It’s Impossible to be in the Market when it is Rising and out of it when it is Falling

Today I received an email from someone who maintains it is impossible to be in the market when it is rising and out of it when it is falling. I was investing this way for several years. I also entered the market in March 2003 using my indicators.

I requested more information and received a more detailed explanation of why the sender thought this was so.

This is the email I received to support the statement above. The email contents are in italics and I respond to each paragraph. I want to thank the writer for taking the time to give me their justification so I could respond. I’m happy to keep this discussion going so please all join in if you want to add (or subtract) from what has been said.

In the 10 years to 31 March 2008, the ASX accumulation index returned 11.41% compound rate of return. This period of time includes the most recent route on markets as well as the bleak period prior to March 2003 when the market hit its bottom.

First using average returns tells us nothing about what really happened to our nest egg during that period. If the first few years were negative and the last few years were very positive to give the 11.41% average return then the nest egg would have been seriously eroded in the early years and may not have recovered yet, only to be hit with a 14.3% drop up to March 2008.

Here is an interesting article by Scott Frances on the Alan Kohler Eureka Report Web site (It is worth a look) called Big-name Funds Disappoint which was written before the market dropped. My point with this article is that most funds do not give us market returns so 11.41% is not what we can expect from our WRAP account, although I have used it below to make my point.

Look at the two tables below where I have tried to show the results of using average return vs. real absolute returns. I have also included real inflation results. I have used a fee of 2% as I believe this is typical when including all fees and charges in Australia for a WRAP account invested in Managed Funds. (My WRAP Fees were 2.24%)

Table using Average Returns and Average Inflation

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Table Showing Real Annual Returns and Real Annual Inflation

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I only show 8 years because I am using a spreadsheet that I used to show what would happen if you retired in 2000. There is no doubt the Australian stock market performed much better in 2000-2003 than the S&P500. But using real returns you can see the combined effect of stock market losses, fees and a pension had on your nest egg by the end of 2003. It needed a return of 52.81% to get back your capital in 2004 by my calculations. At the end of 2007 you still had to make up 11.26% to recover your capital. Whereas using your average returns you are supposedly 12.89% in profit. This demonstrates the danger of using averages when planning your retirement. It is seriously flawed.

Even with the excellent returns from 2004-2007 you still need 11.26% to get back your capital. Being only 8 years into retirement it is important to try and maintain your capital.

Note the second table is titled going into CASH. But in Australia the index did not drop below 10% so you would have stayed in the market.

The email goes on to say:

Had an investor missed just 5 of the best days on the market this return would drop to 9.13%. On a compound basis this is actually a huge differential in return. Mathematically, if you missed the 5 best trading days over that 10 year period, your ultimate return would be 30% inferior to what it would have been. Who is to know when these 5 best days will occur? Interestingly enough they invariably occur very close to when things seem to be at their worst.

Amazingly, if an investor missed the 30 best days, the return would drop to just 2.86%.

Missing the 5 or 10 best days is a marketing tactic put out by the fund management industry. I have seen it on many web sites. It’s a scare tactic aimed at our fear of missing out. it’s also in hindsight and should not be used as a justification for Buy and Hold.

But I agree with this math. There is however an equal argument about if I’d had missed the 5 worse days in the market and which actually yields better returns. See this article on Timing the Market. Unfortunately I only have information on the S&P 500. But to be fair lets agree I missed both the 10 best days and the 10 worst days on the S&P 500 between 1997 and 2006 for which I have the data. Then according to this article instead of a return using Buy and Hold of 14% per annum I would have got 17% per annum. I’d have done better still if I only excluded the 10 worse trading days. The article is more about trading than investing but it makes the point.

If you read my article on A Secret Simple Stock Market Timing System you would note that the writer there used data from 1972 to 2005 and invested in broad based publicly traded indices like,

Standard and Poor’s 500 Index (S&P 500),

Morgan Stanley Capital International Developed Markets Index (MSCI EAFE),

Goldman Sachs Commodity Index (GSCI),

National Association of Real Estate Investment Trusts Index (NAREIT),

United States Government 10-Year Treasury Bonds.

These are very conservative indices. They were not trying to pick stocks and they were certainly not trading. They were not trying to time the market in the way you imply either. They use a simple moving average and buy and sell as the index crosses above or below it. The SMA is not optimized nor is curve-fitting being done.

By the way, there are many other factors to consider such as buy/sell spreads, brokerage and other transaction costs, capital gains tax etc, etc. Even if were to make a correct call, which I repeat is impossible on a consistent basis, there is still going to be a cost to your actions.

You will also note in the practical considerations on page 9 of the report:

“Commissions should be a near negligible factor due to the low turnover of the models. On average, the investor would be making 3-4 round trip trades per year for the entire portfolio, and less than one round-trip trade per asset class per year. Slippage likewise should be near negligible, as there are numerous mutual funds (0 slippage) as well as liquid ETFs an investor can choose from.”

Is it investing or is it gambling?

What you are propagating is not investing, it is gambling. There has been a huge amount of research produced which shows that attempting to time the market is a mugs game. Shares like property are long term assets and need to be held for the long term for that reason.

First I do not advocate investing in individual shares in retirement. I believe that is gambling. Publicly trading index funds or ETFs are more appropriate. If the index or ETF continues to stay above its simple moving average then it will be kept. If it falls below it it will be sold and the profit or loss taken. As previously stated the system only traded 3-4 times a year if that.

When you invest with a plan that tells you when to enter or exit a market it is not gambling. As long as the investment continues to provide a profit you invest. When it starts to cost you money you exit. This is a rational thing to do after giving it a reasonable chance to recover. The simple moving average does that in this system. It makes no sense to watch an investment grow into a large loss and just wait and hope it will come back. The market is telling you you are wrong so get out.

What do you think the Mutual Funds are doing with your money? They are trading stocks like crazy trying to get better returns. This is definitely gambling. These days their turnover rate can be 106% which means they are turning over the stocks in the fund completely within a year. This is why they want you to buy and hold. They need the stability of the money supply to keep trading. You are then up for any capital gains tax as well as all the brokerage. Unfortunately this is often hidden because the funds deduct their fees before you see the returns.

Maybe this article on the Top 3 Stock Market Myths will help clarify things. We have an unprecedented Bull market since 1983. But before that it was virtually flat for 16 years.

The Sydney property market has been flat for 4 years. Should people have sold their investment properties four years ago?

I don’t follow the property market. But from time to time it may well be appropriate to sell investment property. Many retirees in Australia invested in property for their retirement and got caught in the buying frenzy paying too much for investment properties and can’t sell it now without taking a big loss.

I’m sure many property investors in the US and UK wish they had sold before house prices tumbled because of the sub prime crisis.

Using a simple moving average it is possible to be in a market when it is rising and out of it when it is falling. How much profit is made will be determined by how long you are in the market and how much it rises. But that’s not the point. You need to be able to exit the market when it drops below your chosen threshold and be in cash until it turns again. You must avoid large losses. Even small losses are too hard to make up when you have inflation at 3%, fees of 2% and you are paying yourself 4%. The market has to return 9% in real terms for you to maintain your capital. Even a small loss of 5 to 7% in any one year will add to that 9% taking you down by 14-17%. This is what can destroy your nest egg over time.

One Response to “It’s Impossible to be in the Market when it is Rising and out of it when it is Falling”

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