Transforming personal finance since 2011

#22 — Sell in may and go away - continued...

June 8th, 2017

By Andrew Craig

Reading time: ~ 4 minutes

In my most recent article, I looked at the classic stock market idea of “Sell in May”. By the end of the article, I suggested that regular monthly investment was likely a better overall approach than trying to time the market by doing things like selling in May to buy back in September each year. As I said:

“Over a life time … regular investing will very likely help you achieve pretty ambitious financial goals almost no matter what the stock market does. That said, I would argue that, for many people, regular investment into a variety of assets and geographies (“owning the world”) is preferable to regular investment into the stock market alone…”

Regular, monthly investment (i.e. by direct debit) into pretty much any asset class (within reason) over the long run will more than likely make you a very nice return and certainly a much higher return than prevailing interest rates – especially after accounting for real inflation (where interest rates are currently negative – i.e. you are losing real wealth if you  are in cash).

The problem with regular investment into _equities_only however (that is to say 100% into shares and nothing into other assets such as cash, bonds, commodities or real estate), is that we humans are not very good with volatility – psychologically that is.  Most of us are inherently quite risk averse and really not very good at dealing with losses or the appearance of losses (i.e. – the price of something you own being down a great deal – even if you haven’t sold out of it yet - something called “draw-down").

I have written about this before but it arguably bears repeating:  Professors Elroy Dimson and Paul Marsh of the London Business school have shown that investing in UK smaller companies (an inherently risky and 100% stock market investment) has achieved an annual return of no less than 15.4% going back as far as 1955!  You read that right.  15.4% a year for sixty years!

Making that sort of return on the money you save and invest will make you wealthy reasonably quickly – particularly if you’re using an ISA account so you won’t even pay tax.  You can become an ISA millionaire in less than fifteen years if you’re maxing your ISA and making these returns.

BUT (and it is a reasonably big BUT) - there is a problem with this type of investment:  Although this performance track record over no less than sixty years is amazing (and almost entirely unknown by the vast majority of people other than a small minority of folks in the City), the 15.4% returns didn’t come smoothly every year.  Some years smaller companies powered ahead by 30% or even 40% or more.  On several occasions between 1955 and the present day, however, they fell by more than 50%.

It is a very rare person indeed, psychologically, who can see their ISA or pension account 50% in the red, stick to their guns, ignore the noise and carry on investing regardless – confident that it will all be fine in the end.

For most people, enduring these sorts of falls will generally cause them to give up in fear, crystallise their 50% loss and then never invest in the space again.  This means that they have locked in that large loss and, even worse, will then not enjoy those amazing 15.4% returns they would have got by sticking to their guns over many years because, having suffered the huge loss, they will almost certainly avoid the stock market from that point onwards.

The other problem with owning 100% equities, even if you are “averaging in” to your investments, is the fact that stock market corrections can take quite a long time to get back to previous highs.  In the most recent stock market crash of 2007/8 it took until 2013 for the S&P500 to get back to pre-crash levels.  People investing regularly each month would absolutely have benefited from the smoothing effect of being in at the lows from the bottom up but it still would have been some time before they got back into profit.  For many people this increases the risk that they give up on investment altogether and turn the theoretical loss that comes during a stock market dry patch into the real loss of selling out of your investments and compounding that disaster by then sitting in cash for the next few decades (a massive loss over a life time).

These points are arguably of even more relevance right now than they have been for many years, for the simple reason that equity markets (shares) the world over are at all-time highs.

If you are disproportionately in shares at the moment, there are plenty of commentators suggesting more or less aggressively that you might be in for something of a rough ride in the near future.  Even if you are one of the brave few with the psychological strength to ride things out and continue to invest each month, if this crash is as big as many people are saying it could be, you may have to wait years until your investments are back in the black.  Not many people have a long enough horizon psychologically to deal with this.

So what might you do if you find yourself in this position at the moment?

What if you’re sitting on significant profits and don’t want to sell out too early but you’re worried that the crash might be just around the corner.

In my next posts I will write about why there might still be more upside from here despite all these folk suggesting a crash is imminent and, more importantly, a method you can use to enable you to “ride the tiger’s tail” - i.e. stay in equities and catch the remaining upside - but have a fighting chance of getting out before it’s too late…