Market Timing – Worthwhile?

Time and again, there has been a debate whether market timing works. Market timing is termed as predicting the future direction of the stock market by using technical charts and economic data.

There is one camp that believes that investors can move in and out of the stock market and by doing so, maximize their returns. They do this by using moving averages and support and resistance lines on the charts, amongst others. While this might work sometimes, at other times, these investors might miss the sudden gains that the stock market makes out of nowhere. This was the case in March 2009 where the stock market suddenly sprang off its lows and never looked back.

The other camp believes that market timing is futile predicting the direction of the stock market. There are numerous studies showing that being out of the market during only a few of the best days or months can ruin a portfolio’s long-term returns. Here are some of them:

• Had you put $1,000 in the S&P 500 at the end of 1981, your stake would have grown to $25,584 (including reinvested dividends) by the end of 1998. But if you had missed the 30 best days (defined as the days with the highest percentage gain) of those 4,400 trading days, you would have ended up with $4,549, 82% less. (Source: Dow 100,000: Fact or Fiction.)

• Consider three people who each invested $1,000 per year in the S&P 500 Index from 1965 to 1995. Investor A bought on the first day of each year, Investor B — the world’s best market timer — bought at the lowest price each year, and unlucky Investor C bought at the market’s peak each year. Here are the results:
• Investor A (invests on first day of the year): 11.0%
• Investor B (invests at market nadir each year): 11.7%
• Investor C (invests at market peak each year): 10.6%
• As you can see, the differences among the compound annual returns earned by each investor are small. (Source: Peter Lynch, Fidelity Investments brochure, “Key Things Every Investor Should Know.”)

Some of the astute minds of the investing world like Warren Buffett and Peter Lynch are certainly against market timing. Here are some quotes by them:

Warren Buffett -

• “The only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”
• “We continue to make more money when snoring than when active.”

Peter Lynch -

• “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”­
• “I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
• “I don’t believe in predicting markets. I believe in buying great companies — especially companies that are undervalued and/or underappreciated…. Pick the right stocks and the market will take care of itself.”

I also read a research paper called “Black Swans and Market Timing: How Not To Generate Alpha” by Javier Estrada (right-click and “Save link as…”). In it, there’s ample evidence showing why market timing is pointless. I shall quote some information from there:

• The evidence, based on more than 160,000 daily returns from 15 international equity markets, is clear: Outliers have a massive impact on long-term performance. On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represent, in the average market, less than 0.1% of the days considered, the odds against successful market timing are staggering. Hence, of the countless strategies that academics and practitioners have devised to generate alpha, market timing does not seem to be the one most likely to succeed.

• A very small number of days account for the bulk of returns delivered by equity markets. Investors do not obtain their long-term returns smoothly and steadily over time but largely as a result of booms and busts. Being invested on the good days and not invested on the bad days is key to long-term performance. But the odds of successfully predicting the days to be in and out of the markets are, unfortunately, close to negligible.

I feel market timing is not worth an investor’s effort as seen from the examples, researches and quotes above. I, too, have been guilty of market timing recently and I can strongly concur that market timing doesn’t work (at least for me)! I have learnt to just add on to my positions whenever there’s a significant dip in price. However, if my stock doesn’t move much, I will gladly hold on to my stock amid a financial meltdown and cash in on the dividends!

Investments risky? Saving in a bank is “riskier”

Last week, I was watching a drama show on TV and in a particular scene, the husband and wife were talking about investments. The husband said his friend is making $10,000 a month on top of his regular office hours job. He said his friend asked him to invest with him. The problem was that the capital needed would be $50,000. The husband said that the investment involves stocks. The husband suggested that he put in 50% of the capital and his wife, the other 50%. Upon hearing this and the insurmountable capital needed, the wife got astonished and was strongly against the idea of investing such a huge sum in stocks. She reasoned out that stocks are extremely risky, stocks are equivalent to gambling, she doesn’t have enough capital and she would not allow her husband to invest $50,000 in such a venture. The young couple has a pre-school daughter as well.

This whole scene perplexed me. What intrigued me the most was that the wife said stocks are risky and they are the same as gambling. Since they have a kid, they certainly have to finance for her needs as well. So, doing proper investment is one of the way to grow money.After the show was over, I asked my Mom how do the layman finance their personal needs, for example, for kids’ education, house, car, etc if they view investments as risky. My Mom replied that most do not really know how to invest and view investments as risky. They rather sock cash away in the bank as it’s “safer”.

My take on this whole drama scene is that saving money in a bank is actually “riskier” than doing prudent investments. By just saving money in a bank, inflation will be eating our money away. The average historical inflation is around 3% per year. Thus, our money is being eaten away at 3% yearly.

