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Why Market Timing Doesn’t Matter And When Does It Costs A Fortune

Stock MarketImage Credit: Flickr

When I started Minterest back in 2006 it was a personal finance blog — and my goal was to aggregate all things personal finance. Later in 2007 I transformed the website into an internet marketing and technology blog and coined the tagline “Money, Internet, Investing”. But I never published any investing related blog posts all these years — except the Warren Buffett quotes.

Don’t Miss: 101 Hand-picked Warren Buffett Quotes On Investing

A few weeks earlier I came across an interesting blog post about market timing and it has inspired me to write my own version.

On that blog post, Dev created few charts based on three investors. First investor invested in stock market on monthly highs, the second investor invested on monthly lows, and the third investor invested on monthly averages.

Dev shows that the perfect investor (who invested on monthly lows) is not a big outperformer when compared to the one who invest on monthly highs or averages. Well, it sounded so exciting that I wanted to do its math by myself (as he didn’t include it on that blog post).

So today, my goal is not only to decode the math, but also to point out when  market timing do really matter and when it doesn’t.

First things first. What exactly is marketing timing?

Here’s what Wikipedia has to say about Market Timing:

Market timing is the strategy of making buy or sell decisions of financial assets (often stocks ) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market, rather than for a particular financial asset.

In other words, it’s all about buying stocks assuming that the market is going to climb higher. And switching to cash and cash equivalents assuming that the market is going lower.

Everybody want to buy low (lowest low) and sell high (highest high). And everybody want to exit at the peak of the current bull market and reenter at the beginning of the next bull market. Nobody like to lose. The reality? It’s impossible!

I tried, too. But failed once twice several times.

Coming back…

Here’s Why Market Timing Doesn’t Matter Long Term

I used the S&P 500 index and the CNX NIFTY index to do my math. You can apply this math virtually on any stock market index.

S&P 500, or the Standard & Poor’s 500, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

CNX Nifty, also called the Nifty 50 or simply the Nifty, is National Stock Exchange of India’s benchmark stock market index for Indian equity market.

Let’s see what would have happened if you have invested $100 every month in S&P 500 (^GSPC) at its monthly highs, lows, and closing price since 1985. Or, what would have happened if you have invested Rs. 1,000 every month in CNX Nifty 50 (^NSEI) at its monthly highs, lows, and closing price since 2000.

S&P 500

S&P 500 Market Timing


CNX Nifty Market Timing

As you can see, all the three investors (namely A, B, and C) were investing $100 in S&P 500 (or Rs. 1,000 in CNX Nifty) a month. The only difference is the market timing. “Investor A” was investing at monthly highs, “Investor B” was investing at monthly lows, and “Investor C” was investing at monthly closing price.

Now let’s say “Investor A” is the smartest and “Investor B” is the dumbest and “Investor C” is the average investor.

But you know it’s IMPOSSIBLE to buy a stock at its highest high or lowest low. It basically means that “Investor A” and “Investor B” doesn’t/can’t exist in reality. However, it’s very much possible to buy a stock at its closing price so anyone can be an average investor.

It’s very evident from the chart that there was no remarkable out performance by the smartest investor who timed the market perfectly — every single month for the past 3 decades. Again, there was no big under performance by the dumbest investor who always invested at market highs.

It’s worth to mention that to be that “smartest” or the “dumbest” investor you’ve to become an active investor who monitors the market on a daily, weekly or monthly basis and must also spend additional time for research (to time the market). But to become an “average” investor you don’t have to monitor the market on a daily basis and don’t even have to care about the purchase price.

Will It Work For Individual Stocks?

The answer is ‘Yes’ and ‘No’. Why? Well, it works when the stock is moving only in one direction — that’s “up” — in the ultra-long term. If you have picked the wrong stock(s) then nothing works.

That’s why Warren Buffett has mentioned on his recent Annual Letter to Shareholders that:

“Huge institutional investors have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.” — Warren Buffett

That said, if you picked the ‘right’ stocks then with this strategy your returns could be immensely larger than the average returns of the stock market indices.

For instance, consider the following chart. I’ve compared the stock performance of 5 computer companies — that you and I are familiar with — over the past 15 years (2000-2015). Why year 2000? Because it was the peak of the dot-com bubble.

Screen Shot 2015-07-15 at 12.39.31

As you can see from the chart (go here to see the comparison chart directly on Google Finance), even after 15 years, the stock prices of Microsoft, Yahoo, and Hewlett-Packard are way below its dot-com bubble peak.

So imagine what would have happened if you were buying it all these years. But the Dow Jones is up 58%. Meanwhile, Google (the IPO was in 2004) and Apple outperformed the main index and other stocks in a remarkable way.

The Problem With Moving Averages & P/E Multiples

“In the business world, the rearview mirror is always clearer than the windshield.” — Warren Buffett

Now I’m going to assume that you’re not an amatuer investor and you know the basic equity valuation metrics like — Simple Moving Averages (SMA), Earnings Per Share (EPS), and Price-Earnings Ratio (P/E Ratio).

Let’s say you’re a value investor and you want to buy only when the valuations look attractive. So you want to enter the market only when the index or a stock is trading at its 200-day moving average or is trading below a P/E ratio of X times.

The problem with this strategy is that the market does not move the way you want it to. It may take several years to hit the levels you want and when it doesn’t there’s a very high probability that you will miss it as there will be a lot of bad news around the market at that time and all the “investment gurus” must be giving SELL calls.

Another problem is… even if you managed to allocate 100% of your capital at the lower levels there’s  very good chance that it was not the lowest-low. And your portfolio will soon start showing red ticks over the next few days, weeks or even months.

For example, here in India the historical average P/E ratio of CNX NIFTY is around 18 times. So, let’s say an attractive level could be 15 P/E. But the last time it hit those levels was back in August, 2013 and before that it was in 2008 only.

So if the market bounced back from a P/E of 16 and you were waiting for a P/E of 15 times then you would be sitting on the sidelines for months (if not years). Again, the reverse would happen when you were fully invested at P/E of 16 and the market goes all the way to P/E of 11. Yes, it too happens — all the time.

Closing Thoughts

Every investor follows his own style of investing. I have mine and you have yours. I didn’t mean in any way that investment in equity is risk-free. Like I have already mentioned I was just curious to decode the math behind Dev’s calculation and I chose to blog it.

What you should realize is — you don’t have to be a perfect investor. Patience and discipline is everything in the world of investing. That’s why they say “time in the market is more important than timing the market.“.

One more thing… the above strategy is applicable only when you want to invest X amount of money in the market every month. It’s called a Systematic Investment Plan (SIP) — also referred to as a contractual plan or a periodic payment plan.

If you are risk-taker and is an aggressive investor then it makes more sense to invest in individual stocks than index ETFs or funds. For instance, I never invested in a Systematic Investment Plan (SIP) personally. Instead, I prefer to buy individual stocks whenever there’s a market correction and I use dollar-cost averaging to minimize losses and maximize gains. And I rarely buy more quantity when its current market price is way more than my previous purchase price. When it happens I pick another stock and repeat the same.

Note: I haven’t considered dividends (or reinvestment of dividends) while doing the math. So if you reinvest dividends as well then the returns could be more. Also, I used the data from Yahoo Finance, CNBC, and Google Finance to do all the math. Well, I tried my best to avoid all sorts of error it’s still possible. You can download the original Excel Sheets that I’ve created here. And do let me know as a comment below if you noticed an error or any information that requires more clarity.