WHEN you look back over the history of sharemarket crashes there is one recurring theme that emerges.
Sadly it shows that as investors we are lousy at timing markets. When you track inflows into managed funds they typically peak after a strong performance run and the outflows – when investors are rushing for the exits and cashing out also prove to be a good indicator of when markets have bottomed out.
We will have to wait for the data analysis to see if this holds true during the most recent financial crisis but we can look at various scenarios to see the impact two different strategies would have had.
The seductive appeal of market timing is that if you sell out of an investment as a market peaks and then buy in when it bottoms out you will maximise your return.
That is the theory. In practice seasoned investment professionals – who’s job it is to research and understand investing markets - regularly fail those timing tests.
The simple fact is human beings have not mastered the art of reliably predicting the future and that is often compounded by our psychological makeup that drives our behaviour as investors.
Consider the case of two investors. Both invest $10,000 in the Australian sharemarket index on 1 July 1970.
By the time the market peaked on Thursday 1 November 2007 that $10,000 investment had grown to $728,021 – before fees and taxes*. That is the return of the Australian sharemarket measured by the S&P/ASX200 accumulation index with dividends reinvested.
The dramatic impact of the global financial crisis is starkly illustrated by that fact that when the market bottomed on March 6 this year the investment had shrunk to $353,820 – down some 51% from the high
For one investor the point of capitulation was reached at the end of January this year. And certainly things looked grim for both the Australian sharemarkets and the global economy in general in January. Recession or depression was the key question of the day.
Now the good news for the investor who threw in the towel at the end of January is that they would have avoided a further $35,000 in paper losses compared to their alter ego who stayed fully invested.
But the short-term comfort that being in cash provided proved to be short-lived.
If they were still out of the market on 30 September they were $161,000 poorer than if they had stayed invested throughout.
On the other hand if they timed the market to perfection and reinvested on 6 March they would have had a portfolio value of $606,000 – some $55,000 better off than the person who rode out the market downturn.
This really highlights the fundamental challenge of trying to time markets – it is not one but two decisions. And the re-entry point can often prove more elusive than people expect at the time of exit. Look back on your calendar at 6 March – chances are that there is no reminder or note to self that that was the day the sharemarket hit bottom.
With the glorious benefit of hindsight - which tends to aid rational as opposed to emotional behavior - consider what you would have done in the same situation. By selling out of the market at the end of January you avoid further paper losses of $35,000. But if you miss the upswing and were still parked in cash at the end of September you are $161,000 worse off.
The value of the original $10,000 invested in the index back in July 1970 had recovered to be $550,820 on Wednesday 30 September. That is still a long way down on the market peak but certainly reassuring for an investor with a reasonable time horizon.
So if market timing is a fool’s game for investors and advisers are we all condemned to riding out dramatic market rises and falls? Not entirely but neither can you remove all risk either. It is about taking a portfolio approach and not chasing return and ignoring risk.
Diversification across asset classes helps manage the risk - for example if the investors above had put 50% of the portfolio in bonds over that period it would have dramatically lowered the volatility. Property – at least in Australia - has also proved to be a great anchor for individuals’ wealth.
The classic choice investors face is the tradeoff between potential return and risk.
Some things are firmly within our control like the asset allocation decision, the costs we pay and how we rebalance the portfolio over time.
Trying to time markets on the other hand is a simple roll of the dice.
To download a copy of Vanguard 2009 Index Chart click here [http://www.vanguard.com.au/personal_investors/knowledge-centre/index-chart2009.cfm]
* Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia. To receive this column by email each week go to www.vanguard.com.au and register with smart investing.
Update your news preferences and get the latest news delivered to your inbox.