There is a mistake I have seen both beginners and seasoned investors make repeatedly over the years.
It’s scary how easy it is to make this mistake, because all living things have an inbuilt default contrarianism that isn’t so contrarian at all. That mistake could be summed up as “The market has run, so I can’t buy it”. This is a derivation of a concept in behavioural finance known as regret avoidance.
In summary, people exhibit regret aversion to avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove to have been less than optimal.
This bias seeks to avoid the emotional pain of regret associated with poor decision-making. In reality, what is happening here is the experiencing of a sense of self-recrimination (particularly in value-type or cash-holding investors) because the person did not absolutely fill their boots at the rock bottom — which is a point in time that can be known with reasonable certainty only quite long afterwards.
The reason this is silly is quite simply that the default outcome for markets is positive for well over 80% of the time. Of course, markets go bearish sometimes, and that can sting, but the long-term evidence over appropriately lengthy periods of investment is that the good outweighs the bad rather nicely on the whole.
Mebane Faber of Cambria is a US investment researcher and practitioner who comes up with some excellent number play surveys that try to help people avoid self-sabotage. He trumps my observations above by researching the question of “Is it a good time to invest when stocks are at all-time highs?” His answer: “No — it’s a great time.”
Well, that’s much more aggressive than what I proposed above!
How would you test it? Faber created a notional US investor called Jim. Before you object that the US is different, I promise that the outputs of this study have universal applicability. (Also note that taxes and trading costs bear remembering in real life as well.)
Jim is finally interested in going all in on stocks now that we’re back to record highs. In fact, if stocks aren’t setting new record highs, Jim wouldn’t be interested. In that case, he parks his money in US 10-year bonds. What a doofus — it’s like he wants to overpay!
Under South Africa’s investor-unfriendly cost and tax environment, implementing trend following could be costly
Since Jim seems like a chop, we want to test the numbers on what he is doing. Set up a simple rule. Every month, you check to see if an asset is within 5% of its record high. If yes, either buy the asset or continue holding the asset, as the case may be.
Re-evaluate at the end of each month. If the asset doesn’t meet this “record high” hurdle, invest in the relative safety of US 10-year government bonds. Run a test from 1926 to 2019 (when Faber did his study), testing how an ordinary buy and hold in shares worked to give a benchmark. The result is 10.1% a year.
Jim’s modified system gives slightly lower returns of 9.61%. Unimpressive at first glance. However, the annualised volatility of buy and hold was 18.6%, vs 10.8% for the system. Thus the nearly identical returns were achieved with significantly less risk.
Further info from the study is that this also worked well with non-US equities, real estate investment trusts and commodities. The very best news for me, though, was that if you substituted “12-month high” in place of “record high” the return result was 10.6%, with annualised volatility of 12.4%.
The reason I find this be good news is that it is so much easier (emotionally and practically) to implement “12-month high” instead of “record high”.
Right now some of you might be wondering if all I did here was describe a style called “momentum”. Actually no. Momentum does work with a trend, but it’s focused on weighting into the highest-performing assets in a class and is quite high risk. By contrast, Jim’s system is lower risk, and is known in the investment literature as trend following.
Under South Africa’s investor-unfriendly cost and tax environment, implementing trend following could be costly, but in the global context there are funds that do run trend following very successfully. The 12-month high also provides a framework to have a go at a bombed-out market like the UK.
You see, trend following effectively incorporates a “stop loss” mechanism, which is a great way of staying out of trouble.
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