19 August 2019

The costs of timing the market—why captives need to stay the course

There is a saying in my business: “It’s not TIMING the market that makes you money, it is TIME IN the market!” Equities, as with real estate and most other investments, require time to yield the best results.

“When you set your asset allocation model, do so with the intention of holding on to the equity allocation ‘forever’, and your bonds ‘as long as possible’.”

Most people understand this with real estate because they are usually using the real estate, as a commercial property that houses their business, or as the home they live in. The illiquidity of real estate makes it next to impossible to “panic” and “dump”.

The very attribute that makes equity investing so attractive is also its biggest downfall—it is liquid. You can buy a stock today and sell it today, tomorrow, or just about any time on a moment’s notice. Investors operating without advisors, or investors “calling their own shots”, often let a panic caused by some calamity, prospective upcoming event, or even dare I say wayward “tweet” lead them to hit the “sell” button, thereby locking in a loss.

It is human nature to do the wrong thing when buying stocks. When equities are hitting new highs is the same time that investor confidence is highest. When equities are “on sale” after a market pullback (think the week of August 5, 2019, or Q4 2018 as the two most recent examples) is when investors hit the sell button, or sit on cash rather than buying opportunistically because (perhaps) they think shares will go lower and they want to wait. This is called “timing the market” and, quite frankly, it doesn’t work.

With equities you can see the value on a minute-to-minute basis. It is virtually the only thing (including bonds and commodities) priced that way. While that gives comfort to most, it gives heartburn to others. But it goes well beyond one-time mistakes—we will get to that in a moment.

Imagine comparing equities to real estate this way. What if, the day you closed on the purchase of your house, you could flip on the TV at home and see the value of your house on a ticker-tape every night. There would undoubtedly be days, weeks, months and even years where your house is worth much less than you paid. And don’t even think about the interest you pay over the life of a mortgage, or you may pick living in a hotel instead of buying a home.

Captive insurance companies usually have the benefit of longer investment time horizons. They need to be aware of that fact, and invest accordingly. Due to the risks that captives insure and the likely payouts/claims that could develop, captives should do their best to “duration-match” their investments to their claims.

Overinvesting in any asset class—including cash—can adversely affect performance either by keeping funds uninvested, or by forcing untimely liquidations to pay for otherwise predictable claims. Effectively the captive might end up “timing the market” when there is no need to do so.

The costs associated with market timing—or simply haphazardly having to sell when liquidations could be better planned (or cash kept aside)—are high. Just going back 20 years you can see the effects (Figure 1).

Figure 1: Performance of $10K invested in the S&P 500 index under various scenarios 1999–2018 (nb cropping)

Figure 1 illustrates the simple fact that even over 20 years—a period where certainly “time would heal all wounds”—an investor/captive would have lost almost two-thirds of its returns had it missed the 10 best days the stock market had in that 20-year period.

There are about 5,200 business days in 20 years, so missing the best 10 days, which accounts for just 0.19 percent of the days in 20 years, would cost an investor 3.6 percent per year in returns. A $1 million captive allocation to equities like the S&P500 over 20 years would have become $2,984,500 if constantly invested, but would have grown to only $1,489,500 if the 10 best market performance days were missed. If they missed an entire month of best days which is just 20 trading days out of 5,200 in that 20-year period, they would have lost money in the market. A stunning fact.

The right balance
What is a captive to do? When working out your Investment Policy Statement (IPS), and making an allocation to equities, bonds, and cash, keep in mind your cash-flows. When is premium being deposited? Will current premiums cover payments needed in the current year? If not, how much of the existing account will be needed? These assets should be kept in cash or near-cash so as not to disturb the underlying equities and bonds that (should) comprise the backbone of the captive’s surplus and investment capital. Bonds set to mature in the coming year are “near-cash” investments as well, and should be considered as such.

Let’s look at market timing another way. My friends at First Trust offer Figure 2.

Figure 2: Intra-year declines vs calendar year returns nb cropping

On Figure 2, the orange bars show the intra-year decline or how much you could be down during the year. The blue bars show how the year ended.

Note most of the blue bars are above zero, meaning simply that if you just held on you would have made money by the end of the year, even though on average (since 1980) the inter-year declines averaged 14 percent. Note also that every blue bar is higher than the orange one, meaning the market never ended the year worse than, or at, the intra-year low.

It comes down to this: when you set your asset allocation model, do so with the intention of holding on to the equity allocation “forever”, and your bonds “as long as possible”, and have sufficient cash or money funds (or pending receipts of premium and bond maturities) to cover all anticipated or likely expenses and claims payments.

Doing that will not only save you money from untimely liquidations, but will also maximise your potential returns from the equities you are holding.