Financially Speaking

Does anyone really know for sure when to hold and when to fold an investment portfolio?

When stock market returns accelerate, it is only normal that most investors want to be involved in what could be the next big bull market that will quickly put them on the road to riches. During these periods, logic does not always prevail and even the most astute investor has been known to abandon their investment objectives in favor of what they perceive to be the latest “hot tip”.

Chasing performance can involve switching between mutual funds for the sole purpose of rapidly increasing the value of your investment. It typically involves an intensive focus on a particular sector trend or investment style. It may also involve moving out of equity funds altogether and into generally less risky assets such as bond funds or real estate, or even funds that invest in short-term securities lite T-Bills. Movement typically occurs when a certain market has already begun to rise. For the average investor, these assets movements are generally based on emotion and may even contradict their actual comfort level for investment risk.

The concept of “buy low and sell high” actually makes a lot of sense. The problem however is the uncertainty of where the market low and market high are. This results in a tendency to jump on the bandwagon too late. At the other end of the spectrum, you never know when the market is high until well after it has occurred. The direction of the market has been known to change very quickly and quite dramatically. As a result, irrational decisions can mean a considerable sacrifice of overall return.

Figure 1 illustrates how difficult it is to predict which market will do best year after year as the leadership of various domestic and global markets continuously changes. As you can see, the Canadian large cap market is highlighted as an example of just how quickly an investment market can move from a leader to a straggler. The story is the same, regardless of which asset class you choose to focus on.

Why worry about which market will prevail when it is so much easier to diversify within a number on markets so that you are always exposed to one of the top performers. It may not be as lucrative as picking the top performer each year, but a properly constructed portfolio will reduce your exposure to investment risk, will offer a far more reliable rate of return, and above all, is a reasonable investment solution.

The pricing of financial assets such as stocks or bonds involves so many different fundamental variables. Identifying high or “overvalued” assets versus low or “undervalued” assets is a complicated subject. It becomes even more complicated when the direction of the market is fueled by human emotions; fear, greed, optimism, pessimism, and crown psychology. Throw in the political climate, economics, revolution, natural disaster and technology change and you begin to see why diversification is such an important factor in investment success over the long term.

Still, for most investors, trying to guess the market winners is too attractive to resist.

Newspaper headlines often entice investors to turn their attention to a hot industry sector. In support of the headlines, the accompanying articles contain data that was produced by so-called experts whose ongoing task is to develop signals that identify what condition a market is in. In doing so they will use a variety of techniques that include technical, fundamental and quantitative indicators and measures.

Can market action be predicted?

It has become accepted wisdom in financial circles that it is impossible to predict the vast number of variables that can affect the markets. That is why many who claim they can beat the markets usually make one or two great predictions before they are hopelessly out-matched.

Can you time entry and exit points?

Only if you have the necessary “insight and discipline to know when to “hold” and when to “fold”. Both of these are very hard to come by.

Over the years, the market has changed quite dramatically. One thing that remains constant however is the unpredictable nature of the stock market. The best advice is to construct a portfolio you are comfortable with and stick with it unless your investment objectives change.