Market Action Produces Much Heat,
But Little Light

In many respects, the stock market turned in a perfectly "average" performance in the second quarter. The Wilshire 5000 index, which is the broadest measure of the entire U.S. stock market, gained 2.5%. Given the stock market's 200+ year track record of earning slightly more than 10% per year, that's right on schedule. Of course, the market doesn't produce those returns in a straight line fashion, and the second quarter illustrated that tendency as well. The first two weeks of April produced a loss of nearly 3% in the broad market indexes (and as much as 6% in some mutual funds), prompting investors to reach for the air-sickness bags. Not surprisingly, a four-day spurt later in the quarter more than made up for that, shooting the market 3.5% higher. These turned out to be short-term moves that generated some heat, but didn't provide any useful "light" for long-term investors.

There's an important investing principle to be discovered in this type of market action: It's not worth getting worked up over the stock market's short-term gyrations. If you're a long-term investor—and you really shouldn't have money invested in the stock market if you don't have at least a five-year investment time frame—these short-term movements simply don't matter. They're the normal process by which the market grinds its way relentlessly higher over long time periods.

Here's another way to illustrate this important point. At the midpoint of 2005, most of the major stock indexes were close to flat for the year. The most commonly cited index, the S&P 500, ended the first half with a cumulative change of less than 1%. After 125 days of trading, the market had gone nowhere. Or did it?

A closer inspection reveals that on 19 of those 125 days—over 15% of the time—the S&P 500 moved a full 1% or more. A move of 1% in a single day is generally considered to be a pretty big deal, certainly enough to catch the attention of many investors and send them scurrying to their online portfolio trackers to tally their newfound gains or losses. And yet despite these frequent, short-term, emotion-producing moves, taken together the market went nowhere over a full six-month period. The lesson is clear: These daily fluctuations are just noise to be tuned out. Your focus needs to stay fixed on executing your long-term investing plan.

As the table above shows, the funds recommended in four of Upgrading's five stock risk categories fared well relative to their peer groups in the second quarter. The exception was the small company/growth area, where our funds lagged slightly. That's not surprising, given that the market weakness early in 2005 had us positioned in defensive funds that leaned more towards value than the typical small/growth fund. That helped us tremendously in the first quarter, when Upgrading's small/growth funds lost just 1.6% while the average small/growth fund lost 4.8%. But it caught up to us a bit this quarter as the market started rewarding the more aggressive risk takers. (You can read more about this shift in this review  of the Winslow Green Growth fund.) But despite that shift—and our underperformance in Category 4 as a result—the other Upgrading categories made up for it and produced a small margin of victory for the quarter.

Remember, Upgrading isn't designed to catch the very first leg of each new market trend. It's not a predictive system. As a result, the type of action we saw in Category 4 last quarter isn't a surprise. However, as the long-term results in the full performance table show, Upgrading does a good job of jumping aboard lasting trends early enough to capitalize on them and produce a performance advantage. While the "heat" of the market's short-term moves certainly can produce some discomfort at times, the long-term "light" of a successful long-term investing strategy like Upgrading is where our attention is more productively focused.

• Overview of SMI's Fund Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History of SMI's Model Portfolios
• From the SMI Weblog: Grinding it out 
• SMI Subscription Information

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