wall Street Journal editorial he wrote that his research shows that investors who moved money in an out of stocks from 1995-2007 sharply underperformed the market.  "No one has consistently made money by selling America short, and I am confident the same lesson is true today," he wrote.

The current bear market is making many investors question their allegiance to a buy-and-hold strategy. Why sit in a portfolio that is taking such a hit? Why not practice a market timing strategy, selling out of stocks when the market appears "high" and buying back in when it appears "low?"  After all, these investors ask, if we had sold when the market was at its recent peak in October 2007 we would have missed the current downturn. Then we can buy back in before it starts to go up again and end up with more money than if we had simply held our portfolios.  It sounds good; so good that it has always been the Holy Grail of investment management...much sought after but never found. Why? Because no one has been able to do it effectively.

 "The overwhelming evidence shows that market timing is not an effective way to increase returns for one harsh but compelling reason: on average and over time, it does not work," writes Charles Ellis, author of "Winning the Loser's Game" and former chair of the investment committee at Yale.

John Bogle, founder of the Vanguard Group, one of the largest mutual fund companies, agrees: "In 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently."
Market timing requires investors to make two difficult predictions: you must correctly identify the market's peak and its trough. As you can see from any day's financial headlines, hundreds of the investment world's leading minds argue about this point every day without reaching a correct consensus.

Burton Malkiel of Princeton University, notes in his classic book "A Random Walk Down Wall Street" how hard it is for the experts to identify these key turning points.

"[Actively managed] Mutual-fund managers have been incorrect in their allocation of assets into cash in essentially every recent market cycle," Mr. Malkiel wrote.  He notes, they seem to become cautious just about the time the market has already hit bottom. Cash holdings of mutual funds hit their peaks at the end of bear markets in 1970, 1974, 1982, and after the stock market crash in 1987, as well as just before rallies in 1991, 1994, and again in 2002. If the managers had been timing things correctly, they would have had little in cash at those points.

 

Another problem with trying to time the market is that you have to be extremely accurate. You can't wait to get back into stocks until a few months after they have gone up, because most of the stock market's gains come in very short periods of time. "Most of the 'positive action' is compressed into just a few periods, which (perversely but understandably) tend to follow particularly adverse times for stocks," found Robert H. Jeffrey in a study published in the Harvard Business Review.

And that may be the most salient point. Why would investors be thinking about selling stocks now after the market has fallen by 50 percent? We won't know until after the fact but as I mentioned above, perhaps today we are at the market bottom and should be buying. If you had been practicing a market timing strategy, would you be comfortable throwing all of your cash into the market today? That's why it is easier to stick with your well diversified portfolio through thick and thin. 

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Sincerely,

 

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