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If you accept that it is impossible to time the market on a consistent basis, as discussed in Rule 9, then logically it follows that you should always stay invested in the market. This conclusion is certain to raise some controversy. The power of hindsight is just too great, and you do hear stories of other investors who had the foresight of not only avoiding bear markets, but also of hedging or even going short during the slide. You can spend a lot of time looking at the charts that show past performance but today, now, no one can say for sure which direction the market will turn tomorrow. Various studies have shown that past movements cannot reliably predict future results. In one test, eight charts were given to a number of traders who used technical analysis. Four of them were charts of actual stock performance, and the other four were randomly generated by a computer. The traders were not able to distinguish between the real and simulated charts. Staying out of the market, you are also likely to miss some big up days. If you invested $10,000 in 1997, it would have grown to $22,000 by 2006. Missing ten best days during that time would have reduced the return to $14,000. Missing 20 best days would reduce it further to $9,600—below your original investment. Granted, it could take some talent to specifically miss the best days, but nevertheless I think that this illustrates the point. Staying fully invested doesn’t mean that you have to keep holding the stocks that you already have. In fact, it is necessary to keep re-evaluating your portfolio and make sure you are holding the best selections you can possibly choose (see Rule 25). In any kind of market, one can always find stocks with good current prospects. What about hedging? Hedging is essentially an insurance against market declines. One of the most common hedging techniques is a purchase of put options, for example, on a market index such as the S&P 500. Hedging, however, could be quite expensive and, used constantly, may cost you many percentage points in decreased overall performance. While hedging could prevent you from suffering big losses during market declines, its constant high expense in the long term, during flat or rising markets, could drive your overall returns significantly lower—very possibly lower than if you did not have any hedging to begin with. I started my investing career in 1987, after the big correction that year, and stayed fully invested ever since. Yes, I do admit that this was true even in 2000. Moreover, I had very high exposure to tech stocks, since I have a technical background and was actively involved in that industry then. I did have the foresight, however, of not buying into dot com enterprises with no revenues. But, as you know, even solid tech stocks with real earnings fared very poorly during that bear market. In late 2000 and 2001, I re-evaluated my portfolio and sold many tech stocks and replaced them with other equities, while staying fully invested. My portfolio originally suffered together with the rest of the market, but fully recovered to its year 2000 highs in about four years. Granted, it would have been nice to sell out at the top in 2000, but according to many analysts, markets were already overpriced back in 1995. Remember “irrational exuberance?” Should you have sold then? I do believe that it is prudent to stay the course rather than tempt fate by jumping in and out. © 2013 Laura Lowell This excerpt by Leon Shirman is Rule 10 from "42 Rules of Sensible Investing (2nd Edition)". Leon Shirman earned his Ph.D. in Applied Mathematics from the University of California at Berkeley in 1990. He turned his attention to investing in 1987, after a market crash that year. In 2011, he earned Chartered Financial Analyst (CFA) designation. He is now the Managing Partner of his investment company, Emerald Hills Capital. You can learn more about his book and others at http://42rules.com.
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