New Research Shows 2000-2009 Stock Losses Could Have Been Avoided

By: Tom Madell | Mon, Feb 1, 2010
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The last 10 years have been dubbed the "lost decade" for stock investors as trillions of their dollars vanished. But, in newly conducted research, it has now been shown that any investor who used a rather simple approach to stock market investing would not have been part of the carnage. To the contrary, by using a buy and sell strategy based on a series of fixed steps, one could have actually grown their overall investment by over 40% over the decade vs. about a 10% loss incurred by the major stock index.

The study's findings are surprising enough to perhaps appear too good to be true. Granted last decade's results may not turn out to be similar to those during any future decade. And even a straightforward approach to stock investing may not always be easy to implement, especially when it involves having to make purchases after serious stock market losses. But the research data for 2000-2009 do not lie - a systematic approach to when to sell and when to buy an S&P 500 index fund can give ordinary investors a big advantage in succesfully keeping one's costs per share relatively low and helping to actually realize gains.

Most investment experts would agree that in order to do well as an investor, it is best to follow the often touted, but ever so hard to implement, mantra of "buy low/sell high." So how specifically can investor best ensure such an outcome?

One approach is to set some pre-defined levels of stock prices for both purchases and sales. While not guaranteeing buying at the lowest possible prices and selling at the "top," one has a much better chance of at least approaching that objective.

Here is an example: In a rising stock market, buy a fund only after a 10% drop from a high; thereafter, keep buying upon any further 10% drops from the high. Sell some of your position after a 25% rise from a low; hereafter, sell after any additional 25% rise from the low.

Strictly following the above rules, the research described above was able to precisely answer the question as to how you would have done vs. merely buying and holding the S&P 500 Index during the last decade. Below is a summary of the results: (A more complete description of the research is available here.)

The Index started 2000 at 1,469 and ended 2009 at 1,115 which represents a 24.1% cumulative loss for those who merely "bought and held" for the entire decade. However, when dividends are considered, the total loss becomes 9.5%. Since one cannot directly buy the Index, assume you bought the Vanguard Index 500 Fund instead. Its total return for the decade was a cumulative loss of 10.3%

In contrast, an investor who only began to purchase in incremental amounts of $3,000 after 10% drops using 1,469 as their initial baseline, would have gradually entered the market, obtaining successively lower prices as the Index fell over 50%. After having reached a bottom in late 2002, the Index gradually rose well over 75% requiring a series of sales over the following 4 years. Additional purchases were triggered by the bear market of 2007-2009 and sales during the substantial recovery which, for now, we remain in. As a result of the sell/buy criteria, a total of 15 transactions would have been required over the 10 years, or, on average, one every 8 months.

The result of making purchases when prices were relatively low, and sales when prices were relatively high, was a improved cumulative total return: plus 22.2% for the decade vs. minus 10.3% when merely holding. This represents a 32.5% advantage.

Yet this big improved result alone doesn't capture the full extent of what you could have gained using the above strategy. The reason? In the above example, by using the buy and hold strategy, you would have had your entire stock investment locked up for the full 10 years.

Let's assume that by the end of the decade, you would have invested the same total amount, $15,000, regardless of which strategy you used. So, $15,000 was the net cost of your investment.

Using the targeted strategy, much of the time you had less than $15,000 of your money invested in the fund. In fact, for most of the first 9 years of the decade, you would have had considerably below that amount. For less than one year, though, your purchases would have pushed you to as high as $21,000 invested. But on average, you would have had only about $9,500 invested in the fund over the entire decade. This means you would have had available the remaining $5,500 to invest elsewhere. Since the strategy dictated less than full exposure to stocks, it would have likely made sense instead to invest this freed-up amount in bonds, or possibly cash.

Specifically, suppose you had invested in one of the variants of two highly regarded bond funds, PIMCO Total Return or Vanguard Total Bond Market Index. The approximate 10 year annualized return for each was 7.7% and 6.1%, respectively. (If you had invested in one of the two largest money market funds instead, such as Fidelity Cash Reserves or Vanguard Prime, your average return would have been 3.0%.) Let's assume, then, that your excess $5,500 was earning 5% whenever it was not in the stock fund.

The resulting 10 year return on your $15,000 would now be lifted to an annualized 4.1% gain vs the annualized 1% loss for the buy and hold approach. That represents a 51% better return, or 5.1% annualized. This turns out to be more than $7,600 on each $15,000 invested buy and hold over the entire decade. While investors might have hoped for annualized returns closer to perhaps 9 or 10%, such "typical" returns would have been nearly impossible for most stock funds during "the lost decade." Doing 5.1% better on one's investments typically set aside for stocks would have made the last decade far less painful than implied by the term "lost decade."

Sound simple if you wish to undertake such a strategy? Yes, except, that is, for human nature. When you own a position in stocks, and you risk repeatedly losing 10% of that position, sometimes within a short period, it is difficult to have enough confidence (and perhaps, enough other assets) to not only hold on, but to go ahead and add more. And it is almost equally as difficult to sell an asset in the midst of what appears to be a great opportunity for further gains.

Although we obviously don't know what the markets have in store for us during the just begun 2010-2019 decade, if stocks are as prone to both sharp downturns and upturns as during the last decade, such a strategy will likely win out again. (Is there anyone out there who still believes any market will mainly just go straight up without corrections? This would seem to be the main scenario under which restricted purchases and "automatic" selling upon big gains would fail to be a winning approach. Of course, poor results could also occur if the market significantly trended downward over the entire decade, compounding your losses each time you bought on weakened performance. However, it would certainly seem much more likely that stocks act like they do in most decades, that is, with at least a moderate degree of up and down volatility.)

 


 

Tom Madell

Author: Tom Madell

Tom Madell, Ph.D.
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