Market Timing Example

by Mike Holman

This is a “part II” for my original post called “How to Deal With Market Volatility” which I posted last week. I wanted to try to make a spreadsheet to show the effects of someone who “panics” when the market goes down and then later on gets back into the market when it starts going up. Please note that I’m not referring to investors that have specific buy and sell scenarios and follow their own investment plans, but rather people who don’t really have a plan and react to events in the market.

I’ve created a spreadsheet in which I created a rather contrived example of a market that goes up 17% per year for two years and then drops 10% in the third year. This repeats over and over again for a long term return of 8.1%.

I’ve also created three types of investors:

  1. “Buy and hold” has 100% equities and never changes their portfolio.
  2. “Market panicker” has 100% equities when he/she is in the market and a high interest account paying 4% when not in the market. This investor only gets into the market when it’s doing well and sells when it’s doing poorly. When the market drops he switches all his money to a low cost money market mutual fund halfway down, then he sits in cash until the market goes up for a year and then gets back in.
  3. “Conservative buy and hold” has 65% equities and 35% cash and never changes their portfolio except to rebalance once a year.

I started all three of my investors off with $100,000.

According to my calculations:

The buy and hold investor ends up with $478,700 for a return of 8.1% which matches the market (let’s assume no fees).

The market timer investor starts off ok by participating in the first two up years but then after that he continually switches all his money to money market halfway down the crash (so he gets -3% for those years since his equities go down -5% and then he gets half a year of interest), then he sits out the first year of the up market and only get 4% when he could have gotten 17%, then he gets back in the market and enjoys the 17% the next year before the cycle repeats. As a result of this market timing he only gets 6.8% return which gives him $370,100 after 20 years.

The more conservative buy and hold investor has 65% equities and 35% cash which pays 4%. He gets 12.5% in the good years and loses 5.1% in the bad years. This person ends up with $377,600 which works out to a return of 6.9% which is slightly higher than the market timer.

In the end, the buy and hold investor who has 100% equities has an investment account which is worth 23% more than the market timer.

The point of this example is to show that you don’t need to have 100% equities to do well in the markets and that if you are going to panic every time the markets drop and then buy on the way up, you are better off picking a more conservative mix which will reduce your volatility and quite possibly improve your returns by allowing you to stick with your investment plan and stay invested.

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{ 6 comments… read them below or add one }

1 moneygardener

Other factors that matter here:

Timer:

– commissions
– the stress, and guessing game of picking points of entry and exit
– taxes incurred in a non registered portfolio when selling

Conservative:

– tempting to use cash of other facets of life
– taxes on interest gained in savings account

2 FourPillars

Very true MG – I deliberately kept this example very simple – perhaps too simple?

I guess for the purpose of simplicity I’m going to say that all three investors had their money in an rrsp or tax sheltered account. That way I can ignore the tax issues. In a taxable account, the buy and hold 100% equity investor would have an even greater advantage because they wouldn’t be paying any capital gains tax until the end.

I ignored the commissions since the trader only does his switches every year & a half so they shouldn’t be too significant.

Mike

3 Brip Blap

I try very hard to stick with a conservative buy-and-hold index funds strategy and I see no reason to think that it won’t pay out in the long run. I spent a large part of the late 80s trying to time the market and have absolutely nothing to show for it. Show me someone who timed the market and I’ll show you someone who’s lucky or a crook or both…

4 FourPillars

BB – I’ll add to that list “liar”.

I’ve met people who say they can time the market but when it comes down to opening the books and doing a proper accounting (and yes I’m willing to do this), it never happens. All I want to do is compare their trading returns to a broad-market ETF and see how much difference they make.

The reality is that even if someone can beat the market – so what? Unless they can beat it by an incredible amount or they have a huge portfolio (ie 5 mill+) it’s not worth the effort unless they really enjoy it.

Mike

5 Lon Purvis

If timing doesn’t work why was 80% of all the money ever made in the market made between Nov 1st and April 30th. Also a good return can be made by being in the market only the last 3 days of a month and the first 2 of the next month. Not perfect for sure but a lot less risk.
I realize only a few can time the market because most have made it way too complex and I have made the same mistake at times.

6 FourPillars

Lon, the problem with specific strategies such as the ones you mentioned is that they don’t last. Once other traders find out about any perceived trading advantage, it will disappear.

Mike

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