An investment strategy that consistently sells a stock before it peaks and buys after the market reaches its lowest point is the Holy Grail for investors. The idea of timing the market appeals to our inner competitive streak, but there can be huge financial consequences if an investor gets that timing even slightly wrong.
If we look at the equity market, the average return produced by the MSCI World index between January 1990 and March 2016 is 5.6% per year, whilst the S&P Index produced a gain of 8.7% in the same period. Looking at the markets where MoneyFarm operates for the same period, the UK’s FTSE 100 index and the Italian FTSEMIB delivered 6.5% and 0.8% respectively (although FTSEMIB time series starts from 1997). Some might argue that these numbers are not what you would expect from an equity investment but the total returns delivered over the same period are attractive; the MSCI World and S&P 500 delivered 371% and 917% respectively.
Comparing the annualised return with the average inflation over the same period will show us the ‘real’ return (nominal return minus inflation). Given the first two indices are in US Dollars we will use the US inflation (CPI Index) for the calculation. The average inflation in the US is 2.5% per year over the reference period, the total annualised real return for MSCI World and S&P is 3.1% and 6.2% respectively.
Despite this drop, holding equity is still better than holding money in cash products. Using the Barclays 3 month LIBOR Cash index, an individual could have earned around 2.3% over the same period using a cash/short term US dollar saving account. When inflation is taken into consideration wealth that has been kept in cash has actually decreased by 0.2% a year.
If we look at the JP Morgan Global Aggregate Bond index from January 1990 to March 2016, the annualised return was 5.8%, an investor would have pocketed 390% over that period, which again is not bad even when inflation is detracted from the annualised figure. The RJ/CRB commodities index produced a 4.3% gain from January 1994 to March 2016, or 167% in terms of total return. Adjusting for US inflation, commodities also provided positive real returns over the long term.1
If the best 10 days in all indices are excluded we have a very different picture.
The annualised return for the MSCI World would have been 3.5%, 2.1% less than the buy and hold strategy, a remarkable difference for one year investment returns. Focussing on the country indices, S&P, FTSE100 and FTSEMIB would have produced 6.1%, 4%, and -3.6%, respectively. In the bond and commodity space, the JP Morgan Bond index and the RJ/CRB index produced annualised returns of 5.1% and 2.1% respectively.
The attempt to optimise market timing across the asset classes had a huge impact on the returns. The cost implications for trading would have a further impact on the real returns, particularly in the bond space where the bid-ask spread (cost of buying and selling) has been wider in previous years than it is today.
Academics show that most active retail and institutional traders lose money in the long run because adopting a market timing strategy is very similar to gambling in a casino. The chance of being right is around 50%, but that 50% is eroded by trading costs especially if this is multiplied.
Some individuals manage to time the market well, but there are some big questions investors should ask themselves before trying to time the market:
- Do I have access to people who can time the market?
- Do I really think I can time the markets consistently given my skill set?
- Can I cope with the stress of market timing?
- Do I have the time needed for this activity?
Long-term macroeconomic trends, diversification and robust risk management help investors achieve sustainable long-term returns without targeting market timing. There are 3 key pillars that should underpin an investment strategy:
- Understand the long-term expected returns across asset classes, academic research makes it easier to predict 5-10 years returns than it does for returns over a few months.
- Ensure you have diversification in your portfolio to optimise market relationships and achieve better risk adjusted returns, potentially through a buy and hold strategy.
- Ensure you preserve capital in difficult market conditions to ensure you have balanced returns.
1 We have assumed a buy and hold investment strategy which does not incur any transaction costs, such costs are going to erode wealth in all the investments we mention.