Sunday Musings: Making Up Is Hard To Do

Last Monday, I talked about a reader’s question regarding the use of DCA (Dollar Cost Averaging) with trend tracking. GH had an interesting comment on the subject:

I am not a user of DCA nor would I recommend it. However, one should have all his facts straight before coming to any conclusions.

Here is the most interesting fact regarding DCA that I have ever come across, this should surprise some people:

If you had begun investing in the 30 stocks of the Dow just before the Crash of 1929, and you allocated exactly $15.00/month for the next 20 years, as the infamous John J. Raskob recommended in the Ladies’ Home Journal, 1929 to 1948, you would have realized a compounded annual return of better than 8%.

That’s right, and that’s not bad is it? And it is even more surprising when you consider that when you started this plan the Dow was at 300 and at the end of 20 years that same Dow was at 177.

Just another angle to consider.

While that indeed is interesting it is also a very similar argument that the buy-and-hold crowd makes in that if you held on to your investments for x number of years, your compounded annual return would be x percent.

And that presents a problem. No one I know of does these exact things over such a long period of time. In 2001, as the bear market was in full swing, I received a call from an investor who had seen his $1.2 million nest egg sliced in half.

Since he was getting ready to retire, his financial life had been changed forever. No argument could convince this man that over the next 30 years or so, he would be making up his losses, based on historical returns.

That’s why the long-term arguments for buying and holding an investment are flawed. They look at things with the benefit of hindsight and don’t consider the ill effects of a bear market on an individual portfolio when the individual is least prepared for it. In other words, life does not issue margin calls at your convenience.

2008 was another good example of how those entering their retirement years, and did not sell out before the crash, will now have to get by on less. Even if you have many years to go before leaving the job market, you will have to spend a lot of time making up investment losses.

Sure, the rebound rally has many pounding their chest that the S&P; 500 may end up in plus territory by 20% for this year. But that is not the entire story. Last year’s losses were so severe that it’ll take a while longer to get back to the breakeven point.

I have mentioned this before, but when our sell signal kicked in on 6/23/08, the S&P; 500 stood at 1,318; it closed last Friday at 1,091. That means another rally of +20.75% is needed just to get back to the point of where we sidestepped disaster.

Maybe we will get there, maybe we won’t. Given the rally we have seen this year, it seems like a long hard road ahead to squeeze another 20% out of a market supported by very questionable economic conditions.

It’s no secret that for this decade the S&P; 500 has lost 26%, most of it thanks to last year’s market crash. If it had not been for that debacle, we may have ended up the decade with at least a zero gain, but not a loss.

I looked back and found that the dividend adjusted value for the S&P; 500 was 1,469 on 12/31/1999 and had reached 1,481 on 11/30/2007. From that point on it dropped 26% as of last Friday, while via trend tracking we’re down 7% in clients’ accounts for the same period.

The bottom line is that bear markets not only destroy portfolios but also subsequently require you spending an inordinate amount of time making up losses. To me, as a trend follower, the better way is to minimize any losses (you can never avoid them altogether) in order to climb out of the hole faster.

Finally, for many investors the entire process will repeat itself when the next sharp downturn will wipe out this year’s accumulated profits because they do not have the foresight to use any exist strategy to lock in gains. Continuing to ride the Wall Street roller coaster without a plan or disciplined approach will make you realize that making up is indeed hard to do.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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