In the market, you get what you pay for

There has long been a basic principle regarding market investing that has become almost ecclesiastical canon: You can’t time the market.

Like many basic truths, it has led to many other religious doctrines, some of which are either patently false or ridiculous on their face. And yet we accept them as undisputable truth. Like so many basic tenets of popular belief, many of these doctrines are put into place to support the current power structure.

One of the main derivatives of this basic principle of not being able to time the market has been that passive investing, i.e., “buy and hold,” is the only acceptable way to manage one’s investments. Certainly, this is supported by the entire retirement industry, currently valued at more than $20 trillion.

Witness the holy grail of retirement plans, the

401(k). The whole premise of these defined contribution plans is that you put your money in, and then never take it out. For example, in most plans you cannot get access to any of your money except for specific things, and even those generally carry the 10% early (before age 59½) withdrawal penalty. Further, employers are not required to offer even those early withdrawals, so many plans offer no ability to access your money even in very dire circumstances. That’s “buy and hold” on steroids.

And it doesn’t even end there. I can’t tell you how many times people have said to me, “My accountant tells me I shouldn’t touch my qualified (tax-deferred) funds before I have to, because it will be taxed,” which seems to support the notion that these accounts are toxic in the first place because of the tax consequences of owning them. But that’s a topic for another day.

Today, I want to focus on the notion that you are way better off just to purchase an index fund — most often the S&P 500 — and then just ride it out. The notion seems to be, “What goes down must go back up,” and so you really take no risk by just buying and holding.

I have even heard it said that if you miss the top some number of days of market gains over some hypothetical period, the damage to your portfolio will be crippling, never to recover. The truth is, that isn’t true.

Here’s an example: I was recently at a workshop where the speaker pointed to the S&P 500 from 1980 to 2015. During that period, it enjoyed gains of 8.51%. However, she was quick to point out that missing just the best 30 days of gains during that time reduced overall returns to 3.64%, thus “proving” the best approach is to buy and hold. What she failed to mention, however, was that eliminating the worst 30 days raised the average return to 14.82%, and missing both the best and worst 30 days produced a return of 9.66%.

But we are still stuck with the true principle that you can’t time the market. So, what’s the alternative?

While it may be impossible to time the market, you can, in fact, “trend” it. In other words, you can determine if it’s on an up or down trajectory and respond appropriately. We call these trajectories momentum, and like momentum in the physical world, momentum in the investing world tends to maintain itself and build on itself until ... it doesn’t. What that means is if you can determine the momentum of the market as a whole, or various asset classes and market sectors, you can often bank on them until you can’t. So, identifying the momentum shifts becomes that challenge — and the payoff — for this strategy.

Luckily, there are signals that can be monitored that will indicate possible momentum shifts in the market. Some, like the Relative Strength Index, will serve as a predictor of what’s likely to happen. Others, like the Simple Moving Averages, and the Moving Average Convergence Divergence (Mac-d) indicate shifts already under way. Once we have established the prevailing direction the market is in, we have the ability to adjust our positions accordingly.

The ultimate goal of these signals is to capture about 70% of the upside while avoiding 70% of the downside. Imagine how that could help your portfolio. Another element of tactical planning is risk management. Again, we don’t know when or what the next Black Swan will be; we simply know it will be at some point in time.

One of the deadliest forces in market investing is sequence of returns, as opposed to rates of returns. In the last column, I discussed how sequence of returns can damage an income plan. I don’t plan to go into that in detail today; suffice it to say that big drawdowns at the beginning of a retirement can be much more devastating than at the end of the same retirement, even though it makes no difference to the rate of return. In other words, rates of return are relatively meaningless in a retirement strategy, while the sequence is very important.

Another indicator of the lack of importance of rates of return is illustrated by the 4% Rule, which, over the past several years, has been downgraded to the 2.8% Rule. The thing is, if the market consistently provides 8% to 9% returns, why can we only disburse 2.8% to 4% per year? Again, it’s because of the dreaded sequence. If you have a really big drawdown at the beginning, you will never be able to recover enough to finish out your withdrawals without draining the account entirely.

A managed account, however, can really improve the rate of return and restore its importance.

For example, the S&P 500 averaged 6.58% and had a total growth of 237.49% from 2006 to now. One of our moderate tactical portfolios averaged 11.56% and had 706.55% over the same period, nearly three times more. The main reason? Amounts lost during the downturns. The maximum drawdown for the S&P during that time was -52.56%. Our moderate portfolio, which emphasizes safety over returns, had a maximum drawdown of just 12.58%. That low-cost index fund isn’t feeling like such a bargain, anymore, is it?

Put another way, you get what you pay for.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, N.H., he services Greater Boston and the New England areas. You can reach Steve at 603-881-8811 or at www.freetoretireradio.co m.