Predicting market cycles is a tantalizing but unproven tactic
This article was written John Caspar and reproduced with permission from the July/August, 2007 Forum Magazine
I was having dinner with friends the other evening and the topic of investing came up. We talked about this, and we talked about that. And then we talked about market timing. Isn't there a way to avoid the frequent downturns in the market, thus preserving both capital and nerves and speeding the business of building wealth?
It’s a compelling question. For all the
touted reliability of the handsome long-term average returns delivered by stock
markets, the short-term ride feels a lot like the wooden roller coaster at the
PNE in Vancouver. On average, one out of every three months has been negative
for the major North American stock markets. Whoo-hoo! Last year was a classic
example. There were exactly four negative months and eight positive months for
the S&P/TSX stock market index in 2006. Sure, it was a good year for the
stock market, even with those negative months. But can you imagine how great
returns would be if you could avoid at least some of the downturns? That’s the tantalizing promise of market
timing. After all, while folks may line up to experience thrilling ups and
downs on a ride at the fair, they’ll pretty much do anything to avoid it in their investment
portfolios.
As it turns out, though, there’s not a lot of support for the idea that
market timing can be done successfully. Mark Hulbert, publisher of the Hulbert
Financial Digest that has tracked over 180 market timing newsletters since
1980, reports that roughly 80 per cent of those newsletters underperform the
market indexes. That’s
a powerful indictment of timing (and investment newsletters).
Then there’s the issue of who does stay on the top
of the investment guru hit parade. Consistently, it seems like it’s the folks who practice a strict
methodology of looking for value in individual companies. It’s the Warren Buffetts, the John
Templetons, the Charles Brandes of the world who seem to reliably add value to
stock market investing. And every one of them monotonously maintains that they
can’t time the markets,
so they don’t
even try.
And there’s good reason not to try. Perfect market
timing would be wildly useful, of course. But anything less than that runs the
risk of not only being out of the market on the bad days — but of being out of the market on the
good days too. Stock market returns are notoriously lumpy. If you could have
earned the return of the S&P/TSX Composite Index from December 31, 1995,
through December 31, 2005, you’d
have compounded your money at an average annualized rate of 10.96 per cent. A
$10,000 investment would have grown to $28,324. But had you missed the 10 best
days of stock market returns —
only 10 days out of 2,510 days the market was open — your average return would have dropped
to 6.69 per cent. If you missed the 40 best days, you’d have lost money over the entire 10
years. That’s
the reason you hear such consensus from the smart money on not trying to time
the markets. It’s
really expensive to get it wrong.
Really, really expensive. In 2006,
Dalbar, a Boston-based financial market research firm, released an update to an
ongoing study that measures the effects of investor decisions to buy, sell and
switch into and out of mutual funds since 1984. The 2006 report looked at real
investor returns from January 1986 through to December 2005 and found that the
average investor earned significantly less than mutual fund performance reports
would suggest as a consequence of their buying and selling behaviour. According
to Dalbar, real returns for equity investors over those 20 years averaged 3.9
per cent, while the average return for the S&P 500 over the same period was
11.9 per cent. The study’s
consistent conclusion? “Investment
return is far more dependent on investor behaviour than on fund performance.
Mutual fund investors who hold their investments are more successful than those
that time the market.”
So, can you time the markets? The idea is
incredibly attractive, but the evidence for its practical application is poor.
That being said, there is a consequence of value investing that solves the
issue of investment entry and exit points. Strict adherence to the principles
of value investing dictates that you buy stocks when they are undervalued
relative to key valuation benchmarks and sell them when they are fully valued. Although
that’s not “market timing” (since it pays no mind to the market
itself), it’s
the only kind of timing needed to be a successful investor. It’s time to buy a great company when it’s on sale. It’s time to sell it when it is fully
priced.