Special to the Global and Mail
Published May 13, 2013
By Tom Bradley
"Should I get out of the market?" I'm finding this question is coming up again, prompted either by the Dow hitting all-time highs or the central bankers' perilous high wire act (performed without a net). It depends on the week.
But, while we know all too well what it's like holding stocks in a declining market, we never hear what it's like on the other side of the fence. Sometimes it looks greener to be sitting in cash, but is it such a happy, relaxing place? Let's jump the fence and find out.
When you've sold the last of your stocks and equity funds, you'll likely breathe a sigh of relief. But before you get too comfortable, you need to recognize you're now fighting a long established trend (stocks beat cash), and have made your biggest bet ever. Consider the numbers. If your strategic asset mix calls for you to be fifty per cent invested in stocks, you're now fifty percentage points off a plan that's designed to generate long-term returns well in excess of inflation. Your newly-bulging cash position will generate a real return of zero at best.
The psychological challenge of being out of the market is immense, no matter how things play out. If markets go up meaningfully, it will be agonizing. In a matter of months, you could miss out on one, two or even three years of return. Indeed, of all the possible situations investors can find themselves in, I think sitting on the sidelines while the market is going up is the worst. The lost return is one thing, but more important is the fact that rising prices make it almost impossible to get re-invested.
A financial planner once told me that investors who get completely out of the market will take at least 18 months to get back in. They get entrenched in a doomsday scenario such that the only way out is for the bet to work out - i.e. a meltdown eventually occurs.
What if you're on the right side of the bet? If the stock market drops, it will feel good to be in cash and you'll have preserved capital. But the dreaded second decision will be ever present - when do you get back in? Your initial success makes the decision easier, but by no means easy. You'll still want more certainty than is possible.
If you're seriously thinking about getting out of the market, consider the following.
1. Understand what risk is for you. For investors with a time frame of ten years or more, sitting in cash is much riskier than holding a diversified portfolio of high-potential assets.
2. Seek out other views. I guarantee Mr. Market knows both sides of the argument, you should too.
3. Don't base your decision on an expert's short-term view. No matter how impressive the reasons are, there's no possible way she/he knows where the market is going in the next three, six or twelve months.
4. Go beyond the economic fundamentals. The linkage between the stock market and GDP growth, government debt levels and employment numbers is sloppy at best. If you're going to make a big asset mix shift, you need to know how much of your view is already priced into the market. In other words, pay attention to valuation.
5. Consider the implications of being wrong. You know the impact of holding stocks in a down market, but how damaging will it be if your move to cash is wrong? And what will your re-entry strategy be?
6. Limit yourself. If you're going to make a big shift, establish ranges around your long-term asset mix and stay within them. Don't let yourself cripple your long-term return with one mistake.
7. Don't do it. And definitely don't do it if you're at an extreme time in the market. That's when you're almost assured of doing the wrong thing.
Generating attractive long-term returns requires that you go through periods of negative short-term returns. Knowing that, I prefer to take my lumps on the side of the fence where the long-term trend is greener.