Cash Flow Investment Strategy

Because of Simpson’s Paradox, outperforming the market each year doesn’t guarantee outperformance while a person is saving. In fact, a person could underperform the market each year, but still achieve multi-year outperformance if their deposits and withdrawals are judiciously timed. Most commentators feel that market timing has been discredited as a viable investment strategy (along with every other strategy including active management, sector rotation, buy and hold, etc.). And while it’s not possible to call market tops and bottoms, it seems reasonable to be able to generate outperformance based on market cycles. To outperform over the long term, you need good returns on the majority of your money, while bad returns affect a smaller portion.

Good and bad returns are somewhat predictable in the market cycle. The best returns come after a market crash. That’s the easy part, since market crashes are very obvious during and immediately after. The worst returns come after the market has grown for a number of years. This is much more difficult, since a bull market can last for many, many years. Except one day in October 1987, the market experience a bull market from about 1982 to 1991.

The strategy that results can make use of leverage or asset rebalancing. It consists of buying stocks when the market crashes, then slowly taking profits or reducing exposure as the market climbs. This should outperform a portfolio with the same AVERAGE exposure (not fully invested in stocks), even if it underperforms most years (in rising markets). Interestingly, it is the opposite strategy employed by principal-protected notes. Let’s look at how this might work.

An investor saves $80,000. The next year it grows to $90,000. Then the market crashes, and the value falls to only $60,000. For anyone who has the courage, this is the time to invest. This individual either comes up with $20,000 cash or credit and invests just after the bottom. The market recovers and the new balance is $120,000. This represents an excellent return on the $20,000 that was added as a deposit. If the money came from credit, it should be paid back over the next 2-3 years. If it was cash from another part of the portfolio, it should be “rebalanced” back over a similar period. Assuming the latter, the portfolio would outperform a portfolio that is 80% stocks, 20% cash (which is where the capital came from to take advantage of the market crash), or even the same AVERAGE weight of 90% equities, 10% cash, if we consider that the 20% cash is invested about half the time.

This can be done even more easily using dividend-paying common stock. Leaving the dividends in cash until a market crash provides available capital to benefit from buying at the bottom. It will also reduce return over that period by forgoing the compounding that would otherwise take place. If markets are more sideways than growing, it becomes unimportant. When the market crashes, a cash balance is available to buy additional shares at exceptionally low prices. As the market recovers and begins growing again, dividends that are paid to cash accumulate in preparation for the next time. This will likely result in a portfolio that is only 90% invested on average.

This works during the accumulation phase, but is almost impossible during the income phase. When an investor is drawing income from their portfolio, they are either relying on dividend income or drawing down any cash balance that is available. The cash is simply not available to buy stocks at market bottoms.

This approach to strategic asset allocation between stocks and either bonds or cash can help boost performance if the portfolio rebalancing is timed to take advantage of low prices at market bottoms. However, this is emotionally difficult and may not be realistic. At the same time, it assumes the ability to allow cash balances to rise while the market is “doing well”, also a difficult proposition to accept emotionally.