Investors who try to time the market may be indulging in an exercise that may be only mildly rewarding at best, and futile at worst.
There are two ways of making money in the stock market. One, buy and hold superior companies that compound their earnings, and stock prices, over time. Two, buy stocks or an index when you think they are low and exit when they are high.
Now, there are several techniques outlined by successful investors to create wealth using either of the two methods.
But a far higher number of investors focus on the second technique compared to the first – the former requires patience, which many investors do not have. But the latter strategy, enticing as it sounds, is difficult to practise. In fact, as you will know by the example below, it may not particularly be worth the effort.
Assume we are talking about two investors who have an uncanny ability to time the market. Investor 1 is the smartest in the market (Mr Chatur) who is able to successfully, year after year, buy stocks at the lowest point of the year. Investor 2 is his dumb counterpart (Mr Bhola), who manages to always buy at the highest point of the year, year after year.
Assume also that they keep investing Rs 1 lakh every year at the respective high and low points of the year, by investing the money in a portfolio that resembles the Sensex index.
Now, let’s take a look how both investors would have fared if they had managed to achieve their respective feats of timing the market’s high and low and invested Rs 1 lakh annually since 1986.
Mr Chatur, being the smart one, buys the (equivalent of the) index at the lowest point each year. He invests Rs 33 lakh (Rs 1 lakh * 33 years) till 2018 at the lowest point of the year. Since 2019 is ongoing, we have ignored this year’s investment from our calculation.
Mr Chatur's portfolio, considering the Sensex's September 27 closing price of 38,822, would have grown to Rs 6.55 crore. This translates into a rate of return of 14.16 percent.
What about Mr Bhola, who has a particular talent of picking out the worst time to invest every year? Not bad, all things considered. Over the past 33 years, his Rs 33 lakh investment is now valued at Rs 4.11 crore, or an internal rate of return of 12.18 percent.
Not too dumb, eh?
The above simulation ignores the investing method, which relies on generating alpha, or above-market-returns, through picking stocks that will outperform the market.
It merely looks at what would happen if an investor, who does not have the time, skill or inclination to do active stock picking, tries to derive additional returns through timing the market.
The outcome? While Mr Chatur does outperform Mr Bhola, the gap is not huge – only about 2 percentage points.
Astute investors would argue that a difference of 2 percentage points translates into a big difference if you account for compounding over a long period.
But it must be kept in mind that we have simulated an exercise that is virtually impossible to consistently undertake year after year – one of timing the lowest and highest points of the market.
In other words, if your investing strategy relies on trying to time the market, history suggests that it may be a futile exercise as any excess returns you will make by getting your timing right will be small. And that even the dumb investor, as our example shows, is able to make a healthy return.
What’s better, instead of trying to achieve the impossible task of timing the market’s lowest point every year, you could have simply invested a single amount 33 years ago and let it be.
How would that buy-and-hold strategy in the Sensex have fared? Over the same period under consideration, the investor would have clocked a healthy compounded annual growth rate of 13.45 percent. Minus the effort of having to track and interpret where the market is.