Plan and invest for the long term. Don't time the market.
We heard this many times. Talk to any investment professional, and this is likely one of the pieces of advice that will come up. And it is a valid one. Because statistics have shown that most people who time the market end up losing money. On top of that, we can take faith that stock markets go up in the long run. So holding a diversified portfolio of stocks over the long term puts the probability of a positive outcome in our favor.
But what kind of returns or profits can we reasonably expect out of it? Is the annual performance of a stock index since inception a good gauge? What is the worst outcome? What is the best scenario? These are questions often left unanswered. Of course, we cannot foresee the future. No one can. But we can always reference history to get some sense.
The Approaches - Lump Sum & Dollar Cost Average
Suppose you want to put $120,000 into investing in the stock markets. And your end goal is to grow it to $600,000 at the end of 20 years. But there is always this nagging thought in your mind. On the one hand, you are worried that pumping it all in one shot is risky. Because what if the market crash soon after I invested? The loss will be hard to stomach. On the other hand, you are afraid that the market continues ramping up if you spread out your investments over time. Because that means you might miss the upside.
Depending on the individual's preference, he may opt to do it all at one go. This is called the lump sum (LS) approach. Or, if he is more risk-averse, then he may opt to space out his investments into smaller bite-size. This is called dollar-cost averaging (DCA). Another fancy name coined by the industry for a simple concept. It does, however, reflect how most people invest. Because our cash flows from other sources such as work or business don't come in all at once as well.
Let's study both approaches with a straightforward setup.
The 20-Yr Investment Plan Setup
For the purpose of this study, let's use the MSCI World index to proxy the global stock market performance. For LS, we will put the entire $120,000 to work on day one. And for DCA, we will pump in $1000 at the start of each month over 10 years. What we are going to do is to pick different starting years and see how we end up 20 years later with these 2 approaches. Based on the historical CAGR of 8.4% for MSCI World since its inception, you might reasonably expect to end up with $600,000. For your information, all dividends are reinvested and performance measured in USD. The data for MSCI World stretched as far back as 1969, so we have a good range of observations to work with.
Stock Market : MSCI World
Investment Amount : $120,000
LS : $120,000 on day one
DCA : $1,000 at the start of each month over 10 years
Investment Horizon : 20 years
Target Amount : $600,000
Analysis On The Results of The Investment Plan
The chart below summarizes the results neatly. It shows you how much your portfolio is worth after 20 years based on the year you start.
1. The results are highly variable depending on when you start
As you can see, depending on which year you start with, the results can be very different. The range is huge. This is despite having a long investment horizon of 20 years. With LS, you could end up with as little as $230,968 (3.3% CAGR) or as much as $1,553,501 (13.7% CAGR). With DCA, it is between $230,476 (4.4% IRR) to $1,081,129 (15.2% IRR).
Note: CAGR is the Compound Annual Growth Rate & IRR is the Internal Rate of Return.
2. The good news is you didn't lose any money.
A point worth noting is that you didn't lose any money no matter which year you start with if we don't adjust for any inflation. Of course, the picture could be different if we have data stretching back to 1929 during the Great Depression where markets underwent a much tougher period. But nonetheless, the results of this study do strongly support the view of long-term investing.
3. However, the risk of shortfall or missing your target is high
What is shortfall risk? It is the risk of missing your target. This is unfortunately a very real thing that is often overlooked. Many may assume they can make $600,000 investing in the global stock market or close to that. Because that's what the long-term annual performance of the global stock market suggests. But the truth is there is so much variability and unpredictability in the stock market, you can end up with drastically less.
Out of the 32 scenarios in this study, 47% on the LS approach and 63% on the DCA approach underperformed. Both have an average shortfall of 43% against the target of $600,000. That means, on average, for these scenarios, you made just barely over half of what you set out for. This can be a major setback for your financial plans.
Portfolio Stability Is Key In Reducing Shortfall Risk
While everyone welcomes upside above their expectations, most wouldn't mind giving up some of those in exchange for a smaller shortfall risk. Now, imagine a riskless investment product growing in a straight line all the way and hits your target of $600,000 at the end of 20 years no matter which year you start. If such a product exists, it is pretty much a no-brainer, everyone will opt for it and live happily ever after.
Of course, such a product is only available in your dreams. But that doesn't mean we can't do anything. There are ways to construct and manage a portfolio such that it is a lot more stable. Yet, at the same time, it still delivers a good level of returns. Portfolio stability and sustainable returns are what most professionals are after. With it, you can dramatically reduce the probability and potential amount of shortfalls.
A Multi-Strategy Investment Approach In Action
There is no single strategy that can give you everything you need in investing. Every strategy comes with its own strengths and weaknesses. For example, trend following does well as long as there is a clear trend but gets whipsawed when the market swings violently. Asset allocation strategies tend to hold up well until the asset correlations break down. Volatility strategy earns good returns but is volatile and can be susceptible to huge moves.
However, we are not limited to a single strategy. We can always run different uncorrelated strategies together in a single portfolio. When one strategy is lagging, another may step up and make up for the difference. By using the right blend of strategies, we can stabilize our portfolio returns immensely.
Below is the same chart you saw earlier, but now using the model we implemented for the iFAST Global Markets Large Account. To construct this chart, we simulated the monthly returns data before 2005.
In this simulation, the multi-strategy portfolio delivers performance mostly above your target with a lot less variation. In fact, the LS consistently exceeds the target of $600,000. And the probability of any shortfall with the DCA approach is small as well. Even if there is one, the shortfall amount is minimal. And if you are wondering why an LS approach seems to beat DCA all the time here, that is another trait of a stable portfolio. A portfolio whose value increases more steadily means you are likely to lose out if you wait. So anytime is a good time. In fact, the earlier the better.
The Conclusion
You will most likely profit if you invest in the stock markets over the long term. But there is a catch. The higher risks with stocks translate to huge variability in the end results. Yes, you could end up with a lot more than what you expect. Similarly, there is also a good chance you can end up with significantly less. That is a situation we want to avoid. A multi-strategy portfolio comprising a good selection of non-correlated positive yielding strategies can greatly mitigate such shortfall risks. It produces a stable portfolio that is more resilient against different market conditions and still delivers a good return. That enables you to work towards your investment target with greater precision.
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