Warren Buffett once affirmed that risk comes from not knowing what you’re doing. Lack of knowledge promotes risk. So, since many do not know that $50k today is not worth $50k tomorrow, just saving money in a bank is “riskier”. We should educate ourselves by reading books on personal finance and look for alternative prudent investments that will allow our money to grow. Investments are certainly not risky if you know what you are doing.

What are your thoughts on this issue?

3 Essential Things for a Meaningful Kitty

Many of us want to retire comfortably, retire rich and retire without having to worry about money anymore. For a meaningful retirement, we must have a substantial amount of money to tide us through our retirement years. Even for short-term goals such as to finance a house, finance your child’s education or to finance a new care, we need to have enough moolah. For wealth accumulation to take place, three things are paramount. They are:

• Investing as long as possible (time)
• Amount invested and to be invested in the future ($)
• Investing in instruments that give a substantial yield (returns on investment or ROI)

All three elements must be fulfilled before we can reach our financial goal. We will look at each element in detail below.

Time

The earlier we start investing, the better our returns can be due to the effect of compounding. Albert Einstein once said that compound interest in the eighth wonder of the world. Compounding allows our money to increase exponentially for the long-term. This can be seen from the graph below. By compounding, the graph shoots to infinity towards the later part of the investing timeline, although gains are minimal at the start. Thus, a young investor in his twenties will have more time to compound his money over a person in his forties who just starts investing.

Image courtesy of http://www.tvmcalcs.com/tvm/lumpsums_fv

Money

To start investing, we need capital. This can come from your savings mainly. As working adults, we should aim to save at least 10% of our monthly salary and we can slowly increase this percentage as our income increases. Without savings to start with, one cannot make more money by investing in the stock market.

Yield

Leaving money in the bank yields less than 1% in current market situations. Couple that with raging inflation that is around 5% currently, we are getting negative returns on our money. This makes the case for investing much stronger. The general stock market has yielded around 9-10% historically. By investing in fundamentally strong companies, your returns can be higher. However, don’t be cheated by claims cited by certain investment companies that can give u phenomenal 50% returns per annum. If it’s too good to be true, it probably is.

Below is a table with three different scenarios to illustrate my points above.

If you want to play around with the various figures to suit your financial life, you can visit the online “Compound Interest Calculator”.

To use the calculator,

1. Key in the current amount that you have currently invested under “Current Principal”. If you don’t have any money invested currently, type in “zero”.

2. Key in the amount you will invest yearly (take note: not monthly). For example, if you are going to invest $200 monthly, key in “2400″.

3. Key in the number of years you plan to invest.

4. Key in the yield of the instrument. You can key in 9% as that’s the historical stock market return.

5. Key in “1″ in the next row.

6. Select “end of compounding period” in the following row and click “Calculate”. You can see the future value (how much you will have at the end of your investing period).

Happy compounding!

The Famous Marshmallow Experiment

The Stanford Marshmallow Experiment conducted in 1972 was a study on delayed gratification and is regarded as one of the most successful behavioural experiments. In the experiment, a marshmallow was offered to each child. If the child could resist eating the marshmallow, he was promised two the next round. Experimenters then analyzed how long each child resisted the temptation of eating the marshmallow and whether doing so had an effect on their future success. The experimenters followed each child into adolescence and adulthood.

The results were astonishing. The kids who could resist the temptation scored higher in tests, had stronger relationships and were promoted more often. They were also generally happier as adults. How is this experiment related to being financially independent? Delay gratification by not being tempted to buy the latest gadgets. Doing so allows one to save enough money to invest. By prudent investing, one can reap the benefits in the future. Time is an investor’s best friend so delaying gratification buys time and allows compounding to take place.

Stock market returns

Investing in the stock market provides good returns for the long-term compared to other instrument vehicles. Looking at the table below, we can compare the returns across different asset classes.

(Source: http://www.neilsberman.com/pdf/News_Average_Annual_Rate_of_Return_for_Gold_Bullion.pdf)

The average return of the stock market from 1871 to 2010 was 10.62%. You can visit http://www.moneychimp.com/features/market_cagr.htm to calculate the average returns according to different time frames.

Investing for the short-term (eg. 1 year) brings about lots of volatility in the returns. The returns will be up one year and down the next. This can be emotionally draining to an investor. However, investing for a very long-term (eg. 30 years) smoothens out the returns and provides around 10-15% annual returns as seen from the graphs below.

(Source: http://www.getrichslowly.org/blog/2008/12/16/how-much-does-the-stock-market-actually-return/)

For a video discussion of the graphs above, look at the video below:

In the book, “The Random Walk Guide to Investing” by Burton Malkiel, it is stated that, “It turns out that the longer you hold your stocks, the more you can reduce the risk you assume from investing in common stocks. From 1950 through 2002, common stocks provided investors with an average annual return of a bit more than 10 percent. Even during the worst 25-year period you would have earned a rate of return of almost 8 percent — a quite generous return and one that was larger than the long-run average return from relatively safe bonds. This is why stocks are a wholly appropriate medium for investing in long-term retirement funds.”

