The old maxim about ‘it is time in the market and not timing the market’ that matters, is true for a buy-and-hold strategy over many, many years. However, investors who rebalance their portfolios every year, or more frequently, need to consider timing a bit more.
If the average capital gain over the course of the years for the ASX 200 is about 5%, it is easy to lose some, or all, of those potential gains by buying when the market is only a fraction overpriced.
Clearly, it is better to buy in the dips – but nobody wants to ‘catch a falling knife’ – that is buying a stock when it gets cheaper only to find it gets a lot cheaper after you buy it!
To shed light on this problem, I like to think of volatility – or the existence of periods of dips and overpricing – in three parts:
- the market effect;
- the sector effect;
- the company-specific effect.
Taking profits
The simplest strategy is perhaps the profit taking one. Many stocks on the ASX have experienced massive returns in recent times. Two great examples are Ramsey Health Care (RHC, the international hospital/medical group) and Magellan Financial GP (MFG, a prominent funds manager that floated in mid 2012). Ramsey was about $10 at the start of 2009 and peaked at just under $50 earlier this year. MFG floated at just over $2 in 2012 and peaked at just over $14 earlier this year.
While these stocks are the stuff of dreams, they may have ended in tears for some – and still may do so! Selling smaller parcels of the stock on the way up – and even after say a 10% fall once a big gain has been made, guarantees at some point you must make a profit. If you sell to cash, that is a great risk-averse strategy for a super fund. The danger of investing the proceeds in another stock, is that the new acquisition might turn out to be a ‘dog’ and squander the hard-earned profits.
How about investing the profits in the index via an exchange traded fund (ETF) like, say S&P/ASX 200 SPDR (STW)? The index offers diversification benefits – and it never falls by anywhere as much as bad stocks. Perhaps at rebalancing time, the STW allocation can be redistributed. In some way, this strategy instils a discipline that cannot turn into a rash decision to find a new stock in mid-flight. Of course, it might be even better to first go to cash and wait for the index to look cheap – as I do with my exuberance measure – before buying the index.
The losers
The harder problem to deal with is when one of your stocks starts to lose – and the index is not going with it. One example from my set of stocks is Cochlear (COH), which had a product recall a year or two ago. It peaked at above $80 but, because the stock fell so sharply on the news, I judged it was too late to sell and argued to myself the market had over-reacted, as it so often does.
Indeed I bought some more at about $55 as I believed (and still do) that it is a great company and one day would recover. In fact, this week it got approval to sell its improved product in Europe. More importantly, the middle class in China is growing at a very rapid rate and should benefit from that growth.
I am overweight in Cochlear and so will sell some if (when?) it gets back above $80 as I have at two very different times in the past. One could ask why I don’t go to cash and wait for the ‘run up’ to start before getting back in. Many stocks such as this are quite volatile and I find that I have a psychological barrier to buying a stock well into its rally – in case it suddenly ends.
That is precisely the reason I never bought into Ramsay, even though I looked at it. With Cochlear, nearly all of my buys have been in the $50s (it is currently around $60) but I sold some in the $80s and got a nice dividend (currently over 4%) along the way it has been a good investment for me.
And the other healthcare stocks? So many of them have risen so far in the last year or so it looks a long way down from there. More generally, not catching the proverbial knife can partially be mitigated by buying after the falls have seemingly ended.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Also in the Switzer Super Report:
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- Charlie Aitken: Bet on the Endobarrier and buy GI Dynamics [2]
- Staff Reporter: Buy, Sell, Hold – what the brokers say [3]
- Gary Stone: Are Aussie stocks faltering? [4]
- Jelena Stevanovic: Short ‘n’ sweet – Acrux revisited [5]
- Fundie’s Favourite: Buy Greencross for a pet payback [6]
- Questions of the week: Index versus Active and CBA versus no CBA [7]