The challenge with market timing

For those people who are not satisfied with the average sharemarket return, there are two main decisions in looking for extra returns – chasing returns from selecting shares that provide a higher than market average return (share picking) or chasing extra returns that come from picking and choosing when to be exposed to the market (market timing).

Dalbar are a financial services firm in the USA who provide a research report that looks at how well investors perform as ‘market timers’, and the report to the end of 2018 is of particular interest, as it considers the market timing ability in a year when the USA market, as measured by the S&P500, was down 4.38 per cent.

A lot of investors justify market timing activity by assuming that they create value in their market timing decisions when markets are down.

The Dalbar study, which works out the average sharemarket investor return by looking at the movement of money into and out of managed funds, found that the in a year when the average sharemarket was down 4.38 per cent, the average sharemarket investor saw a loss of 9.42 per cent. This is a significant difference, and is worth looking into further – just why did the average investor lag the market by so much?

The commentary Dalbar provided with the report points to an interesting challenge for investors. While investors made what was a reasonable decision to reduce their share investments over the year as a whole, there did not seem to be any ability to be out of the market for the worse months, and then back in for the better months.

October was a particularly poor month with returns of negative 6.84 per cent, however, the average return experienced by investors was negative 7.97 per cent. In the better month of August, where market returns were a strong 3.26 per cent, the average sharemarket investor only captured a return of 1.8 per cent. The average investor withdrew money every time there was a positive month.

This is the challenge with any market timing decision; if you are out of the market when the market rebounds, you can miss out on significant returns. The challenge is compounded by the fact that it is often much harder to buy when markets are down, because the headlines and sentiment at that time will tend to be negative.

The longer-term results from the Dalbar study are interesting – over the 20 years to the end of December 2018, the average market return in the USA was 5.62 per cent per annum; a period of below-average returns that included the global financial crisis and finished with a negative year. Surely the market timing possibilities for an investor were tremendous over this period? What if they had missed most of the 2007 to 2009 downturn? What if they then bought low and held during the recovery? And, if they were out of the market in 2018 they would have been up again.

In reality, however, the average investor did not have a happy experience during this time, with Dalbar calculating the average investor in shares enjoyed a return of just 3.88 per cent over this period. Over a slightly longer period of 30 years (to the end of December 2018), the market return was a more attractive 9.97 per cent per annum, which would have turned $10,000 invested at that rate for 30 years into just over $160,000. The average share fund investor, however, received a return of 4.09 per cent per year, turning their $10,000 into a much more modest $32,400.

When it comes to marketing timing evidence, we have an interesting example here in Australia, around the data on margin loans reported by the RBA. And, as an example of market timing, the evidence suggests that the average margin loan investor is also poor at timing. When markets were at their historical highs in 2007, which we now know was the worse time to be investing in shares in the past 30 years, margin lending peaked at $41 billion when the Australian sharemarket was around 6800 points (about where it is back to now, 12 years later). By February 2009, when markets hit their bottom around the low 300’s and what we now know was a great time to be buying shares, the value of margin loans had more than halved to just over $20 billion.

My personal opinion is supported by the evidence here, that it is a tough thing to have some ‘information advantage’ over other people that allows investors to be able to time their investment decisions. As much as the Warren Buffett investment adage of, ‘being fearful when others are greedy, and greedy when others are fearful’ is easy to say, it is challenging to do.

Over the 10 years to the end of August 2019, the average total return on the Australian sharemarket (capital growth and dividends excluding franking credits) has been 8.53 per cent per annum and over 20 years 8.72 per cent per annum. That means that over 10 years, $10,000 invested through the period would have turned into $22,670 in a fund that matched the average market return. Over 20 years the $10,000 would have turned into just over $52,300.

As others have observed, the power of the sharemarket as a compounding machine is powerful, and being out of the market for periods of time because of market timing decisions creates a chance the possibility of missing out on returns, particularly as markets recover.