As surely as night follows day, stock market upswings are followed by downswings. And during times of uncertainty on the JSE it is only human to be concerned about the impact thereof on the value of your investment.
Many analysts agree that investors would usually be better off if they resist the temptation to change their long-term investments simply because of short-term movements in the market. If your personal circumstances and investment objectives remain unchanged and you can maintain a medium- to long-term view, it is probably better not to do anything in times of uncertainty.
Few investors will dispute the fact that equity investments significantly outperform the return on fixed-interest investments in the long term. Investors also know that equity markets are subject to, sometimes sharp, fluctuations over the short term. In times of uncertainty it may be a temptation to consider selling existing investments and reinvesting when prices are lower. This strategy is known as “market timing”.
Market timing is an investment strategy that relies on your being able to predict the future and to know what it holds so that you can protect your capital by not getting caught in any downswings. You must also know when the market is going to turn around, so that you can exploit any new upswings.
A major issue regarding investment in unit trusts is the question of whether or not market timing works. Buying low and selling high is easier said than done. A fund applying market timing – which buys or sells depending on the direction of the market – can prevent you from losing money in down-markets, but can also result in your missing out on up-markets. A market timer must not make only one correct decision, but two: when to withdraw from and when to re-enter the market.
An analysis by Plexus Asset Management of the daily movements of the FTSE/JSE Overall Index for the period 1995 to 2006 shows that missing out on market performance for only a few days could have a significant effect on performance (dividend income was not included in the study).
The accompanying table shows that by missing the 10 worst days in terms of daily movements (fewer than one day a year), the annualised capital growth is more than 50% higher. By missing the 40 worst days (fewer than four a year), the capital growth increases nearly two and a half times.
Although market timing sounds good in theory, it seldom works in practice. Most of these large daily declines occur as a result of some political or financial shock, which usually cannot be foreseen.
The table also shows that by missing out on only the 10 best days in terms of daily movements, the capital growth declines by approximately one third. By missing out on the 40 best days there is virtually no capital growth over the 12-year period. Most of the large upswings occur when markets start rallying after the political or financial shocks.
It has been found that in practice such shocks result in an investor selling his existing investment once markets have declined sharply and that he therefore does not miss the major downswings. On the other hand, the investor only invests once prices have risen sharply, and he therefore also misses out on the major upswings.
Most academics scorn market timing. Research conducted by Brinson, Singer and Beebower (1991) in the USA found that market timing contributed only 1,8% to the variance in equity returns compared with the 91,5% contributed by asset allocation and the 4,6% by share selection. Another American study by Sharpe (1992) also concluded that active management contributed only 10% to the variance in equity returns, whereas the rest could be ascribed to style factors.
Another approach is to disregard the risks of market timing and to ask how great the benefits would have been if an investor’s timing had been right. Plexus Asset Management’s researchers therefore also looked at the hypothetical situation of three people who decided 12 years ago to invest a fixed amount every year.
Person A was extremely lucky and annually invested at a market low, as determined by the JSE Overall Index. However, person B was unlucky and annually invested at a market high. Person C invested on a ‘random’ date every year, in this case 31 January.
The compound capital growth earned by person A over the period was 12,1% per annum, while in the case of person B it amounted to 9,0% per annum. Person C achieved capital growth of 10,8% per annum.
It is not surprising that an investment made at a market low achieved a better return than an investment made at a market high, but the difference in return between the high and the low was less than expected.
Although there are times when you should be more heavily invested, the risk of underperformance increases considerably if you are continually withdrawing from and returning to the market.
Investors who buy and hold have the best chance of being successful. Those who apply market timing run the risk of holding cash during a bull market. Remember, time, and not timing, is the key to successful investment.
DIFFERENCE IN CAPITAL GROWTH IF YOU MISS A FEW DAYS
Strategy Capital growth (p.a.)
Always fully invested 13.8%
Misses 10 worst days 21.0%
Misses 20 worst days 25.3%
Misses 30 worst days 29.1%
Misses 40 worst days 32.5%
Misses out on 10 best days 9.0%
Misses out on 20 best days 5.6%
Misses out on 30 best days 2.9%
Misses out on 40 best days 0.5%
Source: Plexus Asset Management