For most investors, “buy low, sell high” is the ideal implementation plan, but in reality, that rarely happens. To be successful, one has to be right twice: (1) buy at the ultimate low, when things are chaotic and investors are extremely nervous and (2) sell at the ultimate high, when everything is rosy and investors feel euphoric. Anecdotally, investors usually do the exact opposite!
In Part 1 of this blog (found here), we determined that investors with significant cash balances should first re-evaluate risk tolerances and return targets through a detailed financial plan. Through this process, investors can objectively quantify how much return they actually need and how much downside risk they can absorb to meet their financial life goals. Ultimately, the investment portfolio decisions should be a by-product of your financial plan.
Mental Preparation: Price Level Expectations
Investors can be swayed by their past experiences, especially those that occurred most recently. Often, investors view previous price levels as the default as to where prices should return to. Some investors are especially vulnerable to this view if they own a fallen stock. If a stock was once owned at $100 per share, then the reasoning goes that in time, it must eventually go back to $100. But who says so? The market does not care at what price you purchased an investment. Some damage is indeed permanent. As the renowned economist, John Maynard Keynes said: “When the facts change, I change my mind”. Investors should beware of holding onto opinions and past price levels regardless of the changing backdrop of facts.
Selection: Re-evaluate risk and return expectations
Before making new investments, return and risk expectations need to be re-evaluated. Investors need to work with an advisor to set realistic expectations in their implementation plan. Together, review different asset mixes that will result in different risk adjusted returns. The diagram below visualizes the risk vs return paradigm. Further, investors should work with their advisor to understand volatility statistics like ‘max drawdown’, ‘standard deviation’, and ‘downside capture’, to best ascertain how the portfolio could do in the next bear market.
Purchasing Strategy: Dollar Cost Averaging
If you have a mid to long-term horizon (5-10 years) for investing, investors can consider Dollar Cost Averaging to help remove some emotion out of investing. This strategy involves contributing a fixed amount of money into an investment on a regular basis regardless of the day-to-day market news. The table below illustrates how dollar-cost averaging can lead to smoother returns during a volatile price environment.
The timing and percentage of amounts to be deployed should be predetermined and followed. Setting a disciplined approach is critical as you want to create predictability and structure while eliminating the urge to override. A monthly approach to entering (or re-entering) the market is common, but with the speed that markets have been evolving lately, smaller amounts on a bi-weekly, or even weekly basis may be considered. You can also integrate catalysts such as market levels (ie. if the TSX hits 13,000 deploy 20% of remaining cash) or targets (ie. if RY falls 20% lower, buy back more shares) as considerations. If investors are setting thresholds that target larger deployments of funds, we recommend establishing them up front, set up alerts, and stick to the plan.
To conclude, an implementation plan should include a review of potential future market prices, re-evaluating return and risk expectations, and developing a deployment strategy using dollar cost averaging. Market volatility is inevitable and trying to time the highs and lows has proven to be a near impossible exercise. Bear markets tend to grab the attention of all investors, however, we discourage clients from obsessively looking at their portfolios online. After all, most would admit that they look at their portfolio infrequently during ‘normal times’. Investor should schedule regular reviews with their advisor and clarify their communication arrangement during volatile periods.