In another book, “Yes you can.. Achieve Financial Independence” by James Stowers, it says “[A $10,000] investment made on 01 July 1932 would have realized, one year later, the worst one-year result out of 425 [periods tested]: minus 69%. Most people, if they had experienced those poor results, would have assumed that this was an indication of future performance and would have become discouraged. Many would have traded their investment back for dollars and tried to find another place to invest their money. Had they had confidence in the long-term opportunities of the Dow and left their investment undisturbed for another 29 years (30 years total), it would have been worth $556,563. The original investment, which began with the worst one-year result, grew at an average annual compound rate of 14.34% (the best 30-year result). As you can see, it is unwise to assume that short-term investment results are an accurate indication of long-term performance”.

The graph below shows how the DOW has risen over time from 1901 to 2010 despite numerous economic busts. Remember, during a economic bust, the world doesn’t come to an end and that this too shall pass.

(Source: http://observationsandnotes.blogspot.com/2008/10/100-years-of-stock-market-history.html)

We saw how the stock market gives an average return of around 10% for the long-term. The average returns would, of course, have been better if you invested during a stock market crash. Look at the table below for S&P 500 returns during and after recessions.

Recessions	# of months	During R	1 year	3 year	10 year
Jul 1953 – May 1954	10	17.94%	25%	100%	179%
Aug 1957 – Apr1958	8	-3.94%	6%	26%	107%
Apri1960 – Feb 1961	10	16.68%	20%	28%	50%
Dec 1969 – Nov 1970	12	-5.28%	0%	28%	17%
Nov 1973 – Mar 1975	16	-13.13%	-27%	6%	73%
Jan 1980 – Jul 1980	6	6.58%	13%	27%	188%
Jul 1981 – Nov 1982	16	5.81%	-18%	15%	196%
Jul 1990 – Mar 1991	8	5.35%	9%	26%	302%
Mar 2001 – Nov 2001	8	-1.80%	-1%	-3%
Average	10	3.14%	2.95%	28.20%	139.16%

(Source: http://investment-fiduciary.com/2008/01/25/recession-and-stock-market-performance/)

The table below shows the frequencies of market declines of various magnitudes.

Magnitude of market decline	Frequency of occurrence
>5%	3 times a year
>10%	Once a year
>20%	Once every three and a half years
>30%	Once every ten years
>40%	Once every twenty-five years
>50%	Once every fifty years

(Source: http://investment-fiduciary.com/2011/08/05/how-often-do-market-corrections-happen/)

Currently, the market is down around 10% and this is common as it happens once every year. The trick is not to panic but to invest more during a correction or crash to get better returns when the market recovers. What goes down, must go up (only holds true for the overall market and not for all stocks).

To get average returns of 10% for long-term, one can invest in index funds such as exchange-traded funds that tracks the overall market. SDPR S&P 500 (ticker symbol: SPY) tracks the S&P 500 index of the US. You can also invest in the STI market by purchasing the STI ETF traded on the Singapore Exchange.

To get better than market returns, one can always invest in fundamentally strong companies with wide economic moat, excellent ROE, low debt and with excellent free cash flow generation. You can look at my blog posts on this by clicking on the “Value Investing” tag on the right.

We must also remember not to invest during market euphoria. This is the period when the market is peaking. It is definitely hard to predict when a market will peak. However, when P/E ratios are astronomical and when everyone is talking about how easy it is to make money from the stock market, it’s almost time that the party is going to end. Be fearful when others turn greedy.

In conclusion, investing in the stock market for the long-term would give an average return of around 10-15% and the returns are almost guaranteed as seen from above. The problem is that fear and greed takes over at times and investors tend to cash out when there’s panic. The trick is to always stay invested and buy more when prices go down.

Golden Cross and Death Cross

I came across an article in this week’s The Edge magazine. The article touched on the technicals of the STI and I learnt about predication of long-term trends with the 50-day moving average and the 200-day moving average from the article.

When the 50-day moving average crosses above the 200-day moving average, a ‘golden cross’ is formed. This is a bullish signal for the long-term and the long-term trend is up.

However, when the 50-day moving average crosses below the 200-day moving average, a ‘death cross’ is formed. This is a bearish signal for the long-term and the long-term trend is down.

How can an investor use these signals? He can liquidate his positions when the death cross is formed and enter the market once again when the golden cross is formed.

I back-tested this strategy and I found that it’s quite reliably predicts the trend with extremely low occurrences of fakeouts. This can be seen from the chart below. A death cross was formed around early Jan 2008 and a golden cross was formed around mid-May 2009. Everyone knows it’s difficult to sell at a market top and buy at a market bottom. At least, with the signals, an investor could have cashed out before the market sell-off in 2008 and re-entered the market after the market bottomed in March 2009.