A cost-averaging strategy can be an antidote to uncertainty

It is risky to count on forecasters, many of whom may be wrong Now that the chirpy New Year greetings have waned, what is the realistic outlook for 2010? I expect it to be tricky. We have recently experienced one of the biggest rallies in history from the impish S&P500 bottom of 666 in March 2009, far exceeding the approximately 40 per cent return realised when exiting prior recessions. This year's forecast depends substantially on whether private demand can take over from lavish government largesse when the front-end loaded stimulus programmes taper off.

Meanwhile, the sprightly rally has elevated consensus earnings growth expectations to about 30 per cent for the S&P500 index, which is achievable but not a trivial hurdle. In the past few weeks, the rally has been propelled by strong macroeconomic data that surprised positively, but as expectations rise, the upside surprise factor will fade. However, there are many prominent bulls who argue additional gains can come from continued low interest rates for an extended period, still-reasonable equity valuations, high cash levels on the sidelines, inventory restocking and other factors.

Given brainy arguments in both the bullish and bearish camps, investors will be well served to counter uncertainty by using a cost-averaging strategy in equity markets. Since averaging involves a series of purchases for a given monetary value at fixed intervals, investors can populate their portfolio with discounted purchases if the market dips and accumulate fewer units at premium prices if the market continues to rise.

For example, a steady stream of 24 monthly purchases starting January 2008 until December 2009 would have delivered a total price return of 5.8 per cent in the US, 4.5 per cent in Europe, 23 per cent in Emerging Markets, and -11 per cent in Arabian markets. Without averaging, if you had bought lump sum at the start of 2008, you would be at -24 per cent in the US, -33 per cent in Europe, -21 per cent in Emerging Markets and a dismal -46 per cent in Arabian markets. If you bravely bought at the start of 2009 when others were frozen in fear, your returns would have been dramatically better, about 22 per cent for the US and Europe, a whopping 74 per cent for Emerging Markets and a tepid 17 per cent for Arabian markets.

In my experience across many market cycles, uncertainty always clouds investment decisions, unless diligence is deficient. By the time clarity arrives, valuations have often become stretched, because rival investors decode the diffuse signals and buy ahead of the point of clarity, which is the essential equity forecaster's challenge. Rich valuations can get richer, a notion that underlies momentum investing, but this reliance on the greater fool theory is a high-risk strategy.

Most of the best economists and investors lacked perspicacity either in mid-2008 before the big crash or in early 2009 before the big rally, and even if perceptive on one occasion were not so in both. So, why should we count on them to be particularly prescient this year? "You have to understand that being wrong is part of the investment process", remarked the eminent financial historian Peter Bernstein. Many excellent forecasters will possibly be wrong this year about the market. But you need not be. Regardless of whether you are adding risk to your portfolio to recoup past losses or reducing it to book last year's profits, a decision that should be based primarily on your risk profile, a pre-planned series of patient transactions could promote a better outcome than abrupt action.

Rehan Syed is the head of portfolio management at ABN Amro Private Bank in Dubai. The opinions expressed is his and not necessarily those of his employer.