Certain Uncertainty - Control what you can Control and Moving into Cash - Part 4 of 5

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Allowing for Timing Issues
From those Examples I put in Part 3 of this Blog Series regarding different % Sizes of a Drop (if you look on the Educational Blogs page you should be able to easily find Part 3 if you have not seen it yet), it appears a bit of a ‘No-Brainer’ that if our Portfolio is above a certain Size, then we should seriously consider a ‘Move into Cash’ when we anticipate a Drop in the Markets coming. In other words, as an example, if your Portfolio is worth £50k and you expect a Drop of 10%, the Costs of moving half your Portfolio into Cash (assuming a 2% Spread) would be 6.8% so it probably would not be worth the bother (go back to Part 1 of this Blog Series to get more information about this).

But of course nothing is this simple.

We have to attempt to incorporate ‘Timing Issues’ into our Model Scenarios. These Timing Issues result in Additional Costs as follows:

• You can never Sell right at the Peak.
• You can never Buy back in right at the Bottom (sadly, none of us are my mythical ‘Best Trader on the Planet’).

And it must also be realised that Selling at the Peak and Buying back at the Bottom are hard enough for just 1 Stock - but to do it effectively and efficiently on 20 Stocks is going to be extremely difficult.

Therefore we need to rework the Model trying to allow for these ‘Uncertain’ Costs but we must accept that we cannot be exact - but we can perhaps get a fairly realistic idea of what the Timing Issues will mean in terms of Additional Costs.

And of course all this assumes a Sizeable Drop actually occurs - if the Market just does a small blip and then starts moving up again then ‘Moving into Cash’ will have proved to be suboptimal. On the other hand, some Drops are actually quite predictable - for example, as I write this we are in the middle of a serious Drop in the Markets and most People could easily have seen this coming.

An Example incorporating an allowance for Timing Issues
For our purposes, let’s make an Assumption that when Selling out the 20 Stocks from our Portfolio just as we think the Market is coming off its Peak, we are a bit late but pretty good, and we do all of our Selling once the Market has already fallen 3% (this is probably being very generous and again Readers can play around with their Assumptions and run Models that are more appropriate to their own Portfolios - perhaps 4% or 5% is more like it). I am also assuming that we Sell all the 20 Stocks at the same time although of course in practice my 3% figure here is an Average and of course some would have been sold 1% off the Peak and some 5% off the Peak etc. (remember, this is simply a way of Modelling things in a relatively easy way).

Let’s also assume that on the other end, we Buy Back in after the Market has moved up 3% from the Bottom with the same Assumptions as my paragraph above where the 20 Stocks are all bought at the same time and again it is an Average (and again I suspect this is very generous).

On this basis, let’s assume a 10% Drop and see what this means to the Numbers (again we will use a £250k Portfolio):

• The Market falls 3% before you start Selling the 20 Stocks so you are now Down £7.5k (3% of £250k).
• You then Sell the 20 Stocks and half your Portfolio is now in Cash but you take a further hit to your Portfolio of £8,750 (7% of £125k).
• So your Portfolio gets hit by £16,250k (£7.5k plus £8,750) at the Bottom of the 10% Drop, whereas if you had done no Selling you would be down £25k. Note also that the bit you moved into Cash is now worth £121,250 because it had already dropped by 3% when you started Selling.
• The Market then starts to rebound and your Paper Loss reduces by £3,375 (3% of £112.5k) on the 20 Shares you did not Sell and you start Buying back the other 20 Shares which means with all the Dealing Fees and stuff you take a Real Loss in your Portfolio of £3400 (this comes from the Examples in Part 2 of this Blog Series).
• Your Portfolio then rebounds to get back to the Starting Point on the bit you left Invested so after the Round Trip this portion is worth £125k again. However, the bit you added back in at 3% off the Bottom now grows by about 8% (this is like those complicated Examples I gave earlier in Part 3 - you might think it has to grow by 7% to get back to the Starting Point but in fact it is nearer 8%). Things get really complicated now. After the Drop you had £121,250 in Cash but for simplicity I will just subtract the Costs of £3400 for the Dealing Fees and Spread etc. from this Number and then grow it by 8% - so that means the Portfolio adds £117,850 x 8% which is roughly £9450. Therefore adding it all together, after the full Round Trip, your Portfolio is now worth £125k plus £117,850 plus £9450 which Totals at £252,300.

Wow, that actually was a really useful exercise and the Result has surprised me somewhat. Again it is based on a Portfolio of £250k and for bigger Portfolios the Numbers may lean more towards ‘Moving into Cash’ but for this size of Portfolio on a 10% Market Drop and Rebound, it looks like it is marginal with regards to whether or not it is worth the effort. The elements that factor into this are how good you are at timing your Selling and Buying and of course there are tiny aspects like Dividends you might forego and of course there could be a Takeover Bid or something on a Stock you Sold out of but equally on the Flipside you might have suffered a Profit Warning - hopefully you sold the right ones !!

