Should I Use a Wide Range for Stocks?
My Investment Policy Allows for a Wide Range for Stocks – Should I use it?
Quick Take
An investment policy statement (IPS) can allow asset classes to fluctuate within an acceptable range; however, keeping portfolios close to asset class targets imposes investment discipline and can prevent behavioral mistakes.
Overweighting and/or underweighting stocks is ultimately a market timing decision that we believe is more likely to detract from performance than significantly add value.
Maintaining a consistent mix can improve performance and provide a more reliable risk profile for the portfolio that is consistent with your investment objectives.
A well-crafted investment policy statement (IPS) provides an acceptable range for asset classes to fluctuate within. So, should investors utilize the full range? We think you should stick close to your long-term asset class targets.
Well-known investor Peter Lynch managed the successful Magellan Fund from 1977 to 1990. During his tenure, the fund returned an annual average of 29% per year, exceeding most relevant indices. However, the average investor lost money in the fund. According to a subsequent study by Fidelity Investments, the investor’s poor timing of inflows and outflows from the fund eroded the performance.
The case of the investor’s experience in the Magellan Fund highlights how difficult it is to correctly time buys and sells. Deciding when to overweight or underweight stocks is ultimately a market timing decision that we believe is more likely to detract from performance than significantly add value. Instead, maintaining a consistent asset class exposure imposes discipline and prevents behavioral mistakes.
The Perils of Market Timing
In theory, we as investors want to participate in the good and avoid the bad. It’s just difficult to find reliable predictor of short-term market moves. What may be reliable is likely only known in hindsight, or even just a spurious correlation. Butter production in Bangladesh was shown to be the best predictor of S&P 500 performance for a time. Obviously, correlation doesn’t necessarily provide predictive value.
It might seem intuitive to increase ownership of stocks when they are priced at attractive valuations. But research shows that valuation metrics are poor timing signals that often result in worse performance.
Amidst the COVID-19 pandemic in 2020, investors in the S&P 500 had to endure a stomach churning -31% drawdown in a month. Then subsequently watch the same index skyrocket 71% through December. Keep in mind, COVID cases were hitting new highs, and there was economic carnage as stocks recovered. A successful timing strategy would have had to navigate the unsettling situation quickly and be correct twice – selling at the peak and repurchasing a month later while everything flashed red.
What’s challenging about market timing is that just a few small mistakes can significantly impact long-term returns. Missing the 10 best days in the S&P 500 last year would have yielded a measly 5% return, far short of the index’s actual 26% return. In other words, 4% of trading days accounted for 80% of the indices’ return.
Looking back over a longer time period, a similar story develops. For example, a hypothetical $10,000 invested in the S&P 500 index since 1988 would have turned into $403,407 by 2023. However, missing the ten best days in the index would result in the $10,000 growing to only $184,815. In other words, an investor would have 54% less if they missed out on just 0.1% of the days. If an investor had missed the 50 best days, or 0.6% of the time, the account value would be an astonishing 92% lower.
What’s not obvious is that the best days usually occur in the midst of market turmoil. The worst days are often followed closely the best days. The S&P 500 dropped -9.5% on March 12th, 2020, making it the second worst daily return over the 36-year period. It was followed by a 9.3% gain on March 13th, 2020 - the fourth best daily gain over that same period.
What It All Means
Although an IPS allows for asset classes to fluctuate within an acceptable range, we believe it is in the best interest of investors to stick with a consistent allocation aligned with one’s desired risk and objectives. Typically, we prefer to keep asset classes within 2-3% of the long-term target.
The empirical evidence suggests attempting to be in and out at the correct times often creates more harm than good and can result in considerable drag on performance. Maintaining a consistent asset mix imposes more discipline to sell appreciated assets and buy others that are out of favor and reduces emotional and cognitive biases.
Contact us at 865-584-1850 or info@proffittgoodson.com
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy, or investment product, and should not be construed as investment, legal, or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaims any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income, or other categories. An index reflects the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.
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