Peter Mladina, Charley Grant, Abdur Nimeri | October 1, 2014
Many investors exited equities in 2008, realized their losses and have yet to return. Others since have had liquidity events – business sales, inheritances, etc., – and remain flush with cash. Yet both groups may regret missing significant run-ups that saw global equities return 23% in 2013. At the same time, bond yields remain low by historical standards, deterring investors who fear that rising yields may translate into negative bond returns. By contrast, investors who stayed the course with their diversified, long-term portfolios continued earning meaningful returns over time.
For investors on the sidelines, the fear of market entry is pervasive. In bull markets, they fear an imminent correction. In bear markets, they fear the correction will worsen. But market entry must be considered in the context of the investor’s financial goals and the opportunity cost of remaining uninvested. Those who hold excess cash can lose purchasing power over time because cash continues offering negative inflation-adjusted (real) returns. When investors consider their financial goals and the real returns required to fund them, the optimal place to be is invested in their long-term strategy.
Capital markets are not omniscient, but they are highly competitive pricing engines. We can conclude this because the evidence suggests that alpha – the additional return from manager skill – is rare.1 Capital markets always attempt to price a positive forward-looking relationship between risk and return such that stocks have a higher expected return than bonds, and bonds have a higher expected return than cash.
Investors should focus on things they can control and finding the opportune time to enter the market is not likely one of them. Equity returns are unpredictable in the short-term. When testing equity returns since 1926, we find no relationship between the previous and subsequent quarter’s returns or between the previous and subsequent year’s returns.2 The R-squared (explained relationship) between the sequential returns is 0%. By extension, the returns in 2014 have no relationship to the strong equity returns in 2013, and therefore last year’s equity market run-up is not a sound justification for holding excess cash in 2014.
Similarly, valuations have no meaningful predictive power at the one-year investment horizon. When testing Shiller’s cyclically adjusted price-to- earnings ratio – a popular valuation metric for the stock market – the R-squared between valuation and the subsequent one-year return is a meager 8%. Market entry fears ease when investors accept that short-term returns are largely unpredictable and that expected risk and return are related.
Dollar-cost-averaging (DCA) is one common approach to mitigate the risk of market entry. But even DCA can be boiled down to a risk/return trade-off. Exhibit 1 compares the risk and return of four market entry scenarios over one-year investment horizons formed from rolling quarterly returns since 1926. The All-In Equity scenario represents an immediate investment in the S&P 500 that is held for one year. The DCA Equity scenario represents an initial cash position that is incrementally invested 25% each quarter in equities over one year. The All-In 60/40 scenario assumes an immediate investment in a balanced portfolio of 60% equities and 40% intermediate-term government bonds, a position held for one year.3 The DCA 60/40 scenario assumes an initial cash position that is incrementally invested 25% each quarter into the 60/40 portfolio over one year.
Exhibit 1 shows that over a one-year period – a realistic DCA timeframe in practice – DCA does, indeed, reduce risk. Both the standard deviation (the uncertainty around future one-year return outcomes) and the conditional value at risk (CVaR, or the weighted average of the worst 5% of one-year return outcomes) show reduced risk when employing DCA to enter either an equity or a balanced 60/40 portfolio. However, this reduced risk comes at the cost of a reduced average one-year return. All-In Equity produces 3.5% more return on average over the one-year periods than DCA Equity. All-In 60/40 generates 2.3% more return than DCA 60/40. The results are directionally the same when we limit the analysis to a more contemporary timeframe (e.g., since 1990). The decision to invest all-in or to dollar-cost-average over a one-year investment horizon depends very much on the investor making a risk/return trade-off.
Over longer time horizons, returns are more predictable. Cash flow yields have been shown to predict nearly 50% of the variation of five-year equity returns.4 Although global cash flow yields are currently below average, they suggest five-year global equity returns that are materially higher than current bond yields, which in turn are materially higher than cash yields. Northern Trust’s five- year capital market assumptions maintain this general risk/return relationship between cash, bonds and stocks. Although expected five-year capital market returns appear to be lower than historical averages, investors should be careful not to confuse below-average but positive expected returns with negative expected returns when they consider market entry.
Exhibit 2 reproduces the same market entry scenarios as Exhibit 1 but compares annualized risk and return outcomes after five years. Over the longer holding period, the risk of the All-In scenarios more closely resembles the risk of the DCA scenarios, while All-In still maintains a higher average annualized return outcome. Investors fearing market entry today should consider this longer-term view, which is likely to be more aligned with their financial goals.
The risks to market entry are closely related to the same risk/return trade-off that dominates the investment landscape. Returns are largely unpredictable in the short run, so the decision to deploy excess cash into a long-term investment portfolio should not heavily weigh recent returns. DCA can help mitigate the risks of market entry but at the expense of giving up a higher average expected return. And the risk-reducing benefit of DCA diminishes with longer investment horizons.
The future will always be uncertain, but accepting that short-term returns are largely unpredictable and that expected risk and return are better related over the longer run can ease fears about market entry. When investors consider their financial goals and the real returns required to fund them, the optimal place to be right now – and always – is in a diversified, long-term strategy aligned with those goals.
1See for example Fama and French, “Luck vs. Skill in the Cross Section of Mutual Fund Returns,” The Journal of Finance (2010).
2We tested serial correlation of Ibbotson S&P 500 returns from 1926 to 6/2014. Source: Morningstar.
3Bonds are represented by Ibbotson Intermediate-Term Government Bond index.
4See our May 2013 research article, “Are Equity Returns Predictable?”