With volatility on the upswing and valuations still near the higher end of their historic ranges, many have begun asking whether now a good time to invest. But investors are also concerned that the downdraft experienced by most of the big equity indices in the first few trading sessions of the New Year might be heralding a bear market. So the question is: Invest or stay on the sidelines?
To be very clear, I have no idea whether a correction is on the way. Equity valuations are high, but are nowhere near where they were in 2000 and 2007. Also, when you compare the valuations of equities to the risk-reward profile of other asset classes, the higher valuations may be partially justified. Considering that, barring something completely unforeseen, I wouldn’t expect a repeat of 2008.
The calculated risk
Whenever I make any investment decision, it is about taking a calculated risk. Whether it is choosing a particular investment or deciding when to buy sell, it is important to understand the odds you face, and the probability of your choice being successful.
There are two things that I always look at when evaluating an investment’s suitability for an investor – their risk tolerance and time horizon. In my opinion, it is tough to separate these two, as more often than not, they are quite related. The main reason for that is any investment may be very unpredictable over a shorter period of time, whereas returns have tended to be fairly consistent over longer periods.
Over all time periods, the average annualized return an investor would have earned was 9.3%. But as you can see, the range of returns varies greatly depending on the length of time a person was invested. For rolling one-year periods, the best return was 87% and the worst was -40%. That is a range of more than 126 percentage points.
Looking at longer holding periods, we can see that the range of annualized returns tends to move more towards the average. At the five-year holding period, the best return was 28% and the worst was -2%, for a range of 30 percentage points. Going out to the 20-year holding period, the range of potential returns is quite small, at only 5.4 percentage points, with the same average annualized return.
In fact, if an investor had been able to hold their investment for at least six years, they would have made money in every case. Even an investor who bought in October 2007, just before the financial world started falling apart in 2008, would have realized an annualized gain of 3%.
Time in the market
The point of this is that if you have a reasonably long time horizon, it is more important that you in fact be invested rather than trying to time your investment.
To demonstrate, let’s go back to the 2007-08 period. The market peaked in May 2008. If you had been invested at that time, and had held your investment to the end of January 2015, a $10,000 investment would be worth $12,165, working out to an annualized gain of 3%.
Now, let’s assume you timed it perfectly, selling out at the peak in May 2008, and buying back in February 2009, the market trough. Your $10,000 investment would be worth more than $21,470, an annualized gain of more than 12%. I remember February 2009. The mood was dismal, and nobody wanted to invest in equities. It would have taken extreme courage and conviction to buy back in, not to mention incredible luck in perfectly picking the bottom.
But the reality is nobody can perfectly pick the perfect time to sell and the perfect time to buy back in. Most people have a tendency to sell out at or near the bottom, and then wait far too long to buy back in. If you had sold out in February 2009, as many did, and then waited until early 2010 to get back into the markets, your initial $10,000 investment would now be worth $8,241, or an annualized loss of nearly 3%.
Bottom line
Timing the market is an extremely difficult thing to do. There are very few, if any, who can do it perfectly all the time. The consequences of getting it wrong are often much worse than if you were to take a more buy-and-hold approach, assuming you have a time horizon of at least seven years. In the overwhelming majority of cases, it is more prudent to buy and hold a portfolio of quality investments rather than trying to perfectly pick the top or bottom of a market cycle. In other words, it is more about “time in the markets” than “timing the markets.”
Courtesy Fundata Canada Inc. © 2016. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.
