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Market timing

15th November, 2018

Some people consider those who work in financial markets akin to psychics, with the ability to predict the future in areas from politics to technology. I am frequently asked what President Donald Trump will do next. I do not know. I’m not sure even he does.

It’s time in the market, not timing the market

Unfortunately, in the short term, it is difficult to predict how markets will perform with any certainty. However, if we take a longer-term view, we can stack the odds in our favour. To demonstrate this, I will use the S&P500 Index (S&P) and three generations of my family. I will refer only to the decade of their birth.

The day my mum was born in the 1950s, the S&P stood at 24.96. Today (27/09/2018) it stands at 2914, almost 116 times higher. To put this in context, a $10,000 investment on the day my mother was born would be worth $1,167,468 today. This only accounts for increase in value and ignores dividends. If dividends were reinvested, it would be worth $3,282,945 today.

My wife was born in the 1980s, and a $10,000 investment on the day she was born would be worth $236,449 today. If dividends were reinvested it would be worth $578,041. An investment of $10,000 in 2016, the year my daughter was born, would today be worth more than $14,914, provided the dividends were reinvested.

But perhaps these results are down to luck and these were three perfect days to enter the market. Consider instead my fictional nephew, born the night before the collapse of Lehman brothers. The S&P stood at 1252 and over the following 6 months it would fall 46%, yet a $10,000 investment then would be worth $28,847 today with dividends reinvested.

 

Figure 1: Growth in $10,000 investment

Source: Bloomberg and Davy

 

Current fears

The equity bull market that began in March 2009 continues to reach new highs, with returns of 383% since then. With the global financial crisis still fresh in our minds, investors are increasingly waiting for the next correction. Consistent warnings of trade wars, Brexit ramifications or overvalued equities all add to a sense of apprehension that the current period may not be the right time to invest.

It is well known that one of the greatest dents to investment returns over the long term is investors making emotional decisions. The problem is that when these decisions are made, it is rare that the person making them considers them emotional. Research has shown that 90% of us rate ourselves as above average drivers, when only half of us can be above average. Behavioural biases mean we all tend to overestimate our decision-making ability and need to work hard to prevent this tendency spilling over into our investment decisions. Recent conversations with some investors have been focused on delaying investment or even taking money out of the market. We feel it is important to highlight the implications of trying to time the market.

 

What is market timing?

Market timing is an approach to investing where money is moved in and out of the market depending on predictions being made by the investor. Ideally money would be invested in high return generating stocks during equity bull markets and moved into cash before any market corrections. It has been well demonstrated that market timing strategies do not work. To illustrate this we have run a series of market timing strategies to test their effectiveness.

We tested strategies including waiting on various reductions in price and waiting for a change in fundamentals, such as the price earnings ratio (P/E). We used the S&P to test the strategies as it is the most widely followed index, and did so in US dollars to get the pure equity market results without currency effects. Our findings were consistent across all strategies, regardless of whether they were based on price reductions or change in fundamentals. I have outlined a few of the interesting findings. However, the conclusion is that while market timing strategies can help prevent losses in times of market stress, it is more than offset by the significant gains forgone when they do not work.

 

Markets regularly fall but they recover

Between 1928 and 2018, there are only 4.5% of days where the S&P did not subsequently finish lower at some point in the future. Yet on average, the index doubled in value for an investment made over 10 years. What is more, 58% of the time markets will fall by at least 10%, and 41% of the time by 20% or more. Yet the average annualised return during the period is 10%. So it is clear that equity investments are likely to suffer a loss at some point, however, over time, the probability is that the investment will recover and generate significant returns.

 

Figure 2: Expected return from waiting for a 10% drop

Source: Bloomberg and Davy

 

The cost of waiting

There is a tendency to underestimate the cost of time spent out of the market. While our research indicates that 10% corrections are frequent, if you always wait for one of these corrections to invest, 42% of the time you will never invest. Even when the market does fall by at least 10%, the average time waiting for this to happen is one year and six months.

Consider the most extreme case of an investor who committed to waiting for a 10% drop on 25 November 1996 when the S&P Index was at 757. Their patience would not have been rewarded for almost 12.5 years until 9 March 2009 when the market dropped to 677. A more likely scenario was that the investor tired of waiting and may well have chosen a worse time to invest. In addition, the investor would have lost out on 23% of dividend income while they waited for that 10% decline.

 

Figure 3: More than 12 years waiting for 10% drop

Source: Bloomberg and Davy

 

Assessment of the future

Unless you have reason to believe that for the foreseeable future global growth will cease and public companies will become unprofitable, there is no reason to believe that the market will not recover from any subsequent crisis that occurs.

This is not to diminish the effects of a sell-off on wealth, and the devastating impact if cash is suddenly required. However, if the time horizon is long enough, the impact of a crash should be no more than a temporary paper loss rather than a permanent destruction of capital. It is for this reason that we prescribe a risk-managed, diversified, multi-asset approach for our clients. This ensures that investments are consistent with a client’s risk preference, temporary losses are not turned into permanent ones, and that the client’s time-horizon is sufficient to recover from losses.

We, as an investment team, spend a considerable portion of our time analysing markets. We have access to a wealth of market leading indicators and we position portfolios accordingly. Portfolios are built for clients to ensure investments are consistent with their capacity and tolerance to risk. This is why client engagement and financial planning forms are key to our offering.

In assessing market timing, we also have an advantage as we equally weigh the probability of losses from being in the market, against the probability of lost gains from being out of the market. For the investor that chooses to time the market, all indicators suggest that the odds are stacked against them.

 

 

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