Navigating the investment world can be tricky. In turbulent times, sound investment wisdom is even harder to come by. Common adages can be helpful, but also misleading. In this Markets Explained article, we take a closer look at how time-tested investment mottos hold up.
Investment motto #1: “Let’s make a quick trade.”
The running joke among traders is that “every long-term investment is a short-term trade that went wrong…” Short-term trading depends on luck alone and your probabilities of winning are roughly the same as playing any game of chance (50 per cent). On average, the stock market rewards us (around 8 per cent per year) for our patience.
My view: The key is to have a time-horizon that is long enough. Think about China. The storyline is straightforward: This country might turn out to be the most formidable wealth creator in the future as it is shifting its economic model towards personal consumption. Any exposure should be considered as a core holding that might pay off in the long-term.
Investment motto #2: “Sell in May, and go away.”
“Sell in May, and go away,” meaning to sell in May and get back to the market in November, is not a useful guideline, seen from both a statistical and theoretical view.
Statistically, if it is true that the May-October period underperforms the November-April one, firstly, the absolute performance (on its own) remains positive, and secondly, this does not work systemically (in its entirety), and has certainly not worked in 2020.
Theoretically, it is even worse. If selling in May really makes sense, smart investors should anticipate the May selling pressure and start at selling in April, so that the saying would become “Sell in April and go away.” You would continue, by extension, to always sell a bit earlier.
My view: Make sure you avoid irrational decisions by not following this motto.
Investment motto #3: “Let’s hedge a portfolio for the short-term.”
Implicitly, this means timing the market for a correction which is, in essence, impossible to do.
When hedging, you generally have two alternatives:
- Selling futures is easy to implement, and it incurs no extra costs. However, you give up any potential upsides.
- When buying put options your upside potential remains unlimited, but you pay a premium.
A ‘put’ or ‘put option’ is a stock market instrument which gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put.
A ‘call option’, often simply labeled a ‘call’, is a contract, where the buyer of the call option, to sell a security at a set price. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock.
Two major problems arise:
1. Most hedges will be imperfect. If you sell futures on a benchmark, you perfectly hedge your portfolio only if you own thebenchmark in terms of assets, and there aren’t many investors in such a situation. This may yield unwelcome outcomes, where your assets may go down but the index goes up. You lose on both sides.
2. You need your timing to be perfect, not only when initiating the hedge, but also when closing it. However, closing it at the bottom of the market, when everyone panics and news flow gets horrible, is the most difficult thing to do.
My view: Short-term hedging is more entertaining than effective, with the only exception being FX (foreign exchange) hedging given that this is an important aspect of managing risks. Furthermore, it might make more sense to leave futures hedging to institutional investors (as they may not be able to reduce their equity allocation). On the option side, the most appealing strategy appears to be selling puts to enter a stock or selling calls to take the profits. Simple and effective!
In today’s world, it’s hard to filter out all the noise. Pitchy investment proverbs prevail, and they may seem to serve as a guiding force. However, it’s always better to think twice about whether these mottos still ring true.
Diego Wuergler is the Head of Investment Advisory at Julius Baer