Tuesday, March 31, 2009

On market timing

This is one topic that always attracts a lot of debate and verbal lashes. Value investors are of the view that it is futile to time the market. Over long period of time, studies have shown that you cannot beat market return after factoring transaction costs. This does not mean one cannot have positive returns. It might be possible to generate positive returns but I have enough evidence to believe that it's quite difficult.

Traders, on the other hand, believe that market timing is part and parcel of "investing". Well what value investors define as investing may be different from what traders define as investing though, but for now let's not delve into this yet. Anyways traders believe that those who don't look at charts and to a certain extent, time the entry and exit are idiots.

Ok, first we should actually define the two different types of market timing that exist.

The first type is looking at daily, weekly, monthly, quarterly or even 1-2 yr charts and try to time the bottom and top. ie buy at the low (as dictated by chart patterns or other signals) then sell at the high. To try to win this game is very similar to playing at the casino. Your chances of winning are usually less than 50%. Nevertheless there are ways to make money even when you are up against the house. The book Fortune's Formula provide some interesting insights. I hope to discuss some interesting stuff from this book in the future but for now, we are not interested in this definition of market timing. You are at a value investing blog, remember?

Ok, the 2nd type of market timing involves 5-7 years macroeconomic trends and stock market cycles. This is the important type of market timing that we shall focus today.

From 1950 to 2000, if you invest in a stock index (in this post we use stats from the S&P500) and your investment horizon is only 1 yr, i.e. you buy in any particular year and sell 1 yr later, your returns can vary between -50% to +25%.

This means that if you are damn bloody good and started investing in at the bottom of the cycle, (e.g. 1998 to 1999), then your return can be 25%, in 1 yr. And if you are damn suay, and started at the peak of the cycle (like 2007), your return can be as bad as -50% in 1 yr.

However as your investment horizon stretches, the returns tend to vary less and get skewed towards a +ve return.

If your investment horizon is 1 yr, your returns vary from -50% to +25%.
For 5 yrs, your returns vary from -3% to +23%.
For 10 yrs, your returns vary from 0% to +19%.
For 25 yrs, your returns vary from +8% to +17%.
This is true for the time period 1950 to 2000.

The worst 25 yr return rate on record is when you started investing in 1929, your return is actually 0% after 25 yrs. Incidentally, this may be the case if you started in 2007. In order to avoid this pathetic outcome, someone invested in 2007 should keep buying esp in 2009 and 2010.

If you take the average of all these returns, it is roughly 10% which is average return for S&P500 over an 80 yr period. What about the other markets? Sadly most other markets do not deliver as good returns and the S&P. Japan for one, has a 25 year bear market and still counting. However, it's probably safe to say that stock markets have delivered 5-8%pa over the past 20-30 years even after taking into account this crisis.

Ben Graham, the father of value investing, advocates that we should not try to time the market and simply be happy with this 5-8%. Buffett had also mentioned that one of the best investment strategies for the retail investor would be to set aside some money buy an index fund every year and earn this 5-8%. It's simple, saves time, get rid of the emotions and can make you real money for retirement!
Post a Comment