The risk of being wrong is worse than the downside risk of being on the sidelines.
Too often, investors put off portfolio decisions during bear markets or recessions, hoping that they will be able to buy at exactly the right moment when the market or economy shows signs of an upwards turn.
Many investors often make the worse mistake of sitting on the sidelines during uncertain times, again with the intent of re-engaging with the market once the picture is “clearer.”
The risks of these misguided strategies hinge on the fact that without a crystal ball it is impossible to know exactly when a bear market or recession will end. And missing the bottom, even by a relatively few number of days or weeks, can cause an investor to miss out on much of the gains that they could have earned otherwise.
Long-term-focused advisors and analysts often counsel against attempting to “time the market,” rightly pointing out that no one has ever successfully been able to correctly call the market’s short-term directional changes with any accuracy.
What’s worse, if a guess is wrong about the market’s moves, then whole new risks emerge for a portfolio. Not only are gains missed, but losses are being generated.
For me, this is the biggest risk of market timing. If the only risk in making a wrong call about the market’s direction is that an investor simply misses out on a bit of return, that might be manageable. But losing money and putting a portfolio into the red because the re-entry into the market was too early or too late is a whole other matter.
This is why I believe in bottom-up, long-term, buy-and-hold stock investing supported by sound portfolio diversification and management principles.
Once a portfolio’s foundation has been constructed with an understanding of expected and unavoidable economic slowdowns and market corrections, then the risks of those macro events can be mitigated to a reasonable degree.
Focus on buying well-run companies and let their management teams cope with the problems that a recession brings. Include a collection of defensive companies to offset the risks of the economic cycle. Buy companies of many sizes and from many industries so provide opportunities for at least some of their stocks to hold up when the market and peers are tanking.
To quantify the risks of missing the market’s best days, the following graph from J.P. Morgan illustrates how a buy-and-hold approach outperforms when compared to a portfolio that misses the 10, 20, or 30 best days in a 20-year period. A fully-invested portfolio earned 9.4% a year over the period, while missing the 10 best days reduced the annual return to 5.2%. Missing the 20 best days worsened returns to just 2.5%, while being out of the market on its 30 best days of the 20-year period barely earned any return, at 0.3% a year on average.
A mistaken call about the short-term direction of the market can indeed wreak havoc with an investor’s return.
Given the uncertainty that many investors perceive about the current U.S. economy, I found research recently published by Royce Investment Partners to be quite informative.
They found that small-cap stocks (as defined by the CRSP 6-10 index) tend to bottom out well before recessions end. From there, they move up 33.3% on average from there to the end of the recession. And after eliminating the brief pandemic recession of 2020 from the mix, the returns of small-caps in the trailing end of a recession has averaged closer to 40% since the 1960s.
It is abundantly clear, at least for small-cap stocks, that waiting for a recession to end before jumping in to the market is an ineffectual strategy.
This makes the recent revelation that Warren Buffett’s Berkshire Hathaway had bought three homebuilding stocks to be another bit of evidence about how investors should be thinking right now. (It is also a welcome sign that my ongoing assessment of the strength of the overall economy is holding true.)
Homebuilding stocks have been beaten down given concerns about input costs, high mortgage rates, and demand trends, but the housing shortfall in the U.S. remains significant and many Americans are actively looking for homes to buy.
While homebuilders have been reporting fewer homes built and sold compared to peaks reached in 2022 and earlier, the long-term prognosis for residential construction companies remains solid.
Considering the bargain P/E ratios that many of these stocks are selling for at present, patient investors could profit handily by buying now, before it’s too late.
Of course, the bottom line for a bottom-up investing strategy is that company analysis enables investors to review the key attributes of a business before buying, and make decisions about how that company’s management may respond to widespread economic or direct industry problems. Just because the U.S. economy is a downspin or an entire sector is being pressured does not guarantee that all companies will be affected in the same way or to the same degree.
Buying the best companies available at the best prices and then monitoring the ongoing health of those companies remain the keys to driving a successful long-term portfolio through and beyond periods of uncertainty.
But investors will never profit if they cave in to the noise of the misguided masses and miss the opportunities that are before them.
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In this issue of the SmallCap Informer we introduce a biotechnology company to our coverage list, and discontinue a financial services company that announced its merger with another business.
Stay the course!
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