Timing vs Time In

Old hands often say that time in the market is more important than timing the market. Nic Oldert crunches some numbers to test the truth.

FEAR AND GREED DRIVE equity markets. When markets are bullish investors overestimate future growth and disregard warning signals. When markets turn bearish, investors panic and drive stock prices down.

Market volatility creates opportunities for buying low and selling high. Back-testing exercises often give the impression that fabulous profits can be made if you buy in troughs and sell when the market peaks. But seasoned investors and asset managers know how hard this is in practice. Hindsight is easy; making calls today, with real money, when the future is unknown, is a whole different ball of wax.

Buy-And-Hold

The alternative to trading is the old buy-and-hold strategy, much maligned when the market falls. Traders are very quick to mock long-term investors when favoured blue chips are in decline; investors feel smug when they see traders getting caught in bear squeezes.

The argument for buy-and-hold is that markets always recover and that equities reliably beat other asset classes when it comes to long-term rates of return.

Even though we know this is true, it's small comfort when our investments are wallowing in the mud. Doubts arise. How long before equities recover? What is the worst-case scenario?

To assess buy-and-hold one needs more than a few long-term numbers. Even for long-term investors, entry and exit points can have a dramatic impact on rates of return.

For example, in spite of the JSE's poor performance since 2014, an investment of R1m into the Top40 after the financial crisis of 2008 has grown to R3.5m since March 2009. But the same investment made before the 2008 crash has grown to only R2.3m, a difference of R1.2m.

what are the prospects for the buy-and-hold investor if your entry and exit points are random?

The question we wanted answer was: what are the prospects for the buy-and-hold investor if your entry and exit points are random? This equates to various real-world scenarios where, for example, your entry point is a function of cash flow (you inherit money, you decide it's best to get into the market even though it's high) and, for reasons beyond your control, you can't pick an optimal time to get out.

To test this, we looked at trailing 12 month returns over holding periods from one year to 10 years going to back to March 1996.

It's hard to say if this timeframe is indicative of the stock market in general, but it's certainly not an auspicious period. It includes the major correction of 1998 and the crash of 2008. The period also starts with a long broad sideways market that saw very little overall performance between April 1996 and May 2003. It ends, of course, with the sideways whipsawing market we've had since 2014.

Overall, the results support the argument for buy-and-hold. There was a 95% chance of a positive return across all 2150 periods (that is, only a 5% chance of ending up with a capital loss). Even if we restrict the periods to five years and less (1225 periods), you still had a 90% chance of a positive return.

Perhaps more importantly, all negative returns were for periods of three years or less. The analysis supports the standard disclaimer used by equity unit trusts which advises investment periods of at least three years.

As long as you held for more than three years, you at least preserved your capital. For periods of more than five years, the worst case scenario was a return of 5% per annum. To put it differently, over the 23 years analysed, your odds of a negative return were zero if you were able to delay your exit for a few years. This highlights the importance of investing only unencumbered assets in the equity market.

If you're only going to get 5% per annum, sceptics might ask, why bother with equities? Risk-free investments offer the same or better. The answer is that with equities there is upside. Over the last 23 years, given a medium-term to long-term investment, 5% p.a. was the lowest return you were going to get in equities; in a savings account it was the best you were going to get.

A few other salient points from the data:

Over all periods, there was a 47% chance of a return of 15% p.a. or better, and almost a 75% chance of 10% p.a. or better.
There was a 90% chance of 5% p.a. or better (including holding periods of only one, two and three years).
There was a 22% chance of getting a return of 20% p.a. or better.

Conclusion

The numbers suggest that time in the market pays off, especially if you can delay your exit point until the market is bullish.

Of course, this is only half the question.

It's difficult to evaluate "timing the market" because it's entirely a function of trading skill. Back-testing usually bears little resemblance to what people achieve in reality.

The major study by Barber and Odean, published in 2011, found that individual traders typically fare quite badly. The researchers found that "security selection skill among individuals is rare (ie, confined to a relatively small group of stocks or individuals)." They also found that "even the best stock pickers have trouble covering transaction costs."

The same study also found that individual investors – even those with a long view – generally underperform professional fund managers.

In short, unless you're one of those unusually talented investors, buy-and-hold in good funds is a better bet than trading.

But maybe the answer is somewhere in between. Buying when the market is cheap (ie, after major corrections) makes a huge difference to returns. The best 10 year return was 24% p.a., the worst was 8.5% p.a. – that's a total return of R8.6m vs R2.2m on a R1m investment. All it takes to get superior returns, perhaps, is the patience to wait for market dips before buying into your favourite unit trust of ETF.