I actually think my timing Assumptions of 3% off the Top and off the Bottom are way too generous and in practice you could not achieve this. If I am correct, then if it is more like 5% you would be far better off staying in all your Stocks for a Portfolio of this size. Obviously if the Drop is bigger than 10% then this would favour Moving into Cash a bit more but again it would depend on the size of your Portfolio. But of course this is extremely complex - if your Portfolio is bigger, you could easily have higher Costs of Selling and Buying which could arise from having to Sell and Buy Chunks of Stock which adds to Dealing Fees and you might have to pay a Wider Spread.

It also depends on how quickly the Market rebounds. If the General Market is in an established Bull Uptrend and we get a fairly typical Autumn Sell-off with a Drop of around 10% on the Major Indexes, then you tend to find that the Market Rebounds within Weeks and if you look back at the Bull Market that ran from 2009 to 2018 there were loads of occasions where we had these sort of Corrections. If you had Moved into Cash on many of these occasions then you would probably have run up significant Costs without actually achieving much.

And yet another Variable is the degree to which you Move your Portfolio into Cash. For example, in my Scenario above I moved Half the Portfolio (20 Stocks) into Cash - the Numbers would be different if you moved perhaps 30 Stocks into Cash or only 10 Stocks into Cash. And of course if you move 30 Stocks into Cash and then the expected Drop barely happens and it only falls 5%, you have a lot of Cost and a scramble to get your Money back into the Market and working for you. In such circumstances I suspect your Portfolio would suffer a lot.

It also depends on how you do your Selling - I probably favour Slicing a bit off a Stock Position in my Portfolio rather than Selling out entirely - although that might be appropriate for some Stock Holdings. The advantage of this is that when you come to buying back in, you don’t have to obsess about finding New Stocks to invest in and doing loads of research as would be required - this can take a lot of time and it will be quite difficult to buy back in close to the Bottom if you have to spend loads of time investigating new Stocks. Of course when the Markets are tanking is a good time to be doing Research and getting a List of what you would like to buy and it has the psychology boosting side-effect of taking your mind off of a stinking Market !!

My goodness this is complex……

What if the Market doesn’t Recover?
The Example Scenarios I have used are on the Assumption that the Market Recovers fairly soon after the Drop and in fact most of these are more like a Bull Market Pullback than a full-on Bear Market (I think we had plenty of such Bull Market Pullbacks in the period from 2009 to 2018 but it seems to me that we are now going into a proper Bear Market at the time of writing in Late December 2018).

It is my view that this fairly prompt Recovery is a reasonable and realistic Assumption; there is a very well establish Uptrend for Stocks since the Day the Stockmarket was created back in the Mists of Time and despite various massive Drops along the way like the Wall Street Crash, World War 2, Black Monday, The Dotcom Bust, The Credit Crunch etc., the Market has continued its Upwards Path. This plays to the concept that actually Bear Markets are not all that common - for the vast Majority of the time (I suspect it is as much as 80% of the time or even a bit more), the Stockmarkets are steadily going up.

It is extremely unusual to be in a situation where you Buy a Portfolio of Stocks and then the Market collapses and you never make your Money back in even 20 Years. For example, if you had bought a Portfolio of Tech Stocks back in 1999, assuming you did not buy the utter Junk that was really just a Website with nothing behind it, with time and immense patience you would have got your Money back by now and be in Profit (and if you are in Quality Stocks then you would have picked up a massive amount in Dividend Payments that would then have been compounded assuming you reinvested the Proceeds). I suspect one of the few Examples of a Long Time Period where you would have struggled to get your Money back (in fact, you might not even have it back yet) was if you had put money into Japan in the Boom they had there in the 1980s I think it was. But that is extremely unusual.

In fact, the usual Basic Rules apply - if you understand Valuations and don’t overpay for stuff and if you buy Dividend Paying Quality Stocks, you are highly unlikely to ever be in a situation where you have bought at the Top and you have to wait 10 Years or more to get your Money back. A Portfolio of perhaps 20 decent Quality Stocks will always recover whatever point in the Market you buy it.

Of course this hugely impacts your Decision with regards to whether or not you ‘Move into Cash’ before a Potential Market Drop that you see in the near Horizon - you need to weigh up all the factors and of course understanding the Valuations of the Market would give you a good clue as to how severe the Drop is likely to be. In the case of 1999 when Tech Stocks were on truly insane Valuations (on most of the rubbish you could not even calculate a Forward P/E because they had Zero Earnings !!), it was pretty obvious that when the Bubble popped it was going to take a while to Recover. The other clue was that the Market had ‘Gone Vertical’ which is a situation that never can be sustained and any Chart of anything that does this is highly vulnerable (look at the Bitcoin Chart a Year ago). On this basis, if you think a Drop is going to be meaty then Moving heavily into Cash might be the best option. If you foresee a limited Drop, then perhaps moving 25% of your Portfolio into Cash and Hedging the rest is all you need to do.

