investment commentary
G e t I n v e s t e d – O v e r c o m i n g t h e F e a r of M a r k e t E n t r y
October 2014
Peter Mladina
Director of
Portfolio Research,
Wealth Management
Charles Grant CFA
Senior Analyst,
Portfolio Research
Abdur Nimeri PhD
Senior Analyst,
Portfolio Research
Many investors exited equities in 2008, realized their losses and have yet to return. Others since have
had liquidity events – business sales, inheritances, etc., – and remain flush with cash. Yet both groups
may regret missing significant run-ups that saw global equities return 23% in 2013. At the same time,
bond yields remain low by historical standards, deterring investors who fear that rising yields may
translate into negative bond returns. By contrast, investors who stayed the course with their diversified,
long-term portfolios continued earning meaningful returns over time.
short-term. When testing equity returns since
For investors on the sidelines, the fear of
1926, we find no relationship between the
market entry is pervasive. In bull markets,
previous and subsequent quarter’s returns or
they fear an imminent correction. In bear
between the previous and subsequent year’s
markets, they fear the correction will worsen.
returns.2 The R-squared (explained relationBut market entry must be considered in the
context of the investor’s financial goals and
ship) between the sequential returns is 0%.
the opportunity cost of remaining un-invested.
By extension, the returns in 2014 have no
Those who hold excess cash can lose purchasrelationship to the strong equity returns in
ing power over time because cash continues
2013, and therefore last year’s equity market
offering negative inflation-adjusted (real)
run-up is not a sound justification for holding
returns. When investors consider their financial
excess cash in 2014.
goals and the real returns required to fund
Similarly, valuations have no meaningful
them, the optimal place to be is invested in
predictive power at the one-year investment
their long-term strategy.
horizon. When testing Shiller’s cyclically
Capital markets are not omniscient, but
adjusted price-to-earnings ratio – a popular
they are highly competitive pricing engines.
valuation metric for the stock market –
We can conclude this because the evidence
the R-squared between valuation and the
suggests that alpha – the additional return
subsequent one-year return is a meager 8%.
1
from manager skill – is rare. Capital markets
Market entry fears ease when investors accept
that short-term returns are largely unpredictable
always attempt to price a positive forwardand that expected risk and return are related.
looking relationship between risk and return
Dollar-cost-averaging (DCA) is one comsuch that stocks have a higher expected
mon approach to mitigate the risk of market
return than bonds, and bonds have a
entry. But even DCA can be boiled down to
higher expected return than cash.
a risk/return trade-off. Exhibit 1 compares
Investors should focus on what they can
the risk and return of four market entry
control and finding the opportune time to
scenarios over one-year investment horizons
enter the market is not likely one of them.
formed from rolling quarterly returns since
Equity returns are unpredictable in the
1See for example Fama and French, “Luck vs. Skill in the Cross Section of Mutual Fund Returns,” The Journal of Finance (2010)
2We tested serial correlation of Ibbotson S&P 500 returns from 1926 to 6/2014. Source: Morningstar.
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Exhibit 1 – Market Entry Scenarios over a 1-Year Investment Horizon
Average 1-Yr.
Return Outcome
Standard Deviation
of 1-Yr. Outcomes
CVaR (5%)
of 1-Yr. Outcomes
All-In Equity
12.5%
22.7%
–36.0%
DCA Equity
9.0%
14.8%
–26.6%
All-In 60/40
9.6%
13.9%
–20.9%
DCA 60/40
7.3%
9.3%
–14.8%
Cash
3.5%
3.1%
0.0%
1926. The All-In Equity scenario represents
an immediate investment in the S&P 500
that is held for one year. The DCA Equity
scenario represents an initial cash position
that is incrementally invested 25% each quarter in equities over one year. The All-In 60/40
scenario assumes an immediate investment
in a balanced portfolio of 60% equities and
40% intermediate-term government bonds,
a position held for one year.3 The DCA 60/40
scenario assumes an initial cash position that
is incrementally invested 25% each quarter
into the 60/40 portfolio over one year.
