Market volatility like we saw last week can be hard to handle. When uncertainty is high and shares seem to be falling without rhyme or reason, the temptation to try and time the market is immense.
Private investors often decide they’d rather sell up and sit out the slump in cash, before reinvesting when the outlook is more positive.
However, as Mark commented in The Week Ahead last week, these share price moves often bear little relation to business fundamentals. What’s more, trading in this way can actually add to market volatility:
In small caps, the biggest movers have been the popular stocks as individual investors get stopped out or panic-sell on the down days, before buying back into the very same few stocks on the up days.
Fund managers are often forced to echo these flows in larger stocks and whole indices, responding to unusually large redemption requests and subsequent inflows.
The problem with this situation is not hard to spot. Brokers will reliably make money from heightened trading activity. But while a few lucky individuals may manage to time the market correctly, most will not.
Far more often, investors will sell too late, crystalling losses. They will then wait too long to buy back in, potentially missing out on the rapid gains that typically characterise the early stage of a recovery.
The reality is that as equity investors, the big risk to our wealth is not holding shares through volatile periods, but buying and selling them at the wrong times.
At the same time, it can be very hard psychologically to stay fully invested through a market crash. The feeling that we should be doing something is hard to ignore.
More tangibly, it’s also often true that for investors with cash on hand, unusually profitable opportunities can sometimes emerge.
One way to manage this conflict is to adopt a systematic approach to investing. Screen and rule-based systems can be designed so that a portfolio’s equity exposure will naturally vary to reflect the opportunities on offer within a certain strategy.
In the remainder of this piece I’ll look at two different examples to show how this might work in practice. I’ll also highlight some risks and uncertainties that may arise.
#1: How this guru screen generated a 1,150% return
In my experience,…
