Over the past month, we looked at how you would have fared if you were an uncanny stock picker who consistently beat the market by 30 per cent or so (So you're the world's greatest trader? Taxes will fix that and No matter what, the long-term investor comes out ahead of the short-term trader).
As it turns out, capital gains taxes and other expenses take a giant bite. Even a very successful active trader barely keeps up with the long-term passive indexer.
This week, we consider: What if you were the World's Greatest Market Timer?
Imagine: You, the individual investor, have an uncanny skill at timing markets and picking the lows. Your prescience allows you to buy near the bottom of every major crash.
Anytime the market has a substantial drop, you manage to make a purchase of broad indexes at advantageous prices. Similar to the World's Greatest Trader, you set up an online account, and then you are off to the races, timing markets with the best of them.
How would you imagine a trader with these skills would do?
Before I share the answer with you, a few words about the genesis of this idea. Gaspar Fierro, a reader in Spain with whom I have been exchanging emails, sent along a spreadsheet. It purported to show the results of our thought experiment. Fierro was following up on a different thought experiment run by Ben Carlson: What if you were the world's worst market timer, and you only bought stocks just before major crashes?
Carlson's terrible timer made purchases at the highs before huge drops. Starting in 1970, his unlucky investor saved $2,000 per year to be invested at market peaks. He raised his annual savings by $2,000 per decade (i.e., $4,000 a year in the 1980s, $6,000 in the 1990s, etc.) as his salary increased over time. He planned on retiring at age 65 at the end of 2013.
Our trader, the World's Greatest Market Timer, only buys when indexes are trading at 52-week lows (assuming they are 17 per cent below the last purchase).
Similar resultsThe results of these two thought experiments might surprise you. Our market timer did very well, as you would imagine someone buying near lows would.
But when we compare the trader trying to bottom-tick markets against someone who was dollar-cost averaging into the same broad indexes, the results were pretty close, on a percentage basis. In much of the world, the timer edges out the dollar-cost averager. In the US markets and Greece (?!), our diligent averager actually comes out slightly ahead.
Also surprising: Carlson's top-ticking worst timer of all time did pretty much OK. The results will vary somewhat based on which global index we used, but overall they were surprising - not all that incomparable. One would imagine that only catching the lows would create a huge performance advantage versus the ordinary dollar-cost indexer. I bet many of you assumed buying only at the highs would create losses.
The actual results differed from expectations due to the long timelines involved and the power of compounding. Let's take a look at how these three approaches differ, and why the results were not as expected.
World's greatest timerLet's start with the world's greatest timer. Fierro noted that he did not expect these results. "I had always thought that if someone was able to buy near lows continually, then that person would have spectacular returns that would beat almost any investment strategy." As it turns out, that is not what occurs.
The reason? It's what happens when gains accumulate on top of gains (in other words: compounding). It is an urban legend that Albert Einstein once said, "Compound interest is the most powerful force in the universe." He never made that statement, but there is truth in it.
For proof of the power of compounding, just look at your mortgage. On a 30-year loan at a mere 5 per cent rate, when that interest is compounded over time (i.e., you are paying interest on the interest you owe), a $500,000 loan costs you nearly $1 million ($966,279.60, to be exact).
When you consider that market returns average almost double that 5 per cent rate over 30 years, you can understand the power of compounding. In the case of equities, you are compounding gains on gains, instead of interest on interest, but the principle remains the same.
CompoundingThe world's best timer misses out on the advantages of compounding. Buying only at the lows means that there are going to be long stretches when he is not making buys. Consider the past five years: Buys were made in March 2009, followed by subsequent purchases in July 2010 and October 2011.
Meanwhile, the world's worst timer also misses out on many of the advantages of compounding. Carlson's terrible timer makes four purchases over his investing career: December 1972, August 1987, December 1999 and October 2007. Each of these buys is followed by a crash where his investments lose between a third and half of their value.
These include Black Monday in 1987, the dot-com collapse in 2000 and the financial crisis of 2007-2009. But given the long time horizon, the returns are much better than you might guess. As his blog post shows, the terrible timer invested $184,000 in those four slugs, and that portfolio becomes worth $1.1 million. Not too bad for someone who is such a terrible timer.
Long-term thinkingThe takeaway? Carlson states a clear lesson for investors: "Short-term moves in and out of the market don't matter nearly as much if you have a long-time horizon. Thinking long-term increases your probability for success in the stock market while the day-to-day noise gets drowned out by discipline and compound interest."
What of an ordinary investor who is a dollar-cost averager into broad indexes? He has a huge advantage over the world's best market timer, in that he really exists. What he does is possible. The perfect market timer does not and cannot exist. There is no crystal ball or a magic formula that allows for perfect market timing.
Instead, our dollar-cost averager simply makes regular contributions to his portfolio. It is a simple, powerful strategy that requires no special prescience into the future, and is a formula that actually exists.
The takeaway is that people who sit out for long stretches while waiting for the perfect entry point into the markets are giving up their single most precious asset: Time.
MillenialsOne last thought on this: The demographic group with the longest investing time horizon are the millennials now in their 20s. According to Patrick O'Shaughnessy, author of Millennial Money: How Young Investors Can Build a Fortune, despite their long timeline, members of that generation seem to be missing out. They are significantly underinvested relative to how much time they have until retirement.
Given the dramatic financial crisis of 2007-2009, O'Shaughnessy says it is no surprise that millennials as a group "don't trust Wall Street." They also rank "all four major banks among most hated brands."
"The most basic (and important) decision you make as an investor is your allocation between major asset classes - primarily stocks, bonds and cash." O'Shaughnessy observes that this cohort is wildly underweighted in equities at 28 per cent and overweighted in cash at an astounding 52 per cent.
Perhaps it is ironic: The group that has the longest potential runway for absorbing market volatility also seems to be the least interested in investing in stocks.
When it's time to retire, these folks might be surprised that they cannot go back to live in their parents' basements again.
- Washington Post