Exhibit 1 shows that over a one-year period –
a realistic DCA timeframe in practice – DCA
does, indeed, reduce risk. Both the standard
deviation (the uncertainty around future oneyear return outcomes) and the conditional
value at risk (CVaR, or the weighted average
of the worst 5% of one-year return outcomes)
show reduced risk when employing DCA to
enter either an equity or a balanced 60/40
portfolio. However, this reduced risk comes
at the cost of a reduced average one-year
return. All-In Equity produces 3.5% more
return on average over the one-year periods
than DCA Equity. All-In 60/40 generates 2.3%
more return than DCA 60/40. The results
are directionally the same when we limit the
analysis to a more contemporary timeframe
(e.g., since 1990). The decision to invest all-in
or to dollar-cost-average over a one-year
investment horizon depends very much on
the investor making a risk/return trade-off.
Over longer time horizons, returns are
more predictable. Cash flow yields have been
shown to predict nearly 50% of the variation
of five-year equity returns.4 Although global
cash flow yields are currently below average,
they suggest five-year global equity returns
that are materially higher than current bond
yields, which in turn are materially higher
than cash yields. Furthermore, forward
rates suggest bond prices already reflect the
expectation of rising bond yields (negative
bond returns require yields rise materially
above expectations). Northern Trust’s fiveyear capital market assumptions maintain
this general risk/return relationship between
cash, bonds and stocks. Although expected
five-year capital market returns appear to
be lower than historical averages, investors
should be careful not to confuse belowaverage but positive expected returns with
negative expected returns when they consider
market entry.
3Bonds are represented by Ibbotson Intermediate-Term Government Bond index.
4See our May 2013 Investment Commentary, “Are Equity Returns Predictable?”
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Exhibit 2 – Market Entry Scenarios over a 5-Year Investment Horizon
Average 5-Yr.
Return Outcome
Standard Deviation
of 5-Yr. Outcomes
CVaR (5%)
of 5-Yr. Outcomes
All-In Equity
9.9%
8.9%
–11.0%
DCA Equity
9.5%
8.5%
–10.9%
All-In 60/40
8.6%
5.3%
–2.8%
DCA 60/40
8.2%
5.1%
–2.9%
Cash
3.6%
2.9%
0.1%
Exhibit 2 reproduces the same market
entry scenarios as Exhibit 1 but compares
annualized risk and return outcomes after
five years. Over the longer holding period,
the risk of the All-In scenarios more closely
resembles the risk of the DCA scenarios,
while All-In still maintains a higher average
annualized return outcome. Investors fearing
market entry today should consider this
longer-term view, which is likely to be more
aligned with their financial goals.
Portfolio diversification can mitigate market
risk – and therefore the risk of market entry.
Most conventional asset classes are merely different flavors of stock or bond risk and, therefore,
provide only a marginal diversification benefit to
conventional stock/bond portfolios. Alternative
risk premiums are unique and different sources
of systematic return available from select hedge
fund solutions. They include various forms of
long/short value and momentum premiums
across stocks, bonds, currencies and commodities. They offer true return premiums that are
uncorrelated with stocks or bonds. Exhibit 3
shows rolling 36-month correlations of global
equity and U.S. bonds to a portfolio of alternative risk premiums.5 The correlations show no
meaningful relationship between the returns of
alternative risk premiums and stocks or bonds.
This kind of powerful portfolio diversification
can mitigate the risk of market entry and
ongoing market risk.
Exhibit 3 – Alternative Risk Premiums (36-Month Rolling Correlations)
1.0
0.5
0.0
–0.5
–1.0
Dec-92 Jun-94 Dec-95 Jun-97 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04 Jun-06 Dec-07 Jun-09 Dec-10 Jun-12 Dec-13
Correlation to U.S. Bonds
Correlation to Global Equity
5Global equity is represented by the MSCI ACWI and U.S. bonds are represented by the Barclays U.S. Aggregate Bond Index.
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The risks to market entry are closely related to the same risk/return trade-off that dominates the
investment landscape. Returns are largely unpredictable in the short run, so the decision to deploy
excess cash into a long-term investment portfolio should not heavily weigh recent returns. DCA can
help mitigate the risks of market entry but at the expense of giving up a higher average expected
return. And the risk-reducing benefit of DCA diminishes with longer investment horizons.
The future will always be uncertain, but accepting that short-term returns are largely unpredictable and that expected risk and return are better related over the longer run can ease fears about
market entry. When investors consider their financial goals and the real returns required to fund
them, the optimal place to be right now – and always – is in a diversified, long-term strategy aligned
with those goals.
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purpose of avoiding any penalties that may be imposed by law. For more information about
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IMPORTANT INFORMATION: This commentary is provided for informational purposes only. Information is not intended as investment advice since it does not take into account
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© northern trust 2014
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Q56025 (10/14)