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The Perils of Market Timing

The first question we ask all STYLUS clients during an account review are: What are your financial goals and objectives? For almost everyone, saving for retirement is #1. It’s a simple concept: put away your excess cash so that some day, after those investments have grown in value, they can pay you back.

With this in mind, during the process of developing and updating our clients’ investment plans, there is one underlying, often unspoken, emotional plea: I DON’T WANT TO LOSE ANY OF MY MONEY! Fear of loss is always the top-of-mind risk factor that has to be considered when developing a sound investment plan.

This emotional plea comes back to the forefront (i.e. the phone starts ringing a little more often!) when equity markets get volatile. For the impetuous and emotional investor out there, it is also a time when they start considering how they can outsmart the market by getting in and out to avoid any losses. Is making predictions about the market and then buying and selling based on a gut feel really the best way to achieve your long-term financial goals?

Stock market timing is an attempt to avoid market corrections before they occur and to reinvest in stocks before they recover, by shifting money between cash and equities. A simple idea when it’s written down on paper, but virtually impossible to execute. As much as we would all like to avoid periods of loss, market timing actually adds risk to portfolio management.

You Have to Accept Falling Markets

Have you ever read this over-used cliché: “Markets go up, markets go down, and in the end, markets go up.” As silly as it reads, the saying is 100% correct. And in times of extreme market volatility, it is important for every investor to remind themselves of this truth, no matter how emotionally tied you are to your investments.

Equity markets simply do not go up in a straight line, which means every equity investor has to be prepared for the possibility that the value, on paper, of your portfolio will go up or down on a daily basis. It’s part of the journey that goes along with owning stocks.

What does market weakness look like at the extremes? Over the past 90 years, the S&P500 Index in the U.S. has gone through 13 periods of significant market decline, defined as a loss from market peak to bottom, of more than 20%. These bear markets have, on average, taken the value of stocks down by 42% and lasted 14 months. These periods of time can really test an investor’s mettle! But for those who realized that these losses were only temporary and persevered, they were rewarded with an exceptionally strong period of market strength: the average return over the 5 years after these decline was 17% per year! They made their money back and more.

Market timers typically jump ship during these deep downdrafts and therefore miss out on the strong returns that follow. If you sell when markets are down, your losses are no longer temporary, they are permanent as you have locked in losses and that money is no longer invested for when the market eventually recovers.

You Have to Be Right Twice

Some investors making market calls have been lucky over the short-term, but the odds are against you over the long term because it isn’t just about getting out of the market, it’s about knowing when to also get back into the market. There are plenty of self-promoters out there who will profess that they predicted that 2008 might not be such a good year to be invested in stocks, but did they also predict a robust rally in the equity markets in 2009 & 2010? Or were they still sitting on the sidelines in cash?

Investors (especially the do-it-yourselfers) tend to react emotionally when markets fall, causing them to sell in prolonged periods of weakness. The more the market falls, this reinforces the investor’s negative bias, which makes them reticent to re-enter the market for fear of getting back in too early.

The analysis, therefore, isn’t about what is gained by missing the worst months in the market because of course that’s going to demonstate that your return would be better if you missed those periods. Market weakness can arrive at any time, and be brought on by unforeseen factors that are completely out of your control. As we have seen above, markets have an inherent elasticity – they tend to bounce back! Once again, the timing and magnitude of these bounces is an unknown, but the data will show that when they occur, you better not miss out. Market timing implies that an investor is occasionally out of the market, but the more often you are out, the greater chance you will miss out on gains. How do we quantify the opportunity cost of being out of the market at the wrong time?

In Graph 1 below, we chart the difference between the growth of $1,000 invested in Canadian stocks all the way from January 1956 to August 31, 2015 versus that same $1,000 investment for a very unlucky investor who missed out on the 12 best-performing months in the S&P/TSX over this same period.

Graph 1: Opportunity Cost
Growth of $1,000 invested in the S&P/TSX Index

This reinforces the principle of staying invested, as missing out on just 12 out of 715 months can have a HUGE difference in the value of your portfolio over a long period of time.

It’s Not About Market Timing, It’s About Time in the Market

Central to a successful investment plan is an understanding of an investor’s time horizons. As time horizons get longer, short-term volatility and fluctuations in the market have less of an impact. Investing in stocks reflects this principle perfectly: The longer you stay in, the greater the chances of making money and short-term volatility is just noise.
As Graph 2 illustrates, the odds of a positive return in the S&P/TSX Index on a daily basis is only slightly better than 50%. As the holding period increases, so do your odds. For the investor who has a 5 year window to own stocks, their odds of looking at their portfolio after 5 years and finding a loss are almost 0%. (By comparison, the STYLUS Momentum Fund, has never had a losing 5-year period in its entire 21 year history.)

Graph 2:
S&P/TSX Index: Odds of Positive & Negative Returns over different time periods

This is also a great chart to pull out if you find yourself being pitched on a Guaranteed Investment Fund, which promise you (for a hefty management fee + insurance premium) that after 10 years, you won’t lose money. Why pay those exorbitant fees when it’s an insurance policy on something that has never happened.

Forget Market Timing, Try Investment Planning

The investment team at STYLUS regularly gets asked this question: What do you think the markets will do next quarter? Next year? It’s a flattering question, really, to suggest that we have a clear vision of the market’s behaviour over any period of time. But what does history show us – NO ONE has ever been able to consistently forecast market declines, predict how long they will last, or when best to jump back into the market. Market cycles have lasted as short as hours (e.g. flash crashes caused by trading system computer glitches) or years (e.g. it took the S&P/TSX Index 6 years to reach a new high after starting to fall preciptitously in June 2008).
Instead, let’s ask these questions

  1. Do you have an investment plan?
  2. Do you know your time horizons?
  3. Do you have time to endure the inevitable periods of market weakness?

If you answered “No” to any of the questions above, then it’s time to call STYLUS for an investment plan review.

Brennan Carson, (416) 847-5900 Extension 6

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