I have used Examples with a 20% Drop but a full-on Bear Market could perhaps drop as much as 50% - so clearly in such a case Moving into Cash would be highly worthwhile but of course it is difficult to know in advance just how severe a Sell-off will be.

For clarity, I have written a lot on Twitter etc. about how the Nasdaq Composite Index looks awful from a Technical viewpoint at the time of writing and the Valuations here look very high so I think the Fundamentals are lining up also for quite a sizeable Drop. I expect to be Hedging my Portfolio more in early January 2019.

A Bonus Example
I was going to leave this Part of the Blog Series as it is but at the last minute I have decided to lob in another Example just for my own curiosity as much as anything to see how different Parameters will affect the Result. Therefore I have copied a Chunk of Text from the Example I gave above under the Heading ‘Allowing for Timing Issues’ and you should be able to see where I have ‘borrowed’ the previous Text. This time I am going to alter 2 main Parameters which are a 20% Drop in the Market this time and a Portfolio Value of £500k. Let’s see how it works out……

For our purposes, let’s make an Assumption that when Selling out the 20 Stocks from our Portfolio just as we think the Market is coming off its Peak, we are a bit late but pretty good, and we do all of our Selling once the Market has already fallen 3% (this is probably being very generous and again Readers can play around with their Assumptions and run Models that are more appropriate to their own Portfolios - perhaps 4% or 5% is more like it). I am also assuming that we Sell all the 20 Stocks at the same time although of course in practice my 3% figure here is an Average and of course some would have been sold 1% off the Peak and some 5% off the Peak etc. (remember, this is simply a way of Modelling things in a relatively easy way).

Let’s also assume that on the other end, we Buy Back in after the Market has moved up 3% from the Bottom with the same Assumptions as my paragraph above where the 20 Stocks are all bought at the same time and again it is an Average (and again I suspect this is very generous).

On this basis, let’s assume a 20% Drop and see what this means to the Numbers (we will use a £500k Portfolio):

• The Market falls 3% before you start Selling the 20 Stocks so you are now Down £15k (3% of £500k).
• You then Sell the 20 Stocks and half your Portfolio is now in Cash but you take a further hit to your Portfolio of £42,500 (17% of £250k).
• So your Portfolio gets hit by £57,500k at the Bottom of the 20% Drop, whereas if you had done no Selling you would be down £100k. Note also that the bit you moved into Cash is now worth £242,500 because it had already dropped by 3% when you started Selling.
• The Market then starts to rebound and your Paper Loss reduces by £6,750 (3% of £225k) on the 20 Shares you did not Sell and you start Buying back the other 20 Shares which means with all the Dealing Fees and stuff you take a Real Loss in your Portfolio of £3400 (this comes from the Examples in Part 2 of this Blog Series).
• Your Portfolio then rebounds to get back to the Starting Point on the bit you left Invested so after the Round Trip this portion is worth £250k again. However, the bit you added back in at 3% off the Bottom now grows by about 20% (this is like those complicated Examples I gave earlier in Part 3 - you might think it has to grow by 17% to get back to the Starting Point but in fact it is nearer 20%). Things get really complicated now. After the Drop you had £242,500 in Cash but for simplicity I will just subtract the Costs of £3400 for the Dealing Fees and Spread etc. from this Number and then grow it by 20% - so that means the Portfolio adds £239,100 x 20% which is roughly £47,820. Therefore adding it all together, after the full Round Trip, your Portfolio is now worth £250k plus £239,100 plus £47,820 which Totals at £536,920.

That’s a really interesting result. I guess it confirms what I was already thinking - if you have a Larger Portfolio and the Drop is bigger (of course this is nigh on impossible to know in advance) then ‘Moving into Cash’ looks to be worth doing on this piece of evidence. Of course this would vary by the ability you have to Sell just off the Top and to Buy back just off the Bottom and also if you were to Sell perhaps 10 Stocks rather than 20 it would change the Numbers again. And don’t forget this is based on my Timing Allowance of 3% off the Top and 3% off the Bottom but in practice I think this is not very realistic and the figures are perhaps more like 5% or 6% which would probably wipe out almost all of the expected advantage of Moving into Cash that is suggested by this Example.

As I keep saying, my Examples here are the Framework and Readers can run their own Simulations with Parameters which suit their own Portfolios and desires.

And of course I have not really mentioned the Psychological Benefits of Moving into Cash which help hugely when we get ‘The Big One’ like we seem to be enduring at the time of writing. I have no doubt that the canny Investors who sold out big chunks of their Stock Portfolios many Months ago are feeling a lot happier about the Carnage in the Markets than People like myself who have stayed largely Invested. The challenge for them will be to get back in quickly when the tide turns - but I suspect that is something they have plenty of time to plan in advance.

My head is really hurting now so I will leave it there for Part 4.

Cheers, WD.