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Developing Your Investment Strategy
Investing vs. Speculating
As many investors discover, mapping out an investment plan is the easy part. Sticking with that plan is what separates investors from speculators. To make the most of your investment opportunities, allow your lifestyle to dictate your investment approach — not stock market gyrations. Your goals are what count, so keep them firmly in mind when you make financial decisions.
Are You an Investor or a Speculator?
Many investors use a consistent, long-term strategy to build a more secure financial future through steady purchases of well-diversified investments.
Speculators and market timers are usually less concerned about consistency. They may switch investment philosophies on an emotional whim, sometimes treating their investments more like play money than the serious money needed for future security.
Responding to the Market
Most people would probably say they are investors, but the question is not so easily answered. During a bull market, it can be relatively easy to be a long-term investor. However, when the stock market starts gyrating, investors' mettle can be tested — revealing many closet speculators.
For example, according to numbers compiled by the Investment Funds Institute of Canada, after the August 1998 market correction, investors pulled $6.7 billion out of mutual funds. This pattern continued during September and October with investors redeeming $6.6 and $6.7 billion respectively in funds, despite the fact that the market actually started to rally. In fact, the best single month on the TSE 300 Index in the preceding 14 years occurred during the month of October 1998. This kind of emotional response to short-term market fluctuation is just one example of speculative behaviour.
The Risks of Market Timing
Market timers follow a fairly predictable cycle. When prices seem low relative to historical norms, they buy. When an investment's value seems to peak, they sell. This cycle is repeated with the next "hot tip."
In theory, market timing seems fairly rational, but in practice it rarely works. Even the most sophisticated investors, with years of experience and the best analytical tools, cannot predict the whims of the financial markets. What's more, market timers are often misled by emotional factors such as greed or fear. Many end up buying at the tail end of a market rally or selling in a panic at a loss.
As shown in the chart, a market timer invested in the TSE 300 who missed the market's 40 best days had poor results. An investor who invested in and held on to their stocks in the TSE 300 over this same period earned almost twice as much.
Market Timing isn't the Solution
10-year period ending Dec. 31, 1999
Source: TSE 300 Index
The difficulty of timing the markets is complicated by the fact that most market rallies occur in brief spurts. Market timers waiting for the right opportunity to buy or sell risk being out of the market during these sudden market changes.
To benefit from market timing, you must accurately predict the future, not once, but twice. First you must correctly determine when to sell. Second, you must accurately determine when to get back in. Because falling markets can rise steeply within days, your timing must be nearly perfect.
Russell recently examined the long-term effect of bailing out after the market crash on Monday October 19, 1987. This study examined the effects on $100,000 invested on Friday October 16th into the TSE 300. If the investor was able to resist the urge to bail during the following week, and left the money to grow, the investor would have had approximately $258,725 as of October 20, 1997. However, if the investor panicked and sold after the crash, and decided to purchase "safer" GIC's over various periods starting on October 20, 1987, they would have been left with $186,120 on October 20, 1997. Keep in mind that the 5 year GIC rates at the time were 9.9%! The lost opportunity is a total of $72,605.
Don't Forget Taxes and Fees
Ironically, the timer might also owe taxes. If the investment had doubled, for example, before it was sold on Monday, October 19, 1987, Canada Customs and Revenue Agency may want to collect capital gains taxes on that gain. And don't forget transaction costs. When you buy and sell stock you must pay for the privilege, another blow to the market timer's bottom line. Thus, the market timer may have even less than the $186,120 shown above.
Making Decisions Like an Investor
As many investors discover, mapping out an investment plan is the easy part. Sticking with that plan is what separates investors from speculators and market timers.
To avoid falling into the speculator's trap, focus on the term "individual" before making any investment decision. Your individual long-term goals and your individual financial circumstances — not the daily gyrations of the stock market — should govern your decision.
By focusing on your individual needs and sticking to your investment plan, you could actually benefit from the stock market's gyrations. For example, a good long-term investment strategy generally includes investing a set amount at regular intervals. If you maintain this schedule during a market dip, you may be purchasing some strong stocks at clearance-sale prices.
Of course, changing your investments during a gyrating market is not always speculating. It can be the mark of an astute investor if the reasons for your changes are consistent with your individual long-term goals.
Lifestyle Timing: Making Decisions Based on Your Goals
Instead of market timing, try lifestyle timing. Look at your own investment portfolio and compare it to your long- and short-term goals.
Do you need to withdraw money within the next year or so to begin financing your retirement or to make some other lifestyle change? If so, you might want to reduce your percentage of stock investments.
What about your long-term goals? Short-term market gyrations will probably not significantly affect your long-term plans, and you would be wise to stick with your current strategy.
To make the most of your investment opportunities, allow your lifestyle (not stock market gyrations) to dictate your investment approach. And in following your investment strategy, you may want to use disciplined, systematic investing — like dollar cost averaging.
Dollar Cost Averaging
Dollar cost averaging is a policy by which the same dollar amount is placed in one or more common stocks or mutual funds at fixed, successive intervals, enabling you to average the purchase of your shares over a good many years. Over the long run, dollar cost averaging helps market fluctuations work for you, not against you. Because you buy more shares when prices are lower, and fewer shares when prices are higher, the average cost of your total accumulated shares in an investment increasing in value over time is below the average market price for all of the shares you purchased.
Disciplined, systematic investing does not promise a profit or protect you from a loss, but it does reduce the odds of you putting too much money into an investment when prices are high, and it also removes the emotional factor from your investment strategy.
Nothing contained in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
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